By Procopio Partner Mary Salamone

Should a contractor in California undertake any construction-related project while failing to be properly licensed at any stage during the project, state law allows the client to recoup all compensation paid to the contractor, even if the client knew the contractor was unlicensed. This draconian action, known as disgorgement, is a severe incentive for contractors to proactively ensure all licenses are valid whenever performing work. Two recent California court decisions, however, have made it a bit more challenging for the plaintiff who hired the contractor to recover payments. Namely, plaintiffs face a one-year statute of limitations to file suit, and the clock cannot start as a result of discovery in separate litigation.

To better understand the significance of these two recent decisions, it would be helpful to review some legislation surrounding licensure.

What Exactly is Disgorgement?

California law requires that people who act as contractors on behalf of property owners be licensed by the Contractors State License Board (CSLB). “Contractors” is broadly defined as anyone who undertakes or offers to undertake a project to construct, alter, add to, remove, repair or demolish any building, road, excavation, development or improvement. In California, penalties apply if a contractor fails to maintain proper licensure at all times during the performance of the work. This means that if the contractor is not licensed for even one day of performance, severe penalties can apply. First, contractors who are not licensed cannot sue to be paid for the work they have already performed. This extends to any lawsuit based on contracts or equitable remedies, even if the unlicensed contractor’s claim has merit and the work itself is free from defects. But matters get even worse for the unwary unlicensed contractor.

Pursuant to Business and Professions Code §7031(b), a person that retains the services of an unlicensed contractor can bring an action in any court in the state with proper jurisdiction to recover all compensation that was paid to the unlicensed contractor for the performance of the contract, also known as disgorgement. This draconian and seemingly unfair remedy is intended by the legislature to create a strong incentive to remain properly licensed. Courts in California have ruled that this holds true even if the party that retained the unlicensed contractor is admittedly aware that they were not licensed. For this reason, it is crucial that contractors closely monitor their licensing status and pay close attention to any communications from the CSLB.

To mitigate the severity of this remedy, the legislature amended the Business & Professions Code effective January 2017 by adding §7031(e) to allow the contractor to argue that it was in substantial compliance with the licensing requirements if it can prove the following at an evidentiary hearing: (1) the contactor had been duly licensed as a contractor in the state prior to the performance of the act or work at issue; (2) the contractor acted reasonably and in good faith to maintain proper licensure; and (3) the contractor acted promptly and in good faith to reinstate his/her license upon learning that it was invalid. If any one of these requirements is not satisfied, the licensee cannot claim substantial compliance and will be deemed unlicensed. What the legislature failed to address is the applicable statute of limitations for an action seeking disgorgement.

What Impact Did the Recent Court Decisions Have on Disgorgement?

The case before the Court of Appeal (Second Appellate District) in 2020 involved a plaintiff (Eisenberg) suing the contractor (Suffolk) five years after completion of the work. While the work was completed in 2010, numerous issues with the project arose almost immediately, requiring extensive repairs by Suffolk. Suffolk worked on making repairs until around 2014. When repair efforts eventually stalled, Eisenberg began investigating potential claims against Suffolk. Contractor license law requires that each license holder have a qualifying individual (responsible managing officer or employee) with construction experience actively supervising the contractor’s work. Suffolk’s qualifier had moved out of state in 2008 and was no longer exercising direct supervision over Suffolk’s construction work in California. As such, Eisenberg argued that Suffolk did not possess a valid contractor’s license.

In turn, Suffolk sought to dismiss the lawsuit by arguing that disgorgement was a penalty subject to a specific one-year statute of limitations governing penalties and forfeitures. Since Suffolk completed the project almost five years before the lawsuit, the claim was impermissibly late. Eisenberg in response argued that the disgorgement claim did not arise until it discovered facts giving rise to the claim around 2014. It also argued that disgorgement claims were subject to a three or four-year time limit for claims and as it was not a penalty but a form of restitution.

To determine what time limitation applied to the claim, the court examined the Supreme Court’s definition of a penalty as recovery “without reference to the actual damage sustained” and the policy basis behind the law. It found that a disgorgement claim under §7031(b) is in fact a penalty because the project owner need not suffer any actual injury in order to seek the remedy. As a penalty, the court concluded that the claim is subject to a one-year statute of limitation under Code of Civil Procedure §340(a).

Eisenberg also asked the court to apply a special “discovery rule” that postpones accrual of the claim until it is discovered (in this case, around 2014). The discovery rule usually only applies when the plaintiff has a difficult time understanding the claim, or the claim is hidden in some way. To the extent Suffolk’s license information is public record and available through a website, the claim was easily discoverable upon even a cursory investigation of the license. The court reasoned that if no injury needs to occur for the claim to arise then Eisenberg’s arguments could lead to absurd results, with almost no time limits on claims.

A more recent decision on this subject was handed down in March 2021 by the Court of Appeal (First Appellate District) in a case involving Webcor Construction L.P. (Webcor) and San Francisco CDC LLC (SF CDC). SF CDC brought a §7031(b) claim for disgorgement in 2017, more than eight years after the completion of construction of the InterContinental Hotel in San Francisco. The issue of licensure came to light during litigation concerning construction defects. This would seem to be clearly beyond the one-year statute of limitations. SF CDC argued, however, that because it learned of the licensure issue during separate litigation concerning construction defects, the statute of limitations should not apply.

The Court of Appeal disagreed, upholding the trial court’s dismissal of the disgorgement claim based on the one-year limitations period for statutory forfeiture or penalty causes of action. The court also found that there is no application of the discovery rule to toll or extend the accrual of the cause of action. The court found that SF CDC’s claim accrued in February 2009 when the hotel was completed and final payment was made to Webcor. Thus, SF CDC needed to bring its statutory disgorgement claim no later than March 2010.

What Does This Mean for Contractors and Owners Now?

Despite these two decisions, disgorgement remains a stiff all-or-nothing penalty that provides a windfall to the plaintiff. Despite clarity on the statute of limitations, project owners can still sue contractors for being unlicensed, regardless of the quality of the work or the reasons for the failure of licensure. Those hiring contractors now know they need to make their allegations swiftly, within one year of the completion or cessation of the performance of the contract at issue. Contractors, meanwhile, know they need to continue to remain vigilant in maintaining all relevant licenses at every stage of the construction process.