As of July 1, 2007, construction in Kentucky should now be “fair.”  The Kentucky Governor followed several other states and signed into law the Kentucky Fairness in Construction Act, KRS 371.400 et seq. (“the Act”) to “level the playing field” between contractors and Owner.  While an ambitious effort, it remains to be seen whether this law will accomplish its objective.  Because there are many in Indiana interested by the sound of codified “fairness,” this article addresses the efforts by our neighbors to the south.

With narrow exceptions, the Act affects all construction in Kentucky.   In its broadest sense, the Act covers any building, altering, repairing, improving, or demolishing any structures or buildings, or other improvements of any kind to any real property.  The Act excludes, however, all residential project, maintenance, industrial processing work, and all USDA rural utilities services projects from this Construction Law.

The Act legislates six basic areas:  (1) Timing of Progress Payments; (2) Limits on Retainage; (3) No Damages For Delay Clauses; (4) Dispute Resolution; (5) Mechanics Liens; and (6) Attorneys’ fees.  Each will be discussed in turn.

  1. Prompt Payment.

Construction contracts regularly define when payment should occur and the amount of interest (if any) that will accrue absent timely payment.  Terms are not universal and sophisticated owners will commonly eliminate interest for late payments and (surprise) make their payments to prime contractors on a predictably dilatory schedule.  Prime contractors, in turn, reciprocate to subcontractors.

The Act attempts to eliminate this leverage by mandating “prompt payment” to all contractors.  Payments from Owners to Prime Contractors under the Act are due within 30 business days after “timely, properly completed, undisputed request for payment.”  A “business” day is not defined by the Act, but elsewhere in Kentucky law the term is defined as a business day as observed by the State Government.

Where payment is not timely, interest on unpaid amounts accrues at 12% per annum commencing on the 31st business day.  The right to interest carries an unusual notice requirement, however:  For the statute to apply (and interest to accrue), the Prime Contractor must provide Owner with written notice on the 25th business day indicating non-payment and pending statutory consequences.  The written notice must be sent via certified mail.  This is unusual because (1) it provides for “on” the 25th business day rather than the more flexible “on or before” the 25th business day, and (2) sending certified mail on the 25th business day might not accomplish actual notice will occur much later—possibly after the 30th business day.

The issue is compounded for Postsecondary Educational Institutions and Boards of Education.  Their projects are allowed more time for “prompt payment”—specifically 45 business days rather than the 30 for all other projects.  While it is presumed a similar certified mail notice is required, the Act does not specify whether this should occur on the 25th business day or something closer to the 45 day deadline.

Protections for Subcontractors differ from those afforded to Prime Contractors.  Payments from Prime Contractors to Subcontractors of undisputed amounts are due within 15 business days of Prime Contractor receiving payment from Owner.  Interest at 12% per annum begins to accrue on the 16th business day and there is no pre-notice requirement.  It appears the Act believes Prime Contractors and Subcontractors are more sophisticated in the ways of payment obligations than Owners.  These same provisions apply to payments due from Subcontractors to lower tier and sub-subcontractors.

These timing issues aside, the primary wrinkle in the Prompt Payment portion of the Act may be the duty of payment itself.  The relevant time periods for payments do not begin to run until there is a “timely, properly completed, undisputed request for payment.”  Under this language, not only does a payor retain the right to set terms for pay applications (timeliness and “properly completed”), but any “dispute” may toll the payment obligation.  Given the requirement for an “undisputed request for payment,” for example, it is arguable that the time period does not run if the payor disputes even a portion of the payment applied for.

  1. Limits on Retainage.

The Act limits retainage and codified a common industry custom of reducing retainage mid-way through the project.  Until 50% completion “in accordance with the contract,” retainage is limited to 10% of any undisputed payment due.  Beginning at 51% “completion,” maximum retainage is reduced to 5%.  Unfortunately the ambiguous term “completion” confounds this transition:  does this mean substantial completion or is this final completion?  These terms are typically defined by contract but the simple “completion” is not.

The Act also limits withholding pending final completion of punchlist items.  Within 30 days of “substantial completion,” retainage must be paid to the Prime Contractor(s), less 200% of reasonable estimated cost of completion.  The use of “business days” for progress payments was abandoned without apparent explanation and there is no extended period for payments from Postsecondary Educational Institutions and Boards of Education.  Proportionate retainage payments from Prime Contractors to Subcontractors are due within 15 business days of the Prime’s receipt of the corresponding payment from the Owner.

Likewise the sudden introduction of “substantial completion” (where only “completion” was used for progress payments) prompted the Kentucky General Assembly to define the term—with potentially unintended consequences.  The Act defines
“substantial completion” differently than the most widely used standard form agreements.  Substantial Completion under the Act is “the point at which, as certified in writing by the [Owner], a project is at the level of completion, in strict compliance with the contract, where:  (a) Necessary approval by public regulatory authorities has been given; (b) The owner has received all required warranties and documentation, and (c) The owner may enjoy beneficial use or occupancy and may use, operate, and maintain the project in all respects, for its intended purpose.”

The Act’s “substantial completion” is more “substantial” than required in typical contracts.  The AIA and ConsensusDOCs generally define “substantial completion” as the point where the work has progressed to the point where it can be used for its intended purpose.  Substantial completion in Construction Law is an attainable point that can occur without being certified as such.  Not only is the statutory definition more stringent (e.g., the statutory “substantial completion” requires the Owner’s receipt of “all required warranties and documentation”), it essentially occurs only if the Owner says it has occurred.  Contractors in Kentucky should be very aware of the possibility of two substantial completion dates—a contractual substantial completion and a statutory substantial completion—and take every effort to resist allowing Owners to merge the two so as to forestall payment obligations and extend warranty terms.

  1. No Damages For Delay.

Time is money in construction like nowhere else.  Project delays translate to increased costs.  Owners attempt to insulate themselves from these costs through so-called “no damages for delay” provisions in Construction Law.  Under these provisions, in the event of a delay, the contractor may recover additional time to complete the project but no money with which to pay for the extended performance.

The Act takes an ineffective whack at no damages for delay.  The Act declares unenforceable any “provision that purports to waive, release, or extinguish the right of a contractor or subcontractor to recover costs, additional time, or damages, or obtain an equitable adjustment of the contract, for delays in performing the contract that are, in whole or part, within the control of the contracting entity .”  The causes of delays “within the control of the contracting entity” may be a narrow class.  It is unclear, for example, whether a design negligently prepared by the contracting entity’s architect causing contractor delay is imputed as “within the control of the contracting entity.”  It is very clear, however, that the Act does not afford any relief to subcontractors because Prime Contractors are unencumbered in their ability to carve out the risk of delay claims by subcontractors.

  1. Dispute resolution.

The mounting costs of resolving construction disputes in the courts in the latter half of the 20th century created an increased push toward alternative dispute resolution.  Judges and juries were frequently replaced by arbitrators and mediators.  But there is no perfect ADR method.  And this has caused parties to invent new methods which, occasionally, deprive one party of a fair remedy.  A recently reviewed Design/Build subcontract, for example, caused the subcontractor to waive litigation in favor of a decision rendered solely by the Architect.  This was absurd, of course, because the Architect was employed by the Design-Builder and could never sit as an unbiased neutral between its employer and the Subcontractor.

The Act addresses this trend by rendering unenforceable “any provision that waives, releases or extinguishes the right to resolve the dispute through litigation.”  Arbitration and mediation each remain favored means of resolution in Kentucky in Construction Law, but the Act would outlaw summary provisions similar to the Design/Build contract illustrated above.

  1. Mechanics Liens.

The Act made important and favorable strides in the area of mechanics liens.  Prior to the Act, Kentucky remained one of the few states that allowed a contractor to waive its mechanics lien rights.  This gave Owners the ability to require unconditioned project-wide lien waivers in otherwise standard lien waivers conditioned upon an anticipated progress payment.  The Act eliminates this potential: “Any provision that waives, releases, or extinguishes the right to take a mechanic’s lien on the property is unenforceable.”

The Act also cured a basic problem on public projects.  Prior to the Act, there was a basic timing problem concerning when to assert a claim against public funds.   Previously, a claiming contractor was required to assert claims within 60 days of completing its work.  This was problematic for subcontractors completing work more than 60 days before retainage is due.  A subcontractor would frequently unwittingly waive its claim rights under the notion that the money was not due.  This left the Subcontractor the unattractive options of either asserting a claim early in the job to the extreme dissatisfaction of the Prime Contractor and the Owner or waiving the claim awaiting retainage.  The Act now eliminates this dilemma because claims on public projects are not due until 60 days of last labor or material to site, or substantial completion, whichever is later.

One mechanics lien revision is a curious departure from Kentucky’s mechanics lien law:  “Notwithstanding any provision of the Kentucky Revised Statutes to the contrary, after a judgment for the contractor against a contracting entity is entered by a court of competent jurisdiction, a contractor has sixty (60) days to file a mechanic’s lien.”  KRS 371.420.  This could allow a contractor to resuscitate lapsed lien rights but it begs the question of what the contractor does with the lien.  Does the contractor collaterally estop its way to a quick foreclosure sale or must there follow new litigation concerning the foreclosure?

  1. Attorney’s Fees and Costs.

Finally, the Act provides for attorneys fees.  Kentucky follows the so-called American rule and attorneys’ fees are recoverable only if provided for either by statute or a relevant contract provision.  Prior to the Act, there were precious few statutes available to contractors.  The Act allows contractors to recover attorneys’ fees subject to two limitations.  First, a prevailing party can recover reasonable attorneys’ fees in actions to enforce the Act if the losing party acted in “bad faith.”  Whether a payment dispute amounts to bad faith will be subject to a case by case determination.  Second, public entities will be exposed to attorneys’ fees only to the extent of the “public contract rate.”  The public contract rate, of course, will not pay freight required of some of the more skilled construction attorneys in the Commonwealth.

Conclusion

While the final decision on the impact of the Act requires Court interpretation, the initial analysis must be mixed.  While the Act significantly clarified ADR and mechanics liens in Kentucky, the payment provisions are confusing, at best.  Contractors working in Kentucky are best advised to insist upon contracts that fit within the Act’s requirements, perform pursuant to those contracts and resort to the Act only where payments are not timely received.

If you have questions about this Act or any other Construction Law questions, contact Manion Stigger today.