SUBSTITUTION HEARINGS The Good, The Bad, And The Rest Of It

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By John McGill

 Public Works contracting is a different breed of cat: different rules, different playing field, different everything.  A recent case, JMS Air Conditioning and Appliance Service v. Santa Monica Community College Dist., involved a substitution request on a public project and in dealing with that issue, the court included a pretty good outline of issues that likely arise and surround such a request. If it gets to the point of needing to substitute a subcontractor, it’s not a good situation at all.

In this case, the general contractor, Bernards Bros. Inc., wanted to substitute JMS Air Conditioning because allegedly JMS had not performed and refused to perform its subcontract and because JMS was supposedly not licensed for certain of the work it subcontracted to perform.  The substitution request was made to the public owner, the Santa Monica Community College District, and the District notified JMS of the request.  JMS contested the substitution request, which lead to the District setting up a substitution hearing.  All of this is consistent with Public Contract Code section 4107. 

The hearing officer did not allow any cross examination of witnesses and the witnesses were not under oath. Both Bernards and JMS were allowed to present briefing and documents as well as witnesses but the entire hearing was limited to 2 hours.  The hearing officer granted the substitution request based on his finding that JMS was not licensed to perform plumbing and boiler work notwithstanding JMS’s argument the work was “incidental and supplemental” to its HVAC work. He disagreed there was anything incidentalor supplementalabout the work because the billings for that work were so high.    

JMS appealed the ruling to the Superior Court and then to the Court of Appeals. The decision was upheld by both courts, but not for all the reasons the hearing officer gave. The amount paid for the plumbing and boiler work was rejected as a reason to allow the substitution because billing amounts did not prove the work was not incidental or supplemental. Likewise, there was insufficient evidence to show JMS needed a plumbing license. The substitution wasproperly granted based on evidence a boiler license was required.  

JMS was legitimately concerned about the ramifications of the substitution, and the reasons for the decision, because of its impact on the pending legal dispute. Bernards asked for the substitution because it intended to terminate JMS.  When Bernards terminated JMS, it also made a claim on the JMS performance bond.  The bonding company then sought indemnity for any payment it made, or might make, to Bernards when Bernards hired another contractor to complete and/or correct JMS’s work.  Because there was a claim on the bond, JMS was unable to obtain further bonding and could not bid other public works projects if they required a bond. 

JMS and Bernards eventually sued each other.  In its complaint, Bernards alleged among other claims that JMS was not properly licensed to perform the boiler and plumbing work.  Bernards also sought disgorgement of the money paid to JMS for the boiler and plumbing work performed without a license. 

JMS disagreed of course. JMS contended that any work performed on the boiler (and plumbing) was “incidental and supplemental” to its HVAC work.  While there is such an exception that permits a contractor to perform work outside of its license category, it only applies if the work is necessary- incidental and supplemental- to perform its own work.  

The case raises some fairly significant, and not uncommon, legal issues: unlicensed work, disgorgement, claims on the bond, termination and breach of contract. They deserve attention and consideration. 

First, it’s obvious Bernards knew JMS was going to perform plumbing and boiler work.  When Bernards sent its bid to the District it would necessarily have to list any subcontractor whose bid comprised more than one half of one percent of the Bernards bid. JMS’s subcontract exceeded $8M so it was a listed subcontractor.  But the fact Bernards knew JMS was going to perform work arguably outside its license category does not prevent Bernards from later alleging unlicensed work as a defense to payment.  It also does not prevent a claim for disgorgement of those payments. If you are doing work outside your license category, you are performing unlicensed work and are an unlicensed contractor.  The fact the other party knows this and ostensibly agrees to it does not preclude a the unlicensed claim or the disgorgement claim later.

Bernards also required a performance bond from JMS.  The general can do this if it is included in the invitation to bid the General advertises as long as it specifies the kind of bond required. When JMS was terminated, Bernards made a claim on that bond.  Keep in mind, the bond penal value is not reduced by any payment to the subcontractor, so the entire bond amount is available to pay the follow-on replacement contractor. Whatever Bernards paid to complete or correct JMS’s work would be paid by the surety up to the penal sum of the bond; i.e.- the contract value.

In order to obtain a bond, JMS (or anyone obtaining such a bond) would have a separate indemnity agreement with the surety.  These typically require not only the pledging of accounts receivables and other corporate assets, but also a personal indemnity from the principals of the corporation.  A typical indemnity agreement gives the surety free rein to take and sell anything the corporation and/or the individual has in order to make the surety whole if it makes a payment.  

JMS was concerned the substitution for the reasons stated (unlicensed boiler work) would also have repercussions in the following litigation. The Court of Appeals made it clear however that the substitution hearing had no “preclusive” effect on any rights or claims that either Bernards or JMS could assert in any litigation. The hearing officer was not making a legaldetermination of the license issue. Instead, he was issuing his decision to allow substitution based on what he heard at the non-judicial hearing.   

This statutoryhearing was not determinative of any licensing issue but only showed the hearing officer based his decision on substantial evidence, and because it was based on substantial evidence, the court could not reverse it.  Whether the boiler work and/or any other work could actually be performed by JMS as “incidental and supplementary” would be determined later by CSLB or by the trial court. 

To be sure, Bernards will try and introduce the substitution and the reasons for it at trial. JMS will try and keep it out.  Depending on whether CSLB gets involved and rules, the trial court will decide what evidence comes in about the license issue and whether the work is incidental and supplemental. The real take away though is to avoid this situation in the first place.  Incidental and supplementalis a dicey argument, and disgorgement and bond claim indemnity are the worst of the worst, so it is better to get the licenses you need, joint venture if you must, or exclude the work in your proposal.  Licensing is the causede jurethese days, attorneys are being very clever in their arguments, and the courts are being receptive to those arguments, so be very careful.  The downside is not just a bump, but a cliff.


Bio:  John McGill is an attorney representing contractors and suppliers throughout the Bay Area and Northern California in both private and public work disputes.  He is the author of California Contractor’s DESKTOP GENERAL COUNSEL 3d ed. What You Need To Know About California Construction Law.   

Contact info: 707 337 1932