OP-ED: Allocate payments clearly to avert construction disputes

Construction contracts typically allow contractors to be paid in installments as certain percentages of their work is completed or as certain milestones are met.

Ideally, contractors perform part of the work called for in a contract and then receive an installment payment from the owner for that particular part of the work. The parties continue in this manner until a job is finished.

In reality, though, things don’t always go so smoothly. That’s especially true for projects lasting months or even years.

Often, a contractor’s scope of work for a project extends to include change orders or extra work. Owner and contractors can also execute additional contracts for a scope of work that’s different from what was covered in their original agreement.

As work progresses on the various parts of a project, contractors might send in invoices for different scopes. If the invoices are labeled clearly to reference specific change orders or contracts under which work was performed, and if the owner disburses specific payments in a timely manner with instructions regarding how payments should be allocated, the parties may continue to work together amicably.

Disputes can arise, however, if the invoices are not clearly labeled, or if the owner issues a lump-sum payment in response to invoices without providing instructions on how the money should be allocated. Disputes are especially common when lump-sum payments are not sufficient to cover all outstanding invoices. Owners may claim they already paid for certain work, and contractors may claim they were not paid for certain work. The relationship may sour to the point at which litigation ensues.

If a business owner finds it unclear how payments are to be allocated, check the contract first to see if it provides any guidance. If not, the state may have general debtor and creditor laws that govern the situation.

For instance, in California, Civil Code section 1479 generally dictates how payments are to be allocated between a creditor and debtor when there are several debts to be satisfied. If a contractor intends that its “performance should be applied to the extinction of any particular obligation,” and that intention is “manifested to the creditor (owner),” the owner must apply it to that particular obligation. In other words, if a contractor specifies the work to which payment is to be allocated, the owner should issue checks in that manner.

However, if a contractor does not specify how a payment is to be allocated, the owner may choose how, as long as the payment is made within a reasonable time frame. Finally, if neither the contractor nor the owner specifies how a payment is to be allocated, it should be applied as:

• interest due;
• principal due;
• the obligation earliest in date of maturity;
• an obligation not secured by a lien or collateral undertaking; or
• an obligation secured by a lien or collateral undertaking.

Notwithstanding general laws, like the ones mentioned above, circumstances surrounding payment allocations can give rise to legal complexities. For example, the rules become more complex when joint checks are issued (i.e., a check to be shared by a subcontractor and its materialmen), when multiple projects are involved, or when a contract exists between a prime contractor and subcontractor (instead of just between a contractor and an owner). When neither party has specified how payments are to be allocated, or when payment has been made in a manner in which allocation is unclear, disputes can be riddled with legal pitfalls, necessitating legal advice.

Although it may require additional effort in the short run, keeping an open dialogue with the other party may prevent additional headaches and expense in the long run. A business owner not sure which invoice to pay first, or how to apply a lump-sum payment from an owner, should call the other party and confirm the result of the conversation in writing. This should help avoid extended disputes and will, in cases of unavoidable litigation, help you keep track how money was allocated. For an owner, these practices will help prevent contractors from being able to make claims that they were not paid for certain work. For contractors, it may prevent owners that a contractor was already paid for certain work.

Nicholas Karkazis is an attorney in Stoel Rives’ construction and design and litigation practice groups. Contact him at 916-759-9189 or [email protected]