Constitutionality of Disgorgement of Money Paid for License Defect

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by Bernard S. Kamine

(a version of this article appeared in the Los Angeles Daily Journal)

In California, if a contractor was not licensed at all times during performance of the contract, its customer can sue for return of money paid – not just money paid during the unlicensed period, but all money paid must be disgorged.  Business and Professions Code § 7031(b).  This law is draconian, vindictive and probably unconstitutional in at least some applications.

The Contractors State License Law (B&P §§ 7000 et seq.) is supposed to assure that those who provide construction services possess a minimal level of responsibility.  (See Public Contract Code §1103, which defines a responsible bidder as one “who has demonstrated . . . trustworthiness . . . quality, fitness and capacity, and experience to satisfactorily perform the . . . contract.)

But not every consumer of construction services needs that protection.  The federal government does not; therefore, state license laws cannot be enforced against contractors hired by the federal government. Leslie Miller Inc. v. Arkansas, 352 U.S. 187, 189-90 (1956).  Many other sophisticated consumers of construction services need no such protection, e.g., many state and local agencies, large developers, and large fellow contractors.  For the time being, however, the law applies to all contractors on non-federal projects in California.

California authorizes four penalties for “engag[ing] in the business of, or act[ing] in the capacity of, a contractor” without a license – a criminal penalty, a civil penalty, a shield penalty and a spear penalty.

The first offense criminal penalty can be a misdemeanor conviction with a fine up to $5,000, plus restitution for any actual economic loss.  The fine is payable to the government, the economic loss to the customer.

The civil penalty is a citation by the Registrar of Contractors, an administrative hearing, and a penalty up to $5,000, except for certain named violations.  The civil penalty is payable to the government.

The shield penalty bars the improperly licensed contractor from using the courts to collect money owed for work performed.  This penalty vindicates the judicial system by preventing the court’s use to enforce a contract performed in violation of law.  That purpose outweighs the windfall the unlicensed contractor’s customer gets when the dodged collection far exceeds any actual damages suffered by the customer.

The sword penalty is disgorgement.  It allows the customer to recover all payments made to the unlicensed contractor, in addition to any shield penalty and in addition to compensatory damages due for failure of the contractor to properly perform the work.  Disgorgement, like compensatory damages, is payable to a private party, not the government.

The confluence of the license law’s shotgun approach and the draconian nature of disgorgement causes outrageous effects in some cases.  Take these facts:  A large, sophisticated general contractor on a $50 million construction project subcontracts $4 million of the work to a subcontractor that is a New York corporation.  During the project the subcontractor’s assets, including the ongoing subcontract, are purchased by a Delaware corporation.  The general contractor timely consents to assignment of the subcontract to the Delaware corporation.  All of the subcontractor’s employees and equipment on the project remain the same throughout the job.  The New York corporation’s registered managing employee (RME) for its California contractors’ license becomes the RME for the Delaware corporation; however, logistics issues cause an 18-day gap between the time he withdraws as the New York corporation’s RME and the time the Contractors State License Board recognizes him as the Delaware corporation’s RME.  The subcontract work is timely completed and is accepted as fully complying with the plans and specifications.  However, a dispute remains over the subcontractor’s $300,000 claim for extra work.  Ultimately, the subcontractor sues.  The general contractor discovers the license gap, asserts the shield penalty as a defense against the $300,000 claim, and cross-complains for disgorgement of all $4 million paid to the subcontractor.  In these circumstances, the Delaware subcontractor could suffer all four license penalties – even though its work was perfect.

If the Delaware subcontractor can prove substantial compliance with the license law, it can be saved.  However, even though the RME, employees and equipment were the same throughout the project, the Delaware corporation probably lacks a substantial compliance defense.  Technically, the Delaware corporation had never been a duly licensed contractor in California during the 18-day gap, and that is fatal under B&P Code § 7031(e).  (Note, even the January 1, 2017 amendments to B&P § 7031(e) do not solve this technical problem.)  The Delaware corporation also cannot assert equitable defenses, at least as to the shield penalty. See Alatriste v. Cesar’s Exterior Designs Inc., 183 Cal. App. 4th 656, 672-73 (2010).

But, of course, enforcement of the license law is constrained by constitutional principles.  Disgorgement is a form of damages assessed against the unlicensed contractor and paid to its customer for the violation of the license law and for the unlicensed contractor’s deceit (either affirmatively or by non-disclosure of material facts).  Disgorgement is neither a criminal penalty nor a civil penalty – it is a monetary award to a private party, not the government.

Punitive damages are defined as being independent from, and not in any way compensation for, any actual damages suffered.  Regardless whether disgorgement is a legal or equitable remedy, and regardless what it is labeled, disgorgement is clearly a penalty, unrelated to actual damages, in the form of punitive damages paid to a private party.

California courts have repeatedly held disgorgement to be lawful – on its face – despite the potential harshness of the remedy.  However, even though the Legislature allows juries to assess punitive damages under a statute that is clearly constitutional on its face (Civil Code § 3294), the courts routinely determine whether punitive damages assessed by a jury in a particular case exceed constitutional bounds.  The same must obtain for disgorgement.

The U.S. Supreme Court has established a three-part test for evaluating the validity of punitive damages: (1) the reprehensibility of the conduct being punished; (2) the reasonableness of the relationship between the harm and the award; and (3) the difference between the award and the civil penalties authorized in comparable cases.  State Farm Mut. Auto Ins. Co v. Campbell, 538 U.S. 408, 418 (2003); Nickerson v. Stonebridge Life Ins. Co., 63 Cal.4th 363, 367 (2016).

In the hypothetical case, use of the disgorgement sword to take anything more than nominal damages from the Delaware corporation, and to give it to the prime contractor, would fail the constitutional test for at least two reasons:

First, the conduct is not very reprehensible.  The entity changed its ownership, but in all other relevant respects remained the same throughout the job.  Both configurations were properly licensed, but for that 18-day gap.

Second, the relationship between the harm and disgorgement of $4 million would be grossly disproportionate.  The general contractor claims no compensatory damages; the subcontractor’s work met the plans and specifications and was accepted by the general contractor.  California and federal courts have constrained awards of punitive damages to a reasonable relationship to the actual damages suffered, usually a small multiple.  See Bankhead v. Arvinmeritor Inc., 205 Cal. App. 4th 68, 88-89 (2012).  In the hypothetical case, disgorgement of anything would be an infinite multiple of the non-existent actual damages.  Besides, the general contractor is not a member of the public who needs protection from incompetence and dishonesty in those who provide building and construction services.  Although it has been held that general contractors are entitled to protection against illegal subcontract work by unlicensed persons (Lewis & Queen v. N. M. Ball Sons, 48 Cal. 2d 141, 152-54 (1957)), the general contractor in the hypothetical is a sophisticated fellow contractor that does not claim that it suffered any harm whatsoever.

The difference between $4 million disgorgement and both the criminal and civil penalties authorized in comparable cases is astronomic.  As noted above, the maximum criminal penalty is $5,000, plus restitution of actual economic loss, but the prime contractor suffered no actual loss whatsoever.  Also as noted above, the maximum civil penalty that could be assessed by the Registrar of Contractors would be $5,000.  Thus, a disgorgement of $4 million would be 800 times the maximum comparable criminal or civil penalty.

Therefore, in the hypothetical case, no punitive disgorgement damages in excess of $5,000 would pass constitutional muster.

Kamine Law PC

Serving the Construction Industry since 1976.

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