Allocate Payments Clearly to Minimize Construction Disputes

Originally published as “OP-ED: Allocate payments clearly to minimize construction disputes” by the Daily Journal of Commerce on July 16, 2020.

Construction contracts typically provide for contractors to be paid in installments as certain percentages of the work become complete or as certain milestones are met. Ideally, the contractor performs a portion of the work as provided for in the contract, and the owner pays the contractor an installment payment for that portion of the work. The parties continue in this manner until the work is finished. In reality, when projects span months and years, things don’t always go so smoothly.

Often, a contractor’s scope of work for a project expands to include change orders or extra work, or the owner and contractor may execute an additional contract for a different scope of work than what was covered in their original agreement. As work progresses simultaneously on each piece of the project, the contractor might send multiple invoices for the different scopes. If the invoices are clearly labeled to reference each specific change order or contract under which the work was performed, and if the owner timely disburses specific payments with instructions regarding how each payment should be allocated, the parties may continue to work together amicably.

Disputes may arise, however, if invoices are not clearly labeled, or the owner issues a lump sum payment in response to multiple invoices without instructions regarding how to allocate the funds. Disputes are especially common when lump sum payments are not sufficient to cover all of the 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 where litigation ensues.

If you find yourself in a situation where it is unclear how payments are to be allocated, check your contract first to see if it provides any guidance. If not, your state may have general debtor/creditor laws that may 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 the 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 the contractor specifies the work to which payment is to be allocated, the owner should issue checks in that manner. However, if the contractor does not specify how payment is to be allocated, the owner may choose how to allocate payment, as long as the payment is made within a reasonable timeframe. Finally, if neither the contractor nor the owner specifies how payment is to be allocated, payment should be applied as follows:

1. interest due;
2. principal due;
3. the obligation earliest in date of maturity;
4. an obligation not secured by a lien or collateral undertaking; or
5. an obligation secured by a lien or collateral undertaking.

Notwithstanding general laws, like the one above, circumstances surrounding payment allocations can create 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 the contract exists between the prime contractor and subcontractor (instead of just between the contractor and owner). When neither party specifies 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 the advice of counsel.

Although it may require extra effort in the short run, keeping an open dialogue with the other party may prevent additional headaches and expense in the long run. If you’re not sure what invoice to pay first, or how to apply a lump sum payment from an owner, call the other party and confirm the result of the conversation in writing. This process should help avoid extended disputes and will, in cases of unavoidable litigation, help you track how money was allocated. For an owner, these practices will help avoid claims by a contractor that it was not paid for certain work. For a contractor, these efforts may prevent potential claims or defenses by an owner that the contractor was already paid for certain work.