Yes, owners, construction managers and architects need to be careful to assure compliance with the requirements of the prompt pay act to avoid problems and lawsuits on construction projects.

The private sector Prompt Payment Act for construction projects has not necessarily resulted in prompt payments to contractors, subcontractors, and material suppliers since its enactment in 2000. After all:

An owner may decline to approve and certify a billing or estimate or portion of a billing or estimate for unsatisfactory job progress, defective construction work or materials not remedied, disputed work or materials, failure to comply with other material provisions of the construction contract, third-party claims filed or reasonable evidence that a claim will be filed, failure of the contractor or a subcontractor to make timely payments for labor, equipment and materials, damage to the owner, reasonable evidence that the construction contract cannot be completed for the unpaid balance of the construction contract sum or a reasonable amount for retention. A.R.S. 32 1129.01.D.

These reasons for an owner not to approve or certify a billing, along with the effect of pay when paid or pay if paid clauses in contracts, often prevent payments from being prompt on construction projects.

Due to Stonecreek Building Company, Inc. v. Shure (162 P.3d 675, Ct. App. 2007), owners and construction managers designated by owners will need to carefully document decisions to delay payments on construction projects or will find themselves paying interest at the rate of 1.5 percent a month (or fraction of a month) on the unpaid balances (or more if the parties agree to higher rates in the contracts). The Stonecreek case will require greater specificity in payment denials to escape the 1.5 percent per month penalties for slow payments.

What happened in the Stonecreek case? The owners, Shure and Hecker hired Stonecreek Building Company to build a custom house. The owners complained during construction of defective workmanship, especially the masonry work. The contractor told the owner that the masonry subcontractor would not be paid until the masonry was fixed so the owners kept making payments.

Finally, the owners had their lawyer write to the contractor complaining about the masonry work and the heating, ventilation, and air conditioning system ("HVAC"). Two days after the letter by the lawyer, the owners received Pay Application Number 8 for $122,447.00 for different aspects of the work, but not for masonry work. The architect approved the Pay Application in the amount of $122,447.00. The owners withheld payment of $100,000.00 of the bill because of complaints about the masonry work and the HVAC system. So the contractor quit working and the owners terminated the contract for alleged failures to remedy construction deficiencies. Naturally, the parties then sued each other. The contractor, Stonecreek, said the owners violated the Private Prompt Payment Act by withholding payment for work not listed in the unpaid invoice. Stonecreek argued that the invoice was approved because it was certified by the architect and "deemed approved" because the owners failed to file a timely written objection.

The trial court said that the letter complaining about the work was a sufficient and timely written objection under the statute, even though it was written and delivered two days before the invoice was received. The court also found, however, that the invoice which was disputed did not include the disputed masonry work. The court said that "an owner can withhold payment only to the extent that it disapproves work included in the invoice." So the court let the owners withhold $26,781.00 for the disputed HVAC work because the HVAC work on the invoice might have been the same as the HVAC work objected to by the owners in their attorney's letter.

Because the masonry work was not included in the invoice that was not paid, the court awarded Stonecreek $73,219.00 under the Private Prompt Pay Act.

The Court of Appeals went back to basics and reminded us that A.R.S. 32 1129-1129.06 require owners to pay progress payments to contractors "on the basis of a duly certified and approved billing or estimate of the work performed and the materials supplied during the preceding thirty day billing cycle." The payments must be made within seven (7) days after the date the billing or estimate is approved or certified.

The owners argued that they were entitled to withhold payments for work that was not included on the specific billing statement. The Private Prompt Pay Act, A.R.S. 32-1129.01(E), says that an owner "may withhold from a progress payment only an amount that is sufficient to pay the direct expenses the owner reasonably expects to incur to correct any items set forth in writing" in the objection to the invoice. Thus, the owner said it could withhold funds for "any items" in its written objection whether or not the items were in the specific bill.

The problem for the owners in the Stonecreek case was that the statute says that the owner needs to send a written statement "detailing those items in the billing" that are denied. Thus, the approval or disapproval has to be related to work covered in the particular invoice.

The Court of Appeals thought about it and said that the main reason for the Private Prompt Pay Act was to make sure of timely payments from the owner to the contractor and then down the line to the subcontractors, suppliers and others whose work was approved. The Court said that if the owner could object on a later billing and withhold payment for amounts previously approved, the time limits of the Private Construction Prompt Pay Act would be meaningless.

Of course, the owner said that defects in workmanship may not be discoverable until after the progress payment was made. The owners thought they should be able to withhold progress payments after a defect is found that was covered by prior billings. The Court said that the owner could always sue later for latent defects and problems that were discovered later. The Court found that an important purpose of the Private Prompt Pay Act was to require owners to disapprove items needing correction early so that contractors could fix them and receive prompt payment.

So if your company is the owner or the construction manager for the owner, you need to be careful to follow the provisions of the Arizona Private Prompt Pay Act to avoid liabilities. You need to make sure that a response is given to billing statements within 14 days after the owner receives the billing statement. The owner or the owner's construction manager or other agent needs to prepare and issue a written statement of the items in the invoice that are disapproved. While an owner can decline to approve and pay for items for a variety of reasons related to construction project disputes, the objection must relate to items contained in the billing statement to which objection is made.

Probably, the owner or the owner's construction manager should have contract language requiring that every pay application be substantiated and include backup documentation from all subcontractors and material suppliers about the work included in the invoice. If the owner or the owner's agent has any doubt about whether the work in the invoice should be approved, the owner should ask for additional information and documentation to assure that the invoice is proper and correct.

Internal policies and procedures need to be in place to make sure that nonpayment of invoices will only relate to the specific work billed for in the invoices. The problem of how to handle payments already made on prior invoices for work that later proves defective needs to be addressed by careful drafting of your construction contracts. Proper and legal retention arrangements may help. So will provisions requiring setoff and reimbursement to the owner in the event that defects or problems are discovered after payment has been made.

Contractual protections can be built into agreements to make sure that all parties to the construction process receive the performance and payment to which they are entitled. Without deliberate policies and procedures and careful contract drafting, the Private Prompt Pay Act on construction projects may be a minefield for the unwary.

If you have any questions regarding your construction contracts or compliance with the Arizona Private Construction Prompt Pay Act, please call me.

Michael R. King is a partner with the law firm of Gammage and Burnham which is a sponsor of the Phoenix CEO-CFO Group.
May 15, 2009 (602) 256-4405