The California Supreme Court Declares “Pay If Paid” Clauses Are Void

THE CALIFORNIA SUPREME COURT DECLARES APAY IF [email protected] CLAUSES ARE VOID

In the case of Wm. R. Clarke Corporation V. Safeco Insurance Company of America the California Supreme Court has ruled in a benchmark case that “pay if paid” provisions violate public policy and are void and unenforceable. A “pay if paid” provision makes payment by the owner to the general contractor a condition precedent to the general contractor’s obligation to pay the subcontractor for work the subcontractor has performed. The clauses transfer the risk of a failed project from the general contractor to the subcontractor.

The factual background of the case is typical of many contract payment disputes. The owner of a commercial building in Los Angeles entered into a contract with Keller Construction Co., Ltd. for rehabilitation work on the building. Keller, in turn, entered into subcontracts for this project with Wm. R. Clarke Corporation and other subcontractors. Each subcontract contained a “pay if paid” provision and three of the four subcontracts also included an addendum reiterating the “pay if paid” limitation, but also purported to preserve the subcontractors’ mechanic’s lien rights and to make those rights the subcontractors’ sole in the event the owner failed to pay Keller. The owner went bankrupt and did not pay the general contractor who, in turn, did not pay the subcontractors. The subcontractors sued the general contractor and the payment bond surety, Safeco. The bonding company asserted that the “pay if paid” clause was applicable and thus it did not have to pay the subcontractors. The trial court and appellate court found in favor of the subcontractor.

The California Supreme Court stated: A that “pay if paid” provisions like the one at issue here are contrary to the public policy of this state and therefore unenforceable because they effect an impermissible indirect waiver or forfeiture of the subcontractors’ constitutionally protected mechanic’s lien rights in the event of nonpayment by the owner. Because they are unenforceable, “pay if paid” provisions in construction subcontracts do not insulate either general contractors or their payment bond sureties from their contractual obligations to pay subcontractors for work paid.

PAY WHEN PAID CLAUSES ARE NOT IMPACTED

However, the Court did not make an explicit ruling on “pay when paid” clauses. A “pay when paid” clause generally states that the subcontractor will be paid when the general contractor is paid. Such pay when paid clauses merely fix the time for payment to the subcontractor, with the implied understanding that the subcontractor, in any event, has an unconditional right to payment within a reasonable time.

The distinction between a “pay if paid” provision and “pay when paid” is significant. Most subcontracts contain a form of a “pay if paid” clause which are now unenforceable. As result of the case most general contractors will replace their “pay if paid” clauses with “pay when paid” clauses. Once the clauses are replaced, the next question will be what is a reasonable time under a “pay when paid” clause if the owner never pays the general contractor. In all likelihood that question will be resolved on a case-by-case basis by the trial courts.

Surety companies are now, clearly, liable even if the principal (general contractor) did not breach the subcontract. General contractors typically obtain a payment bond to protect the owner in the event the general contractor does not pay its subcontractors. Now, the general contractor’s surety will also be obligated to pay on the payment bond when the owner breaches its agreement to pay the general contractor. The Supreme Court stated: AWhen a general contractor executes a statutory labor and material payment bond as principal, the obligation on the bond is not limited to the subcontractors and material suppliers with which the general contractor has executed valid contracts, but extends also to lower tier subcontractors and material suppliers with which the general contractor has no privity of contract, and to which the general contractor owes no payment obligation apart from the bond, provided only that they have valid lien claims for that.  The language makes it clear that the surety on a payment bond is obligated to pay a bond claimant even if the contractor has no contract with the claimant.

Many general contractors and surety companies consider the Clarke decision to be a catastrophe. Many smaller contractors believe that surety companies will toughen their underwriting practices for private projects. The Associated General Contractors of California has already stated that it will seek legislation to reverse the court’s decision. Irrespective the subcontractors counsel has won the first round in a fight that is sure to continue.

This article, 81997, was written by William C. Last, Jr. Mr. Last is an attorney who has been specializing in Construction Law for 20 years. Mr. Last also holds a California A & B contractors license. He can be contacted at . This bulletin is published periodically to provide general information about current legal issues. If you have a specific legal question or need legal advice, you should contact an attorney.