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Recent Court Decision Affects Enforceability of Pay-When-Paid Clauses

Recent Court Decision Affects Enforceability of Pay-When-Paid Clauses

Recent Court Decision Affects Enforceability of Pay-When-Paid Clauses

By Procopio Partner Mary A. Salamone

Construction contracts are exchanged so routinely that it is not uncommon for contractors to give the documents a quick glance or not even read them altogether before signing. Even when a contractor examines a contract thoroughly, legal terminology with profound impact may be overlooked. Since it is rarely feasible to have an attorney read every contract, the best course of action for contractors to avoid risk is to understand some of the key things to look out for. “Pay-if-paid” and “pay-when-paid” clauses illustrate how a single word can make a vast difference in contract interpretation.

To compound matters, a recent court decision titled Crosno Construction, Inc. v. Travelers Casualty (Cal. Ct. App., Apr. 17, 2020, No. D075561) 2020 WL 1899278 has just significantly changed the landscape on what constitutes a permissible pay-when-paid provision. The court held in that case that an open-ended pay-when-paid clause was unenforceable. Before delving into the details of that case, let’s begin with a background discussion about these types of clauses.

Distinction Between Pay-If-Paid and Pay-When-Paid Clauses

If you are a general contractor or subcontractor in the construction industry, you have likely heard these terms, but may not fully understand their implications. Pay-if-paid and pay-when-paid clauses can alter the normal (i.e., common law) payment obligations running from the contractor to its subcontractor or subcontractor to its supplier. Without a contract clause or statute addressing payment obligations, payment for construction work is due on substantial completion of the work.

A pay-if-paid clause alters the common law payment obligation by requiring payment from the owner as a condition precedent to the contractor’s duty to pay a subcontractor or supplier. In other words, a pay-if-paid clause means the contractor is only obligated to pay the subcontractor if it actually receives payment for the subcontractor’s work from the owner, thereby shifting the risk of nonpayment to the party lower down on the chain.

An example of a pay-if-paid clause is as follows:

Contractor’s receipt of payment from the owner is a condition precedent to contractor’s obligation to make payment to the subcontractor; the subcontractor expressly assumes the risk of the owner’s nonpayment and the subcontract price includes the risk.

Conversely, a pay-when-paid clause is a payment condition that establishes a reasonable time for the contractor to comply with its obligation to make payment to a subcontractor or supplier upon the contractor’s receipt of payment from the owner. This type of clause does not absolve the contractor from paying subcontractors if it does not receive payment. A pay-when-paid clause governs the timing of a contractor’s payment obligation to the subcontractor, usually by indicating that the subcontractor will be paid within some time period after the contractor itself is paid by the property owner.

An example of a pay-when-paid clause is as follows:

The contractor shall pay the subcontractor within seven days of the contractor’s receipt of payment from the owner.

Pay-If-Paid Clauses Disallowed in California

Certain states disallow pay-if-paid clauses and deem them to be void and unenforceable since this form of contractual risk shifting violates protected mechanics lien rights. California is one of those states. The seminal opinion on pay-if-paid clauses in California contracts was issued by the Supreme Court of California in the case of Wm. R. Clarke Corp. v. Safeco Insurance Company (1997) 15 Cal.4th 882 (Clarke v. Safeco).

By way of brief factual background, in 1990 the owner of a commercial building hired Keller Construction Co., Ltd. as general contractor on a project to rehabilitate the building. Keller then subcontracted with a wide variety of parties, including the plaintiff, Wm. R. Clarke Corp. At the owner’s insistence, Keller obtained a payment bond from Safeco Insurance Company. Once “substantial work” was achieved on the project, the owner stopped sending money to the general contractor. Keller then refused to keep paying the subcontractors, including Clarke. As a result, the subcontractors, again including Clarke, filed mechanics liens on the property and later sued to foreclose on them.

At trial (and later on both appeals), Safeco argued that it had no duty to pay any of the subcontractors since it was protected by the pay-if-paid clauses in each of the subcontracts. The California Supreme Court affirmed the lower courts’ judgments against Safeco. The court concluded that pay-if-paid provisions are contrary to the public policy because they effect an impermissible indirect waiver of the subcontractors’ constitutionally protected mechanics lien rights in the event of nonpayment by the owner.

Following Clarke v. Safeco, an appellate court applied the same principles to preclude enforcement of a pay-if-paid provision in a public works project. (Capitol Steel Fabricators, Inc. v. Mega Const. Co. (1997) 58 Cal.App.4th 1049.)

Recent Challenge to Pay-When-Paid Clauses

The Clarke v. Safeco decision has direct bearing on a recent Court of Appeals decision handed down on April 17, 2020, titled Crosno Construction, Inc. v. Travelers Casualty and Surety Company of California. The case involved a 2014 public works project for construction of an arsenic removal water treatment plant in North Edwards, California. The North Edwards Water District entered into a contract with Clark Brothers as general contractor. Crosno Construction, Inc. was hired by Clark to fabricate, erect and coat two 250,000-gallon steel reservoir tanks. After Crosno completed most of its work, a dispute arose between the District and Clark halting the project. As Clark sued the District, Crosno sought to recover payments owed under the public works payment bond issued by Travelers Casualty and Surety Company of America on behalf of Clark for the project.

By the time the case reached the Court of Appeals, the principal balance had been paid but a judgment for interest and attorney’s fees was outstanding and still in issue. It had been three years since invoicing when the principal balance was paid. The crux of the dispute was whether the pay-when-paid provision in Crosno’s subcontract precluded Crosno from recovering under the payment bond while Clark’s lawsuit against the District was pending. The subcontract notably stated that a reasonable time to make payment “in no event shall be less than the time Contractor and Subcontractor require to pursue to conclusion their legal remedies against Owner or other responsible party to obtain payment….”

Relying on the Clarke v. Safeco decision discussed above, the court found the open-ended pay-when-paid provision in this particular contract to be unenforceable. The court determined that this provision affected or impaired Crosno’s payment bond rights in violation of Civil Code § 8122, since Crosno had never executed a statutory waiver and release form (as prescribed by Civil Code §§ 8132, 8134, 8136 and 8138) to validly “waive, affect or impair” its payment bond rights. To be valid, a release and waiver must also be accompanied by payment pursuant to Civil Code § 8124. As such, the definition of “reasonable” time in the contract was unreasonable and unenforceable because it impaired the subcontractor’s right to timely payment under the bond. The court discussed at length the statutory scheme behind payment bonds as reflecting an express legislative preference to provide expedient enforcement procedures to subcontractors. The court added that the primary focus of the surety should have been on whether the subcontractor furnished material and performed labor that was used in construction, not on the rights of the general contractor or owner.

It is noteworthy that the Crosno v. Travelers ruling only applies to public works payment bonds where there is no dispute regarding the work performed by the subcontractor. More significantly, the court cautions a number of times throughout its decision that it only applies to an expansive pay-when-paid clause deferring payment for an indefinite period of time, similar to the one quoted above. This seems to leave room for a finite pay-when-paid clause. By way of example only, the court might have ruled differently if the contract had specified a limited time period, such as one year from the date that payment became due under the subcontract, in which to collect from the owner.

Unfortunately, the court did not offer any guidance as to what might be deemed a “reasonable” period for nonpayment in a pay-when-paid contract clause, other than a strong suggestion that payment more than 3 years later is not reasonable. This pivotal question will have to be the subject of a future judicial test, unless the legislature steps in first. In the meantime, we strongly encourage both general contractors and subcontractors to closely review their current pay-when-paid provision to assess if revisions are in order in light of this recent ruling.

Mary A. Salamone is a Partner in Procopio’s Orange County office and a member of its Construction Law team. Recognized by Chambers and Partners, she brings in-depth knowledge and experience to her clients in all aspects of both public and private construction projects and disputes.

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