Credit: Scott Blake | Unsplash
Introduction
California’s construction industry is booming. Approximately 15% of construction activity within the U.S. is concentrated in California. Before beginning any new construction project in California, contractors must ensure that they are properly licensed for the scope of work. Under current state law, project owners may recoup compensation paid to a contractor if that contractor is not properly licensed during any phase of the project, i.e., the contractor must disgorge all amounts paid for the construction work even if the contractor was unlicensed for only part of the work. As discussed below, recent California Court of Appeal decisions have established various rules that impact litigation regarding disgorgement claims that construction industry professionals and project owners should know.
What is Disgorgement?
Under California law, contractors must be licensed by the Contractors State License Board (“CSLB”) before the contractor begins any work of over $500 on a project and at all times thereafter during the project. The CSLB aims to protect California consumers by raising construction standards through state regulation and licensing. The California Business and Professions Code (“B&P”) defines “contractor” as anyone who undertakes or offers to undertake a project to construct, alter, repair, improve, or demolish any building, roadway, excavation, or development. “Contractors” also include any subcontractor or specialty contractor.
Contracting without a proper license may expose contractors to serious legal consequences, including criminal liabilities. First-time offenders are subject to a $5,000 fine and possible jail time. Second-time offenders must serve a 90-day jail sentence and pay a fine equal to 20% of the contract price.
Additionally, under B&P section 7031(a), contractors are barred from suing project owners to recover payment for work they have already completed if they were not duly licensed during any stage of the performance. And, unlicensed contractors are subject to disgorgement of all amounts paid by an owner for unlicensed work. B&P section 7031(b) provides that a person who utilizes the services of an unlicensed contractor may bring an action to recover all compensation paid to the unlicensed contractor for the performance of any work or contract. This is known as a disgorgement claim, a remedy requiring a party to repay all amounts obtained through illegal or wrongful acts. It applies even if the owner knows when hiring the contractor that contractor is unlicensed.
Although disgorgement is a one-sided remedy, B&P section 7031 does provide a defense for unlicensed contractors. Under B&P section 7031(e), unlicensed contractors may evoke a “substantial compliance” defense against B&P section 7031(a) and section 7031(b) claims. A court may determine substantial compliance with licensure requirements only if the contractor establishes that (1) the contractor had been licensed as a contractor in California prior to the performance, (2) the contractor acted reasonably and in good faith to maintain proper licensure, and (3) the contractor acted promptly and in good faith to remedy the failure to comply with state licensure requirements upon learning of the failure. The defense fails if any one of these elements is not satisfied.
B&P section 7031(b) is not comprehensive, and recent case law has answered questions regarding B&P section 7031(b) disgorgement actions, such as whether a subcontractor must be licensed when the upper-tier contractor is already licensed for the work, and what is the applicable statute of limitations period for disgorgement claims.
Disgorgement Claims Under B&P Section 7031(a)
B&P section 7031(a) and section 7031(b) establish harsh penalties barring unlicensed contractors from recouping compensation for completed work and require disgorgement of payment for all work when the contractor was unlicensed for part of it. However, what happens when a licensed contractor hires an unlicensed subcontractor to complete work on a project that the contractor is licensed to complete?
The Court answered this question in Kim v. TWA Construction, Inc. (2022) 78 Cal.App.5th 808 . In Kim v. TWA, the Sixth District Court of Appeal barred a licensed general contractor from recovering compensation from an owner for work completed by an unlicensed subcontractor and ordering disgorgement of funds paid for unlicensed work—even though the contractor was duly licensed to complete the work.
In this case, Kim hired TWA Construction, Inc. (“TWA”) to construct a home in Los Gatos, California for more than $1.5 million. The construction project included removal of a eucalyptus tree straddling the property line between Kim’s property and the property of Todd, Kim’s neighbor. TWA secured necessary permits to remove the trees, and hired an individual subcontractor (“Hoffman”) to perform the tree-removal work. Hoffman was not licensed to perform the tree-removal work.
After Hoffman began removing the tree, Todd demanded that Hoffman’s workers stop and then Todd contacted the police. Kim subsequently terminated the contract with TWA because Kim could not secure a construction loan using TWA as the contractor. Todd sued Kim and TWA for trespass, negligence, and damage related to work on the eucalyptus tree. Kim then filed a cross-complaint against TWA for comparative negligence and equitable indemnity among other claims. TWA filed a cross-complaint against Kim alleging a breach of contract. Todd eventually settled with Kim and TWA.
Before the trial on the remaining claims began, Kim filed a motion in limine seeking an offer of proof from TWA as to whether Hoffman had a valid license. Kim contended that B&P section 7031(b) requires that TWA disgorge $10,000 Kim paid for the tree-removal work if it was performed by an unlicensed subcontractor. The trial court ruled that B&P section 7031(a) barred TWA from “collecting compensation for services performed by the subcontractor for the tree trimming, if, in fact, the subcontractor was unlicensed at the relevant time.” Following trial, the trial court entered judgment in favor of Kim and ordered TWA to disgorge the $10,000 Kim paid for the unlicensed tree-removal work. The court also awarded Kim $137,921 in attorney fees, $22,505.16 in expert witness fees, and $18,196 for their contributory negligence and indemnity claims.
TWA appealed the trial court’s ruling, arguing that the trial court erred as a matter of law by applying B&P section 7031 to its pretrial ruling and that the ruling caused TWA to forfeit its claim for compensation from Kim for the value of the tree work. The Appellate Court rejected TWA’s argument, emphasizing that “[t]he purpose of the licensing law is to protect the public from incompetence and dishonesty in those who provide…construction services.”
The Court reasoned that permitting a contractor to recover compensation for the performance of unlicensed work, “simply because the work was accomplished by hiring a subcontractor, would circumvent the purpose of B&P section 7031 and render meaningless the B&P section 7031 expansive definition of contractor to include work performed ‘by or through others.’” The Court ultimately affirmed the trial court’s ruling and held that B&P section 7031 “bars even a licensed general contractor in California from bringing an action for compensation for an act or contract performed by an unlicensed subcontractor where a license is required.” Therefore, the Court held that TWA must disgorge all payments by Kim for the unlicensed tree-removal work.
As highlighted by this decision, a contractor’s failure to hire a subcontractor who is duly licensed for its scope of work can be a costly mistake that could be discovered after project completion. Thus, as discussed below, it is not only important for contractors to understand the scope of a contractor’s disgorgement liability, but it is also important to understand how long a contractor is subject to disgorgement claims under B&P section 7031.
The One Year Statute of Limitations for Disgorgement Claims Under B&P section 7031(b) After Eisenberg v. Suffolk
Eisenberg Village v. Suffolk Construction (2020) 53 Cal.App.5th 1201 presented two issues of first impression for the California Court of Appeal regarding disgorgement claims under B&P section 7031(b). First, the Court needed to determine the applicable statute of limitations for B&P section 7031(b) disgorgement claims. Then, the Court had to decide when these claims began to accrue. In short, the Court held that a one-year limitation applies and that the statutory period begins to accrue upon completion of the construction work or when the contractor ceases work on the project.
This case involved a dispute between the Eisenberg Village of the Los Angeles Jewish Home for the Aging (“Eisenberg”) and Suffolk Construction Company, Inc. (“Suffolk”). In 2007, Eisenberg contracted with Suffolk to build a 108-unit, assisted-living facility. Upon completion of the project in 2010, numerous issues arose at the facility. Suffolk worked on repairing these issues until 2014. Once Suffolk completed the repairs, Eisenberg began investigating claims against Suffolk.
Under California law, contractor entities must qualify for a license through a qualifier. A qualifier may be a responsible managing officer or a responsible managing employee (“RME”). The RME must have construction experience and be actively engaged in supervising the project. Under B&P section 7068.2(a), a contractor’s failure to employ a bona fide RME automatically suspends the contractor’s license. In 2014, Eisenberg discovered that Suffolk’s RME had transferred to Suffolk’s Boston office in the latter half of 2008. Eisenberg alleged that Suffolk’s RME did not exercise direct supervision over the project upon transferring, and therefore Suffolk was not duly licensed as a contractor at all times during the project. In May 2015, five years after the completion of the project, Eisenberg filed a B&P section 7031(b) disgorgement claim against Suffolk to recoup all payments made to Suffolk for its work on the project.
Suffolk sought to dismiss the disgorgement claim, asserting that Eisenberg’s claim was barred by a one-year statute of limitation. Eisenberg argued that its claim did not accrue until 2014 when its lawyer discovered the licensing issue. Eisenberg further argued that a four-year or a three-year statute should apply because a B&P section 7031(b) claim is equivalent to a restitution claim under unfair competition law.
The Court rejected Eisenberg’s arguments. The Court examined the California Supreme Court’s definition of penalty as a “recovery without reference to the actual damage sustained.” The
Court reasoned that the fact a contractor is unlicensed cannot, by itself, cause a plaintiff harm. The Court held that disgorgement falls within the Supreme Court’s definition of “penalty” because it deprives the contractor of any compensation for labor and equipment used in the construction while allowing the plaintiff to enjoy continued benefits of the completed work. Since the Supreme Court’s definition of penalty does not require the plaintiff sustain any actual damage, the Court concluded that a one-year statute of limitation shall apply to all disgorgement claims under B&P section 7031(b).
Turning to the issue of when a disgorgement claim accrues, the Court acknowledged that a cause of action typically accrues when it is “complete with all of its elements.” The Court refused to apply the discovery rule because it generally applies only if it is particularly difficult for a plaintiff to understand a breach of duty, or when the breach itself is hidden. The Court held that the discovery rule should not be applied to B&P section 7031(b) claims because these claims do not require any injury to the plaintiff, and it would lead to absurd results since plaintiffs could assert claims without a time limit. Therefore, the Court further held that a B&P section 7031(b) claim accrues once an unlicensed contractor completes or ceases performing the contract at issue. Applying this rule, the Court found that Eisenberg’s claim accrued once it amended its original complaint to include Suffolk as a defendant in March 2014. Since Eisenberg did not assert its B&P section 7031(b) claim until May 2015, the Court held that Eisenberg’s claim was untimely.
More recently, the First District Court of Appeal agreed with the Eisenberg Court and applied the one-year statute of limitation to a B&P section 7031(b) claim in S.F. CDC LLC v. Webcor Construction L.P. (2021) 62 Cal. App. 5th 266. In this case, S.F. CDC filed a disgorgement claim against Webcor more than eight years after Webcor had completed construction of the plaintiff-appellant’s InterContinental Hotel. The Court held that S.F. CDC’s claims accrued after the hotel was completed and final payment was made to Webcor, regardless of whether the doctrines of equitable estoppel or delayed discovery applied. The Court further held that the parties’ tolling agreement and the pendency of a defect action did not extend the limitations period, reasoning that these events occurred long after the statute of limitations expired.
Practical Guidance
In light of these recent decisions, those seeking to file a B&P section 7031(b) disgorgement claim must act promptly. California courts have stood firm on the accrual rule established in Eisenberg and have refused to apply the discovery rule to B&P section 7031(b) claims. Thus, project owners and developers should investigate licensure issues within one year of completion or of contractor’s leaving the project or risk the claim being barred by the statute of limitations.
On the other hand, contractors and their counsel should be aware of the statute of limitations defense established by Eisenberg and be sure to raise it against disgorgement claims. Also, contractors and their counsel should raise the substantial completion defense under B&P section 7031(e) against disgorgement claims when applicable.
Moreover, in light of Kim v. TWA, to guard against loss of right to be paid and against disgorgement, general contractors must verify that their subcontractors are licensed for the scope of their work at all times during the performance of such work. General contractors should thoroughly investigate prospective subcontractors, and require subcontractors to submit updated proof of licensure with each payment application.
In sum, while the time to bring a disgorgement claim under B&P section 7031 may be relatively short, the risks of a licensure mistake can be immense. Thus, questions about the law regarding licenses and disgorgement claims should be directed to counsel with experience in construction licensing issues.
*The views expressed in this article do not represent the views of Santa Clara University.