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December 02, 2015 Articles

Surety's Defense Against "Pay-If-Paid" Construction Clauses

By Michael Jay Rune II and Dana Chaaban

Under contract formation, the majority of transactions, services, and/or liabilities may be contracted based upon the parties' "freedom to contract." Ordinarily, in construction, a general contractor bears the risk of an owner's potential insolvency. However, over the years, general contractors have begun to negotiate a shift in the distribution of risk from the general contractor to the subcontractor by making the general contractor's receipt of payment from the owner a condition precedent to the general contractor's ultimate payment to the subcontractors. These clauses may be enforceable even though a subcontractor has fully performed its obligations under the subcontract. These provisions, coined "pay-if-paid," typically consist of some variation of the following:

Subcontractor agrees that Contractor shall be under no obligation to pay Subcontractor for any work performed or materials or equipment furnished for this Project unless and until Contractor has been paid therefor by Owner, and the making of any and all progress and final payments and the amount thereof are expressly subject to this condition precedent. Subcontractor states that it relies primarily on the credit and ability of Owner to pay and not upon Contractor's credit or ability, and further, expressly accepts the risk that it will not be paid for work performed by it in the event that Contractor, for whatever reason, is not paid by Owner for such work.

Generally, contractual language that eliminates the general contractor's duty to pay a subcontractor for its completed work is disfavored. In California, New York, North Carolina, and Wisconsin, such clauses are prohibited altogether; while in other jurisdictions, these clauses are limited through judicial interpretation. See Wm. R. Clarke Corp. v. Safeco Ins. Co. of Am., 938 P.2d 372, 380 (Cal. 1997); West-Fair Electric Constr. v. Aetna Cas. & Sur. Co., 661 N.E.2d 967, 971 (N.Y. 1995); N.C. Gen. Stat. § 22C-2; Wis. Stat. § 779.135(1).

For instance, Maryland recognizes "pay-if-paid" provisions as valid and enforceable. However, the Maryland legislature enacted a statute that provides:

A provision in an executory contract between a contractor and a subcontractor that is related to construction, alteration, or repair of a building, structure, or improvement and that conditions payment to the subcontractor on receipt by the contractor of payment from the owner or any other third party may not abrogate or waive the right of the subcontractor to:

  1. (1) Claim a mechanic's lien; or

  2. (2) Sue on a contractor's bond.

Md. Code Ann., Real Property § 9-113(b) (emphasis added).

In Florida, the Florida Supreme Court has declared that unambiguous "pay-if-paid" clauses are enforceable under the law. See DEC Electric, Inc. v. Raphael Constr. Corp., 558 So. 2d 427, 429 (Fla. 1990); J.J. Shane, Inc. v. Aetna Cas. & Sur. Co., 723 So. 2d 302 (Fla. Dist. Ct. App. 1998); Robert F. Wilson, Inc. v. Post-Tension Structures, Inc., 522 So. 2d 79 (Fla. Dist. Ct. App. 1988); accord Everett Painting Co. v. Padula & Wadsworth Constr. Inc., 856 So. 2d 1059, 1061 (Fla. Dist. Ct. App. 2003); Dyser Plumbing Co. v. Ross Plumbing & Heating, Inc., 515 So. 2d 250, 252 (Fla. Dist. Ct. App. 1987).

Where a "pay-if-paid" provision is not enforceable, courts will construe the provision as a "pay-when-paid" provision governing the timing of payment. Under such a provision, the general contractor must tender payment to the subcontractor within a reasonable time. A typical "pay-when-paid" provision might read: "Contractor shall pay Subcontractor within fifteen days of Contractor's receipt of payment from the owner." Notwithstanding, where the general contractor and subcontractor have clearly expressed an intent conditioning payment to the subcontractor upon the owner's payment to the general contractor, the court, in construing such a provision, should give full force and effect to this clearly expressed intent of the contracting parties.

Due to the prevalence of such clauses in recent years, subcontractors have sought to circumvent contractual "pay-if-paid" provisions by bringing claims against sureties who may guarantee payment. Imagine this common scenario: At the point of nonpayment, a subcontractor brings a lawsuit or demands payment from both the general contractor and its surety for failure to pay pursuant to the subcontract. The subcontract between the general contractor and subcontractor contains a valid and enforceable "pay-if-paid" provision within the particular jurisdiction. In response to the lawsuit, the general contractor raises this contractual provision as an affirmative defense and is likely off of the hook, if in fact no payment has been made by the owner.

While the general contractor likely has a valid defense in the foregoing scenario, consider the general contractor's surety raising such a defense on its behalf, despite the fact that it was not in privity with the parties during the contract negotiations. Is this in fact a valid defense? Courts are split on whether to extend the "pay-if-paid" defense to the surety. On one side of the spectrum, some courts are unwilling to permit the surety to escape its obligation to pay a claim by assertion of the "pay-if-paid" provision in the subcontract. In OBS Co. v. Pace Construction Corp., 558 So. 2d 404, 408 (Fla. 1990), the Florida Supreme Court explained that "[t]he payment bond is a separate agreement, and any inability to proceed against the general contractor does not necessarily prevent recovery against the sureties under the bond." In OBS, recovery under the payment bond was not conditioned on the owner making final payment to the subcontractor, and the bond did not incorporate the subcontract's payment terms. The Florida Supreme Court went on to note that "it would be inequitable to nullify the bonding company's liability because the owner has not paid the contractor. When a surety on a private construction project issues a bond that purports to protect against mechanic's liens, the bond must be construed and applied in accordance with the conditions of section 713.23, Florida Statutes." OBS, 558 So. 2d at 408.

Similarly, in United States ex rel. Walton Technology, Inc. v. Weststar Engineering, Inc., 290 F.3d 1199, 1203 (9th Cir. 2002), the court, in holding that the surety could not enforce a conditional payment clause contained in its principal's subcontract, found that such a provision, if extended to the surety, would negate the rights and obligations created under the Miller Act specifically intended to ensure protection for subcontractors. Although the court noted that general rules of suretyship law apply to extend the principal's rights to that of the surety, such is not the case wherein the Miller Act limits the coextensive liability between a surety and its principal.

Juxtapose the foregoing analysis with other courts' rationale that the surety stands in the shoes of the general contractor and thus is afforded all the contractual defenses of the general contractor. The United States District Court for the Southern District of Florida put this logic succinctly in Great American Insurance Co. v. School Board of Broward County, No. 09-61636-CIV, 2010 U.S. Dist. LEXIS 120030, at *45 (S.D. Fla. July 30, 2010), by stating that once a surety has fulfilled its obligations under the bond, "the surety confers a benefit upon the obligee . . . . That benefit relieves the obligee of the burden of completing the construction." See also Int'l Fid. Ins. Co. v. Cnty. of Rockland, 98 F. Supp. 2d 400, 429 (S.D.N.Y. 2000). Therefore, the principal's rights shift to the surety.

It is unclear, absent clear and unequivocal language supplementing the subcontract to include this additional condition precedent, whether courts will give credence to the surety's attempted defense. One thing is for certain, we can anticipate more litigation in the near future pertaining to the applicability and extension of "pay-if-paid" clauses. In the interim, general contractors have begun to supplement such "pay-if-paid" provisions to include terms extending the "pay-if-paid" condition precedent to the general contractor's surety, despite the fact that the surety is not privy to the original transaction, which may or may not be enforceable.

Keywords: litigation, minority trial lawyer, minorities, construction, general contractor, subcontractor, surety, pay-if-paid clause

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