By: Allison B. Kingsmill, Jones Walker, LLP
Can a surety refuse to pay an otherwise legitimate bond claim if the subcontractor’s agreement with the general contractor contains what is known as a “pay-if-paid” clause? It depends, but most jurisdictions reject such a defense. 1
“Pay-if-paid” clauses entitle the general contractor to withhold a subcontractor’s payment if the general contractor itself has not been paid by the owner. There are numerous jurisdictions that enforce such “pay-if-paid” provisions if their language is express, unambiguous, and explicit. Still, there are some jurisdictions that refuse to enforce such provisions because these “pay-if-paid” clauses are seen as limiting what is otherwise a public policy in those jurisdictions in favor of protecting payment to subcontractors who did the work. Notably, “pay-if-paid” clauses are generally different than “pay-when-paid” clauses which tie the timing of the subcontractor’s payment to the time when payment is made by the owner. This article only addresses “pay-if-paid” clauses.
Regardless, disputes around “pay-if-paid” clauses can arise if the general contractor was also required to post a payment bond that is supposed to guarantee that subcontractors and material suppliers on a project will be paid. Presuming the payment bond incorporates the subcontract—and most typically do, the surety who issued the payment bond may raise the “pay-if-paid” clause as a defense to paying on an otherwise valid bond claim. That’s when a legal conundrum arises.
On one hand, if this surety defense is allowed, the contractual “pay-if-paid” clause negotiated between the general contractor and subcontractor is enforced giving life to the parties’ arms-length, negotiated agreement, however the guarantee of payment under the payment bond would be effectively rendered meaningless. But on the other hand, if the surety who stands in the shoes of its principal (the general contractor) is not allowed to enforce the subcontract’s “pay-if-paid” clause, then the contractually negotiated risk shifting clause is rendered meaningless because the surety will be forced to make payment to the subcontractor and then seek payment from the general contractor through the typical indemnity agreement commonly contained in the agreement between the surety and general contractor. Consequently, if a payment bond surety cannot enforce a “pay-if-paid” clause, the result is effectively the same as if the general contractor could not enforce the otherwise enforceable “pay-if-paid” clause.
Whether the surety can raise the “pay-if-paid” clause as a defense to the same extent as the general contractor differs dramatically state by state. Some states have expressly allowed sureties to assert pay-if paid clauses as a defense. These courts reason that surety’s liability can be no greater than that of its principal. Therefore, if the principal is not liable, neither should be the surety. In contrast, other states have allowed sureties to use a “pay-if-paid” defense only if the bond expressly incorporates the payment terms of the subcontract. For example, in Florida, courts have found that sureties could not rely on the “pay-if-paid” clause as a defense explaining that the unpaid subcontractors were not suing the surety under the subcontract, but rather pursuing their claims against the payment bonds (separate and distinct agreements) which did not incorporate the “pay-if-paid” terms of the subcontracts. Still, other states have not yet addressed whether the surety may raise this defense. Therefore, if you are a general contractor trying to enforce a “pay-if-paid” clause, it is essential to understand the defenses available to the surety under your state law.
States, like Florida, that have refused to allow the surety to raise the “pay-if-paid” defense have suggested that parties can avoid this result by incorporating the “pay-if-paid” terms expressly into the bond itself. This would be a novel and untested legal approach.
Whether the surety can raise the “pay-if-paid” clause as a defense will also depend on whether “pay-if-paid” clauses are enforceable in your state. Some states have enacted statutes which make “pay-if-paid” clauses void and unenforceable. In other states, even where there is no statute expressly prohibiting “pay-if-paid” clauses, courts have found them to be unenforceable as against public policy. Here, the underlying theory is that a contractual requirement shifting the risk of owner non-payment is too great a risk for a subcontracting party that has no control over, or contractual rights against, the party withholding payment. For bonded projects in such states, the surety, therefore, would not be able to assert the “pay-if-paid” clause as a defense to claims for payment by lower tier subcontractors. Considering the differences in enforcement of “pay-if-paid” clauses state by state, general contractors and subcontractors should consider including favorable choice of law clause in their subcontracts.
Those states allowing sureties to rely on “pay-if-paid” clauses as a defense only do so if the clause clearly and unambiguously shows the parties’ intent to shift the risk of non-payment from the general contractor to the subcontractor. If the clause is unclear, it will likely lead a court to construe the clause as a “pay-when-paid” clause, which is different than a “pay-if-paid” clause as the “pay-when-paid” clause only controls the timing of payment, not whether any payment is due at all. Most courts have held that unless the contract clearly shows that the parties intended to make payment from the owner a “condition precedent” to payment of the subcontractor, the clause governs only the timing of payments to the subcontractor and does not allow the general contractor to avoid paying the subcontractor altogether. Therefore, contractors wishing to include contingent payment clauses in their subcontracts should err on the side of forceful language. Courts have held that use of the term “condition precedent” clearly shows the parties’ intent to transfer the risk of the project owner’s nonpayment from the general contractor to the subcontractor. Additional language broadly indicating that the subcontractor assumes the risk of non-payment by the owner will also strengthen the clause such as, this condition precedent “shall not be construed as a time payment clause.”
In conclusion, if you want to include a “pay-if-paid” clause in your subcontract, general contractors should take time to understand the effect of such clauses on a surety’s defenses. If you do not, that “pay-if-paid” clause you negotiated in the subcontract may not be worth the paper it is written on. To avoid that scenario, general contractors should first expressly incorporate the payment terms of the subcontract into the bond itself. Second, general contractors should closely review the applicable state law to determine whether there are any limitations against pay-if-paid clauses and consider including a favorable choice of law clause. Third, general contractors should choose an abundantly clear clause that includes language making payment from an owner a condition precedent to payment to down-stream subcontractors. Finally, subcontractors who have completed work but have been denied payment as a result of a pay-if-paid clause should carefully review the subcontract language and the relevant state law because even a clearly worded pay-if-paid clause may not be sufficient to defeat your right to recover against the surety.
1 This article does not address statutory bonds posted for public contracts, which are governed by either the Miller Act bonds (federal government projects) or a state’s Little Miller Act bonds.
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