Are Payment Bonds, a Construction Security Escrow Account, Irrevocable Letters of Credit,

Most Contractors, Subcontractors and Suppliers are aware that - because Mechanics Liens are not recordable against public properties - California Law mandates that all prime contracts for government construction projects or “public works” construction projects by the State or by other government entities or political subdivisions in the State must require that the prime contractor post a Payment Bond on the project, to secure payment to subcontractors and suppliers, in the event that the prime contractor becomes insolvent, bankrupt or goes out of business, etc.

These are usually coupled with Performance Bonds for the benefit of the contracting public entity, to assure or to secure performance of the Public Works project by the prime contractor in the event it defaults or fails or refuses to complete the construction project..

If the State or other public entity fails to require the prime contractor to post such payment bond, or fails to follow up on that requirement, then the public entity itself can become directly liable to the subcontractors or suppliers etc., in the event that the prime contractor fails to or can’t pay them.

However, under a law which appears to be unique to California (Civil Code §§ 8700 et seq.), there are some circumstances where the Owner of the private property on which a private construction project is being performed must post a Payment Bond or other security to pay the general contractor - but not necessarily subcontractors and suppliers- in the event that the wner becomes insolvent or bankrupt, or when there otherwise may be an inability to effectively recover on a Mechanics Lien against the property, such as where there are prior or superior liens against the property, including prior liens or construction loans or little Owner net equity in the property..

Thus, where the construction contract with the property Owner exceeds $5,000,000, or where the prime contract is over $1,000,000 and the contract is with a short-term leasee or other person who is not the Owner of the property, a Payment Bond or other security must be posted for at least 15% to 25% of the value of the prime contract, depending on the expected length of the project.

The security may be a normal construction Payment Bond from a surety or insurance company, a bank letter of credit, or a construction escrow account.

A payment bond must satisfy all of the following requirements:

“(a) The bond shall be executed by an admitted surety insurer that is either listed in the Department of the Treasury's Listing of Approved Sureties . . .
(b) The bond shall be in an amount not less than 15 percent of the contract price for the work of improvement or, if the work of improvement is to be substantially completed within six months after the commencement of work, not less than 25 percent of the contract price. (c) The bond shall be conditioned for payment on default by the Owner of any undisputed amount pursuant to the contract that is due and payable for more than 30 days.”

Civil Code § 8722.

The Prime Contractor may request a copy of the security for payment under this statute, as well as a certified copy of the Construction Loan mortgage or deed of trust.

If the Owner fails to provide the bond or other security for payments under the prime contract or the Construction Loan documents within 10 days from a written demand from the general contractor, the general contractor may legally suspend work on the project, without penalty, despite contrary provisions in the prime contract.

“If an Owner fails to provide or maintain the security required by this chapter, the direct contractor may give the Owner notice demanding security. . .. If the Owner does not provide or maintain the security within 10 days after notice demanding security is given, the direct contractor may suspend work until the Owner provides or maintains the security.” (Emphasis added).

Civil Code § 8712.

The law also provides that the prime contractor’s rights under this law may NOT be waived or forfeited by the terms of a contract.

Failure of the Owner to pay per the contractor for more than 30 days allows the contractor to proceed directly against the payment bond or other payment security.

However, these security requirements do NOT apply to the construction of a single family home, to work requiring an “A” engineering contractors license, to residential housing projects entitled to a density bonus under Gov. Code § 65915, or where the project Owner is an “investment grade” company publicly traded on a U.S. stock exchange.

If the security posted is an escrow account, or a “construction security escrow account”, the Owner is required to deposit with a licensed escrow agent a cash amount in the same amount as required for the bond, above, or the total amount remaining on the prime contract, which ever is less.

Also, retention payments owed to the contractor and deducted from progress payments must also be deposited into the escrow account, pending completion of the work.

The prime contractor is granted a perfected first priority security interest in the escrow account, which can be enforced by the prime contractor in a legal action, as can presumably claims on the Payment Bond or Letter of Credit.

Separately from the provisions of this statute requiring the posting of security on a private construction project by the Owner of the property, under a separate statute (Civil Code §§ 8600 et seq.) an Owner may voluntarily post or record - or the Construction Lender may require - a Payment Bond in connection with the property in the amount of 50% of the amount of the prime contract.

The posting of such a payment bond may restrict the amount of Mechanics Liens which can be recorded against the property.

This type of Payment Bond exists for the benefit of all who provided work on the project, including subcontractors and suppliers, but those second tier businesses must have timely served a valid Preliminary Notice or have served a Payment Bond claim notice similar to the Public Works Payment Bond Claim Notice required on Public Works Construction projects.