ONE WAY GENERAL CONTRACTORS seek to limit their exposure to the risks of owners not paying them is by including pay-if-paid clauses in their contracts. These clauses state that a subcontractor will not be paid unless the prime contractor is paid. Because of the harshness of such a provision, several states have declared pay-if-paid clauses unenforceable. When they are allowed, they are typically enforced only when the parties meet a certain threshold, such as expressly agreeing that payment by the owner to the general contractor is a condition precedent to the subcontractor being paid.
Another way general contractors seek to limit their risk is through pay-when-paid clauses. These provisions differ in that they deal only with timing. Pay-when-paid clauses link the timing of the subcontractor’s payment to the time when payment is made by the owner, as long as that is within a reasonable time.
This month, we highlight a recent California appeals court decision striking down a general contractor’s pay-when-paid provision as patently unreasonable.
California’s North Edwards Water District wanted to build a water treatment facility that would remove arsenic from its water. It engaged Clark Bros. Inc. as the general contractor to build the plant. It was a public project and not subject to mechanic’s liens, so state statute required Clark to obtain a payment bond. The bond was intended to provide a distinct remedy to the subcontractors in the event of nonpayment by Clark. Insurance company Travelers issued the bond at Clark’s request.
Clark subcontracted with Crosno Construction to build two 250,000 gal. steel reservoir tanks at the site for $630,000. The subcontract included a pay-when-paid clause in case the district delayed making payments. The clause stated, in part, that if payment was not forthcoming by the owner, Clark or its sureties had a reasonable time within which to make payments to Crosno. The clause went on to detail that a “reasonable time” would mean sufficient time for the contractor to litigate with the owner. The relevant section read:
If Owner … delays in making any payment to Contractor from which payment to Subcontractor is to be made, Contractor and its sureties shall have a reasonable time to make payment to Subcontractor. ‘Reasonable time’ shall be determined according to the relevant circumstances, but in no event shall be less than the time Contractor and Subcontractor require to pursue to conclusion their legal remedies against Owner.
Crosno worked on the project for nine months, at which point it was ordered to halt all work because of a dispute between Clark and the owner. At the time it stopped work, Crosno had fabricated the steel, primed the steel in its shop, transported the steel to the site, erected the tanks, and almost completed coating the steel in the field. Most of its invoices were unpaid, leaving a total of $562,435 outstanding. Crosno filed a stop-payment notice with the district and made a claim on the payment bond. Travelers denied the bond claim as premature, citing the pay-when-paid clause in Crosno’s subcontract and claiming that Travelers was not obligated to pay until the end of the litigation between Clark and the district. Crosno then sued the district, Clark, and Travelers.
At the trial, Crosno sought an early ruling that the surety was liable under the bond. It argued that the pay-when-paid provision in its subcontract was unenforceable because it was at odds with a state statute protecting against the imprudent or unknowing waiver of rights. Specifically, the statute requires a signed written waiver and release by a subcontractor in order to affect or impair its rights under the payment bond. Because there was no written waiver by Crosno, it argued that the clause requiring it to wait for Clark and the district to end their litigation violated the statute.
The trial court agreed with Crosno, relying in part on the reasoning in a recent California Supreme Court case declaring pay-if-paid provisions void because they are against public policy.
On appeal, the court framed the legal question as relating to whether a surety may use a pay-when-paid clause as a defense “to delay its bond obligation to a subcontractor until some unspecified point” in time. The appellate court decisively agreed with the lower court’s analysis that the clause at issue impermissibly waives the subcontractor’s payment rights.
While careful to clarify that not all pay-when-paid clauses in subcontracts are void, the appeals court determined that the fact that the pay-when-paid clause defined “reasonable” as dependent on a potential, unknown, future litigation “impaired or affected” the rights of the subcontractor to receive payment within a reasonable time. The appeals court also said the timing of the litigation between Clark and the owner illustrated why such a clause was unreasonable: the owner and Clark were still involved in a lawsuit almost three years after Crosno initially sought recovery.
The appellate court decisively agreed with the lower court’s analysis that the clause at issue impermissibly waives the subcontractor’s payment rights.
Travelers’s arguments were likewise unpersuasive. The surety argued that voiding the pay-when-paid clause would effectively make contractors and their sureties “financers of … projects when the owner delays making payment.” The court did not mince words in response to the surety’s protest, stating: “[T]hat is precisely the point.”
Likewise, the court noted that the statutory scheme reflects an express preference to provide expedient enforcement procedures to subcontractors over prime contractors, who are required to insure against the risk of owner nonpayment. Finally, the court was not convinced that the surety should be able to rely on the subcontract provisions just because its bond incorporates the subcontract.
This ruling was of such importance to the industry that both the American Subcontractors Association and the Construction Employers Association filed briefs attempting to persuade the appeals court to rule in their respective favors. While we will, of course, report on any subsequent appeal to the California Supreme Court, it is noteworthy that just a few months ago, a New York state court issued a similar ruling.
That court ruled that a pay-when-paid provision was not enforceable when a subcontractor had to wait for more than two years to receive payment. Instead, the provision could only be enforced to the extent that the delay in payment was for a reasonable amount of time after the work was completed. To hold otherwise would be to obliterate any difference between a pay-when-paid and pay-if-paid, according to the court.
Suffice it to say, subcontractors face substantial financing risk when they depend on general contractors getting paid by owners. Notably, neither the New York nor the California decision defined what would be considered a reasonable amount of time for a general contractor to withhold payment under a pay-when-paid provision. Three years was essentially found to be unreasonable in California (although the case was decided because of the uncertainty of the payment) and “well over two years” was held to be unreasonable in New York.
This column first appeared in the September 2020 issue of Civil Engineering.