TWENTY SECOND ANNUAL NORTHEAST SURETY AND FIDELITY CLAIMS CONFERENCE

Transcription

1 TWENTY SECOND ANNUAL NORTHEAST SURETY AND FIDELITY CLAIMS CONFERENCE nd rd SEPTEMBER 22-23, 2011 PAY-WHEN-PAID & PAY-IF-PAID CLAUSES AND THE SURETY PRESENTED BY: DARREN GRZYB, ESQUIRE Wolff & Samson PC One Boland Drive West Orange, New Jersey DAVID ANDERSTROM Hartford Insurance Company Bond Claims-T-4 One Hartford Plaza Hartford, CT 06155

2 INTRODUCTION With the ever-present risk that a project owner will run out of funds before the job is complete or that the adequacy of the work of a subcontractor may be disputed by the owner, general contractors will often include a provision in their subcontracts which makes their obligation to pay subcontractors contingent upon the general contractor s receipt of payment from the owner for the subcontractor s work. These clauses come in two forms: (a) pay-whenpaid provisions, where the general contractor is deemed to have an unconditional obligation to pay the subcontractor, but may postpone payment for a reasonable time to allow for receipt of contract funds from the owner covering the subcontractor s work, and (b) pay-if-paid provisions where the general contractor is obligated to pay the subcontractor only if it receives contract funds from the owner, and the risk of owner insolvency or nonpayment is shifted from the general contractor to the subcontractor. In truth, subcontractors extend credit to general contractors and general contractors extend credit to owners all the time, by performing the work first and thereafter submitting requisitions and awaiting payment. This reality has tended to cause courts to find that contingent payment clauses are of the pay-when-paid variety (i.e. unconditional promises to pay), unless the parties clearly express an intent that owner payment is a condition precedent to the contractor s obligation to the subcontractor. Unfortunately, even when the language used clearly shows such an intent, the availability of a pay-if-paid defense varies widely from state to state. One would think that a payment bond surety, whose liability under well-established principles of suretyship is coextensive with its principal, could avail itself of pay-if-paid clauses in those states where such provisions are recognized and enforceable. However, that is not always the case. Some courts have required that the payment bond itself set forth that the obligation is contingent on the owner s payment. Furthermore, in two states in this region, Delaware and Maryland, there are statutes which expressly void the pay-if-paid defense as to the surety. In Maryland, this provision appears to apply even though the surety s principal may itself be permitted to escape direct liability to its subcontractors under a pay-if-paid clause by virtue of the owner s failure to make payment. This victory for the general contractor/bond principal is of little comfort, however, because the principal has a common law obligation and, invariably, a contractual obligation under an indemnity agreement to place its surety in funds with which to satisfy all proper payment bond claims. PAY-WHEN-PAID CLAUSES: ESTABLISHING A TIME FRAME WITHIN WHICH PAYMENT IS DUE Example of a Typical Pay-When-Paid Clause: Contractor shall pay subcontractor within seven days of contractor s receipt of payment from the owner. 1 Unless the subcontract expressly states that payment by the owner to the general contractor is a condition precedent to the general contractor s obligation to pay the subcontractor, a clause such as the one set forth above will likely be deemed to be a paywhen-paid provision and not a condition precedent to the right to receive payment. For more than a century courts have interpreted pay-when-paid clauses as unconditional promises, 1 Midamerica Constr. Mgt. Co. v. Mastec N. America, Inc., 436 F.3d 1257, 1261 (10th Cir. 2006) (quoting Robert F. Carney, et als, Payment Provisions in Construction Contracts and Construction Trust Fund Statutes: A Fifty State Survey, 24 Construction Law 5 (2004)).

3 which do nothing more than afford general contractors a reasonable amount of time to secure payment from the project owner before paying subcontractors. 2 Many of the more recent cases that have come to this conclusion have relied on Thomas J. Dyer Co. v. Bishop International Engineering Co., 3 where the Sixth Circuit affirmed summary judgment in favor of a subcontractor (Dyer), who sued the general contractor (Bishop), and its surety, for a balance of $108,519.11, relating to subcontract change order work performed on a project at a Kentucky racetrack. Dyer was paid for the original subcontract work and some of the change order work by Bishop out of contract funds received from the Jockey Club, the project owner. However, Jockey Club became insolvent and sought reorganization in the bankruptcy court. Thereafter, payments from Bishop to Dyer stopped. Paragraph 3 of the subcontract in Dyer provided: [t]he total price to be paid to Subcontractor shall be [$115,000.00] lawful money of the United States, no part of which shall be due until five (5) days after Owner shall have paid Contractor therefor. 4 Bishop argued this clause made payment to the Dyer contingent upon Bishop s receipt of contract funds from the Jockey Club, and therefore, since the Jockey Club ceased making payments to Bishop, Bishop s obligation to pay Dyer had not arisen. In seeking to divine the intention of the parties as expressed in paragraph 3 of the subcontract, the Dyer court noted that, typically, general contractors rely on the solvency of the owner, and subcontractors rely on the solvency of the general contractor, the only party with whom subcontractors have an agreement. The court held that straying from this traditional risk apportionment required that specific language expressing this intention be included in the subcontract: It is, of course, basic in the construction business for the general contractor on a construction project of any magnitude to expect to be paid in full by the owner for the labor and material he puts into the project. He would not remain long in business unless such was his intention and such intention was accomplished. That is a fundamental concept of doing business with another. The solvency of the owner is a credit risk necessarily incurred by the general contractor, but various legal and contractual provisions, such as mechanics' liens and installment payments, are used to reduce this to a minimum. These evidence the intention of the parties that the contractor be paid even though the owner may ultimately become insolvent. This expectation and intention of being paid is even more pronounced in the case of a 2 David R. Hendrick, et als., Battling For the Bucks: The Great Contingency Payment Clause Debate, The Construction Lawyer, July 1996, p. 14. The authors of Battling for the Bucks found that one of the earliest decisions interpreting a pay-when-paid clause is Crass v. Scruggs, 22 So. 81, 82 (Ala. 1897). There, the subcontract provided that payment was to be made on the 15 th of each month, or as soon thereafter as [the railroad company owner] pays [the general contractor], which the court held to merely prescribe a time of payment, and not a condition upon which payment was dependant. The court doubted that the subcontractors would devote their time, labor, and means to the work they were bound to complete within a particular period, without an absolute engagement from the defendant to pay them, particularly since the subcontractors had no contract with the railroad company, were unknown to the railroad company, and the railroad company owed no duty to the subcontractors. Id F.2d 655 (6th Cir. 1962). 4 Id. at (emphasis added). 3

4 subcontractor whose contract is with the general contractor, not with the owner. In addition to his mechanic's lien, he is primarily interested in the solvency of the general contractor with whom he has contracted. He looks to him for payment. Normally and legally, the insolvency of the owner will not defeat the claim of the subcontractor against the general contractor. Accordingly, in order to transfer this normal credit risk incurred by the general contractor from the general contractor to the subcontractor, the contract between the general contractor and subcontractor should contain an express condition clearly showing that to be the intention of the parties. 5 In sum, in Dyer, because paragraph 3 of the subcontract did not make specific reference to the possibility of the owner s insolvency, but did refer to the amount, time and method of payment, the pay-when-paid clause was held to be merely a provision designed to postpone payment for a reasonable period of time after the work was completed, during which the general contractor could be afforded the opportunity of procuring from the owner the funds necessary to pay the subcontractor. 6 In the case of Seal Tite Corp. v. Ehret, Inc., 7 the New Jersey federal district court was faced with similar facts, a similar payment clause and nearly identical arguments to those at issue in Dyer. The Seal Tite court relied upon the above-quoted portions of Dyer, noting that the Sixth Circuit s decision represented the majority view. Therefore, the court was unwilling to interpret the payment provision at issue as imposing a condition precedent because to do so would effectively render the subcontractor a creditor of the owner. 8 Such an arrangement was unacceptable in the absence of express language indicating the parties intention to shift the collection risk from the contractor to the subcontractor. 5 Id. at Id. at 661. See also Eastern Heavy Constructors, Inc. v. Fox, 231 Md. 15, 188 A.2d 286 (Md. 1963) (holding that, under a pay-when-paid clause which provided that progress payments would be paid within five days of the contractor s receipt of payment from the owner that month, and the retainage to be paid within ten days after final payment, the contractor could not indefinitely suspend payment to the subcontractor for either progress payments, or the retainage, while the contractor resolved its dispute with the owner, which had nothing to do with the subcontractor s work) F. Supp. 701 (D.N.J. 1984). 8 The operative clause of the subcontract in Seal Tite provided that the contract price of $1,330,450 was: payable in the following manner: Ninety (90) percent monthly of work completed, within seven (7) days of receipt of payment by the Owner, or his Agent, provided statements of such work completed are rendered by the TWENTY-FIFTH OF EACH MONTH and are approved for payment by the architect. The balance to be paid within thirty (30) days after acceptance and receipt of final payment by the owner of the building and after complete release of all liens arising out of this contract have been delivered to ehret, inc. 589 F.Supp. at

5 PAY-IF-PAID CLAUSES MAKE THE PRIME CONTRACTOR S OBLIGATION TO PAY THE SUBCONTRACTOR CONDITIONAL UPON RECEIPT OF PAYMENT FROM THE OWNER FOR THE SUBCONTRACTOR S WORK Example of A Very Strong Pay-if-Paid Clause: 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 for subcontractor s work and the subcontract price includes this risk. 9 It is important to note that Dyer and the decisions which followed it left open the possibility that contractors could require subcontractors to bear the risk of owner insolvency or non-payment. In fact, the Dyer court gave a road map for doing so, stating in order to transfer this normal credit risk incurred by the general contractor from the general contractor to the subcontractor, the contract between the general contractor and subcontractor should contain an express condition clearly showing that to be the intention of the parties. One would think, therefore, that so long as the subcontract contained the magic words condition precedent and subcontractor assumes the risk of owner insolvency, courts would uniformly interpret pay-if-paid clauses to mean that the contractor s obligation to pay the subcontractor does not arise, unless and until, the owner pays the general contractor, particularly since Dyer has been recognized as the majority approach. While some jurisdictions allow the parties to contractually shift the risk of owner insolvency, others void pay-if-paid clause as against public policy. (i) Judicial Constraints to the General Contractor s Assertion of Pay-if-Paid Clauses Beginning with West-Fair Electric Contractors v. Aetna Casualty & Surety Co., 10 New York has categorically precluded contractors, and more recently their sureties, from relying on pay-if-paid clauses as a defense to paying subcontractors on the grounds that such clauses violate the public policy expressed in New York s Lien Laws. West-Fair was originally a federal court action. Plaintiff/subcontractor, L.J. Coppola, Inc., substantially completed the mechanical and plumbing work specified in its subcontract by October 1993, and through then, had been paid by the general contractor for that work out of funds received from the owner. However, when the owner subsequently became insolvent, payments to Coppola ceased, prompting Coppola to commence an action against the general contractor and its surety (Aetna), in federal district court. Coppola s subcontract contained the following pay-if-paid clause, which included the magic words condition precedent : IT IS SPECIFICALLY UNDERSTOOD AND AGREED THAT THE PAYMENT TO THE TRADE CONTRACTOR [COPPOLA] IS DEPENDENT, AS A CONDITION PRECEDENT, UPON THE CONSTRUCTION MANAGER [THE GENERAL CONTRACTOR] RECEIVING CONTRACT PAYMENTS, INCLUDING RETAINER FROM THE OWNER 11 9 Midamerica, 436 F.3d at 1261(quoting Carney, supra) N.E.2d 967, 87 N.Y.2d 148 (1995). 11 Id. at

6 The federal trial court granted summary judgment in favor of plaintiff, voiding the pay-ifpaid clause as against the public policy of New York State as an improper waiver of Coppola s right to enforce mechanics liens. 12 The general contractor and its surety appealed to the Second Circuit, which, based on the lack of a definitive statement from New York s highest court, certified the following two questions to the Court of Appeals for clarification: 1. Whether a pay-when-paid provision in a subcontract, which transfers the risk of an owner's default from a general contractor to a subcontractor, violates New York public policy as set forth in the Lien Law; and 2. Whether a surety's liability is contingent on the duty of a contractor to make payment to a subcontractor when the surety bond created an independent obligation to that subcontractor. 13 The Court of Appeals reached only the first question, holding that a pay-when-paid provision which forces the subcontractor to assume the risk that the owner will fail to pay the general contractor is void and unenforceable as contrary to public policy set forth in the Lien Law Lien Law 34 provides, [n]otwithstanding the provisions of any other law, any contract, agreement or understanding whereby the right to file or enforce any lien created under [the Lien Law] is waived, shall be void as against public policy and wholly unenforceable. 15 In New York, mechanics liens may not be enforced until a debt becomes due and payable. 16 A pay-if-paid provision, the court found, requires the subcontractor to defer payment for its work until the general contractor has been paid by the owner. Thus, if the insolvent owner never again pays the general contractor, the subcontractor s debt will never become due and payable, which, the court found, effectively amounts to a waiver of the subcontractor s rights to enforce its lien. 17 Therefore, paid-if-paid clauses appear to be void in New York as contrary to the public policies expressed in the Lien Law. 12 Id. at N.Y.2d at N.Y.2d at The court also referred to the Lien Law s legislative history, wherein the bill s sponsor, James H. Donovan, found the surrender of the protections afforded to those who contribute work, labor and materials to the improvement of real estate by the Lien Law as a prerequisite to obtaining a contract or subcontract is repugnant, against public policy and should be void. Id. at (citing Mem. of Senator Donavan, L.1975, ch. 74, 1975 N.Y. Legis. Ann., at 341). 16 West-Fair, 87 N.Y.2d at 158 (citing In re Application of Schiavone Const. Co., Inc., 181 A.D.2d 580, 581(1st Dept. 1992)). 17 West-Fair, 87 N.Y.2d at 159. In 2006, however, the New York Court of Appeals softened the position it took in West-Fair by holding that pay-if-paid clauses can be enforceable in contracts which specify that the laws of states other than New York govern the agreement. Welsbach Elec. Corp. v. MasTec North America, 7 N.Y.3d 624 (2006). One commentator found that the effect of Welsbach has been tempered by the New York Prompt Payment Act, which voids choice of law provisions that seek to make the law of another state the governing law of a construction contract. Among other exceptions, the Prompt Payment Act does not apply to public contracts. Richard P. Dyer, et al., New York Court of Appeals Upholds Pay-if-Paid Clauses as Enforceable and Not Contrary to Public Policy When Contract is Governed by Out-of State Law, The Construction Lawyer, Spring 2007, p

7 (ii) Judicial Constraints to the Surety s Ability to Assert Pay-if-Paid Clauses as a Defense The second question certified to the New York Court of Appeals in West-Fair concerning the surety s ability to assert the pay-if-paid clause was rendered moot by the fact that the Court struck the provision from the subcontract altogether. However, in Blandford Land Clearing Corp. v. National Union Fire Insurance Company of Pittsburgh, 18 the Appellate Division, First Department held that a payment bond surety (National Union) had an independent duty to pay subcontractors under the payment bond, in essence ruling that the surety s liability on its bond was broader than the obligation of the principal/general contractor (York Hunter). In Blandford, the contract between the owner (Bruckner) and York Hunter was unique in that it provided that York Hunter was Bruckner s agent for purposes of paying subcontractors. The general contract also contained the following condition-precedent/pay-ifpaid language, which was incorporated into the project subcontracts: a condition precedent to payment by York Hunter to [subcontractors] is the receipt of funds by York Hunter from Owner designated for payment to [Subcontractor]. [Subcontractor] acknowledges it is relying solely on the credit of Owner and not the credit of York Hunter for payment for Work performed by [Subcontractor]. 19 National Union was found to be liable under its payment bond, notwithstanding the payif-paid clause in the general contract. The court found that the bond itself contained an unqualified promise to make payment to any claimant that had a direct contract with the contractor to furnish labor, materials or equipment for use in the performance of the Contract. Without citing to any legal authority for doing so, the court thereby expanded National Union s exposure beyond that of its principal. Indeed, in contravention to basic principles of surety law, the court stated that had the surety intended to make its obligation coexistent with that of the general contractor, it would have been a simple matter to add a phrase to qualify its obligation to the extent that the contractor is obligated to pay for services and materials furnished in connection with the construction contract. 20 Similarly, in Moore Brothers Co. v. Brown & Root, Inc., 21 the United States Court of Appeals for the Fourth Circuit, applying Virginia law, also precluded a surety (Highlands) from asserting a pay-if-paid clause in its principal s subcontract as a defense to a payment bond claim by the subcontractor. Like Blandford, the court in Moore Brothers relied upon the fact that the bond contained an unconditional promise to pay any claimant who has not been paid in full within 90 days after work is completed for sum as may be justly due. Highlands argument that nonpayment by the Owners absolved it of its obligation was deemed to be nonsensical for if it were accepted, the purpose of the bond to insure that claimants who A.D.2d 86 (N.Y. App. Div., 1st Dept. 1999). 19 Id. at A.D.2d at F.3d 717 (4th Cir. 2000). 7

8 perform work are paid for their work in the event that the principal does not pay 22 would be defeated. 23 (iii) Pay-if-Paid Clause Found to Be a Viable Defense for the General Contractor Recently, in Fixture Specialists, Inc. v. Global Construction, LLC, 24 the federal district court in New Jersey expressed a willingness to enforce a pay-if-paid clause that expressly stated that payment by the owner to the general contractor was a condition precedent to the contractor s obligation to pay the subcontractor. 25 There, the subcontract between Global, the general contractor, and Fixture, the subcontractor, contained the following provision: Subcontractor agrees that Contractor shall never be obligated to pay Subcontractor under any circumstances, unless and until funds are in hand received by Contractor in full, less any applicable retainage, covering the Work or material for which Subcontractor has submitted an Application for Payment. This is a condition precedent to any obligation of Contractor, and shall not be construed as a time of payment clause. This condition precedent also applies to Contractor's obligation to pay retainage, if any. Contractor shall never be obligated to pay retainage to Subcontractor until Contractor has received its retainage in hand in full. This paragraph governs all other portions of this Subcontract, and any conflicting language shall be modified or deemed to be consistent herewith. Fixture moved to preclude Global and Liberty, Global s payment bond surety, from asserting this clause as a defense, arguing that it merely provided Global with a reasonable time to make payment. Fixture also argued that the clause violated the anti-waiver statute of the New Jersey s Construction Lien Law. 26 The court rejected the first ground by finding that the language was clear in that the parties intended to shift any and all circumstances of Owner s nonpayment to Fixture. This was because the all-encompassing nature of phrases never be obligated to pay and under any circumstances clearly and unambiguously expressed that Fixture agreed to assume the risk of the Owner s nonpayment. It did not matter that the provision did not expressly state that the risk of owner non-payment was being shifted from the contractor to the subcontractor. In this regard, the court stated that it is not the use of when 22 Id. at 723 (emphasis in original). 23 Judge Wilkins entered a dissenting opinion in Moore Brothers, which set forth a more accurate description of surety/principal relationship. Reasoning that, under Virginia law, the surety stands in the principal s shoes, Judge Wilkins believed that Highlands could avail itself of any defenses that were available to the principal, including the pay-if-paid clause. Furthermore, by agreeing in the payment bond to pay those claims which were justly due, Highlands undertook only to make payments which were due from the contractor under the subcontracts, meaning the surety would not be obligated to pay unless and until the owner paid the general contractor. Most notably, Judge Wilkins took issue with the majority s decision to broaden the surety s liability beyond the scope of the bonded contract. Id. at WL (D.N.J. March 30, 2009) 25 Id. at *2 (D.N.J. 2009) 26 N.J.S.A. 2A: 44A-38. 8

9 or if that is dispositive of the enforceability of the clause, but whether there is a clear evidence of an intent by both parties to shift the risk of collection. 27 Relying on West-Fair, Fixture argued that the clause violated the anti-waiver statute of New Jersey s Construction Lien Law. That statute provides: [w]aivers of construction lien rights are against public policy, unlawful, and void, unless given in consideration for payment for the work, services, materials or equipment provided or to be provided, and such waivers shall be effective only upon and to the extent that such payment is actually received. 28 Fixture also cited to N.J.S.A. 2A:44A-8, which provides that a lien claimant must verify that the amount claimed is due and owing at the date of filing, pursuant to the claimant s contract... Thus, according to Fixture, the pay-if-paid clause conflicted with the anti-waiver statute in that if the amounts were never due and owing from Global because Global was not paid by the owner, Fixture could not make the verification required by N.J.S.A. 2A:44A-8, and therefore, could not file a lien. The court held that the New Jersey s anti-waiver statute did not invalidate the pay-ifpaid clause. The court noted that in Thomas Group v. Wharton Senior Citizen Housing 29 the Supreme Court of New Jersey dismissed an overly technical interpretation of the due and owing requirement for filing a lien claim. In New Jersey, in balancing the interests of owners and contractors, contractors who have not technically performed all of the work or completed all of the conditions required for payment under a contract can nonetheless file a lien to protect the work installed, but cannot foreclose that lien until the contractual perquisites have been satisfied. Thus, the Fixture court held that under Thomas, Fixture was not precluded from filing a lien against the owner, even though the obligations of Global to pay Fixture were not technically due under the pay-if-pay provision of the subcontract. 30 (iv) Pay-if-Paid Clause Found to Be a Viable Defense for the Surety Fixture Specialists is also significant because the court permitted the surety to assert the pay-if-paid clause as a defense under its payment bond. Unlike New York s and the Fourth Circuit s approach, the court in Fixture Specialists adhered to the well-established principle of suretyship that the liability of a surety is conditioned on accrual of some obligation on the part of the principal; the surety will not be liable on the surety contract if the principal has not incurred liability on the primary contract. Stated differently, the central theme imbedded in New Jersey s concept of suretyship is the surety s unique character a surety s liability is triggered only when the principal s debt matures. Therefore, the court held: Thus, consistent with the objectives of the New Jersey surety law... if a condition precedent has not been satisfied pursuant to a valid pay-when-paid clause in a subcontract, a surety may use such clause as a defense against the subcontractor for demand of payment, because the contractor's duty to pay has not accrued. Here, having determined that Section 5.3 creates a condition precedent, Global has no WL at *5 (quoting Avon Bros, infra). 28 N.J.S.A. 2A:44A N.J. 507 (2000). 30 Fixture Specialists, 2009 WL , at 7-8 (quoting Thomas Group, 163 N.J. at 520). 9

10 liability for any amounts due to Fixture except to the extent that Global has actually received funds from the Owner. It logically follows that if Global has not received funds in full from the Owner, it has not incurred a debt, nor has it defaulted or miscarried on a debt owed to Fixture... Consequently, Liberty [the surety] may pursue its defense that it is not obligated to pay on the Surety Bond until Global becomes obligated on the debt. 31 Earlier this year, in BMD Contractors, Inc. v. Fidelity & Deposit Co. of Maryland, 32 a federal district court in Indiana granted summary judgment in favor of a surety on a payment bond claim pursuant to a pay-if-paid provision in the principal s subcontract with the claimants. There, the payment clause provided: IT IS EXPRESSLY AGREED THAT OWNER S ACCEPTANCE OF SUBCONTRACTOR S WORK AND PAYMENT TO THE CONTRACTOR FOR THE SUBCONTRACTOR S WORK ARE CONDITIONS PRECEDENT TO THE SUBCONTRACTOR S RIGHT TO PAYMENTS BY THE CONTRACTOR. 33 Because the parties used the magic words condition precedent, the contract was deemed to contain an unambiguous pay-if-paid clause, resulting in the surety being relieved of a current obligation to pay the claimants because the owner had not paid the principal for the claimants work. The decision is interesting because the court rejected the claimants argument that the pay-if-paid clause was void on public policy grounds pursuant to Indiana Code (b), which provides that a provision in a contract for the improvement of real estate in Indiana is void if the provision requires a person who... furnishes labor, materials or machinery to waive a right to... a claim against payment bond. Instead, the court agreed with the surety that the pay-if-paid provision did not amount to a waiver of the right to assert a payment bond claim, rather the claimants rights against the bond [had] simply not arisen, since [the principal could not] be in default of its obligation to pay [the claimants] unless it is first paid for [the claimaints work]. 34 Furthermore, the Indiana anti-lien waiver statute, which provides that [a]n obligor s receipt of payment from a third person may not... be a condition precedent to the provider s right to record or foreclose a lien against the real estate that was improved by the provider s labor, material or equipment, 35 was found not to preclude the surety from successfully asserting the pay-if-paid provision in the subcontract. This statute, the court held, addressed only the provider s (subcontractor s) right to record a lien, without mentioning bonds, an omission the court found meaningful. In the recent case of Sloan & Co. v. Liberty Mutual Insurance Co., 36 the Third Circuit, applying Pennsylvania law, read a pay-if-paid clause in conjunction with a liquidating WL at * No. 1:09-cv-0121-TWP-DML, Doc. No. 177 (S.D. In. January 13, 2011) 33 Id. at 8 (emphasis supplied by the court). 34 Id. at Ind. Code (c) (West 2011). 36 No , Document: (3d Cir. Aug. 1, 2011). 10

11 agreement 37 in the principal s subcontract and held that the subcontractor was entitled only to a pro rata share of the amount recovered by the principal/general contractor from the owner. In Sloan, IOC, the project owner, entered into a prime contract with Shoemaker to develop waterfront condominiums in Philadelphia. The plaintiff, Sloan, was Shoemaker s drywall and carpentry subcontractor. Liberty Mutual executed the payment bond. At the project s completion, IOC refused to pay Shoemaker nearly $6.5 million owed under the prime contract, $5 million of which was due downstream to the subcontractors, including approximately $1 million that was due Sloan. In a separate action, Shoemaker sued IOC for the contract balance but due to IOC s insolvency Shoemaker entered into a settlement agreement for only $1 million, of which Shoemaker had only collected $300, Sloan then sued Liberty under the payment bond, and obtained summary judgment in the federal district court. The Third Circuit reversed, relying on Paragraphs 6.f (a modified payif-paid provision) and 20 (a liquidating agreement) of the Sloan/Shoemaker subcontract. Paragraph 6.f contained two subparagraphs, the first of which provided: Final payment shall be made within thirty (30) days after the last of the following to occur, the occurrence of which shall be conditions precedent to such final payment... [IOC] shall have accepted the Work and made final payment thereunder to [Shoemaker, and Shoemaker] shall have received final payment from [IOC] for [Sloan s] Work. 39 That subparagraph was modified by the second subparagraph of 6.f, which provided: Notwithstanding anything to the contrary in this Paragraph 6.f, if within six months of the date that final payment is due to [Shoemaker by IOC], [Sloan] has not received final payment for its Work, [Sloan] may pursue its claim against [Shoemaker] and its Surety [Liberty Mutual] for final payment as follows: If within six months of the date that final payment is due and payable to [Shoemaker], [Shoemaker] commences a legal proceeding against [IOC] (the Contractor Dispute Resolution ) to resolve its own claim for final payment, [Sloan] agrees not to pursue its claim against [Shoemaker] or [Liberty Mutual] until the Contractor Dispute Resolution and appeals thereto are completed and become final... Upon completion of the Contractor Dispute Resolution..., [Sloan] may pursue any remaining claim for final payment it may have against [Shoemaker] or its Surety. 37 Not to be confused with a liquidated damages clause, a liquidating agreement provides a procedural mechanism for pass-through claims a process by which a general contractor may assert the claims of its subcontractors against an owner. Id. 16 & n Id. at Id. at 9 (emphasis supplied by the Court). 11

12 Nothing in Paragraph 6.f is intended to modify the provisions of Paragraph 20[, which deals with dispute resolution,] under the Subcontract. 40 The court found this language, which includes express language of condition, to be sufficient to establish a pay-if-paid condition in accordance with Pennsylvania law. 41 However, the court held that the second subparagraph of 6.f, created an override provision, which modified the pay-if-paid condition, such that Sloan had a claim for any remaining final payment in the event that IOC failed to make final payment within six months. 42 But, both subparagraphs of 6.f were subject to Paragraph 20, the liquidating agreement, which was deemed to be a super-override. Paragraph 20, in relevant part provided: In the event [Sloan] asserts a claim for payment of the Subcontract Sum or a portion thereof... and in the event that [Shoemaker] in its sole, exclusive and arbitrary discretion submits said... Claim to [IOC]... for a decision or determination, then all decisions and determinations made by [IOC] or its representative shall be binding upon [Sloan] even though [Sloan] may not be a party thereto... The decision or determination of [IOC] or its representative making the first and/or original decision shall be final and conclusive on [Sloan] except to the extent that [Shoemaker] may in its sole, exclusive and arbitrary discretion appeal to other representatives of [IOC] or arbitration or other dispute resolution form... Then, in such event, [Sloan] agrees to be bound to [Shoemaker] to the same extent [Shoemaker] is bound to [IOC] by any final decisions of said other represnative of [IOC] or of a Court of competent jurisdiction or by any final or interim award issued in arbitration or by any final decisions issued in any other dispute resolution forum. Under this liquidating agreement, because Sloan agreed to be bound to the decision of IOC, the Court held that Paragraphs 20 and 6.f created a mechanism for passing through Sloan s remaining claims for final payment and peg[ged] Sloan s recovery to the amount that Shoemaker receive[d] from IOC for Sloan s work. 43 Lastly, because Paragraph 20 also required Sloan to reimburse Shoemaker for expenses incurred by Shoemaker in prosecuting Sloan s claims against IOC, the court held that Sloan s pro rata share of the $300,000 paid to Shoemaker pursuant to the settlement in the related Shoemaker/IOC case would be reduced, pro rata, by Shoemaker s attorney s fees in that action. 40 Id. at Id. at 11 (citing C.M. Eichenlaud Co. v. Fidelity & Deposit Co. of Md., 293 Pa. Super. 11, 437 A.2d 965 (Pa. Super. Ct. 1981)) (discussed infra). 42 Id. at Id. at

13 STATUTORY CONSTRAINTS UPON THE ENFORCEABILITY OF PAY-IF-PAID CLAUSES Given the courts inconsistent treatment of pay-if-paid clauses, it is not surprising that some states have enacted legislation voiding them entirely or circumscribing their use. Delaware for example has determined that for private construction contracts, pay-if-paid clauses are contrary to public policy, and are void and unenforceable. The relevant Delaware statute provides: If a subcontractor performs in accordance with the provisions of its contract, the subcontractor shall be entitled to payment from the party with whom the subcontractor has contracted in accordance with the payment terms of its contract or this section, whichever applies; provided, however, that a provision in a contingent payment clause in a construction contract which: (1) States that a contractor assumes the risk of nonpayment of the owner; (2) Requires a contractor to waive any statutory or other right to commence litigation or arbitration until payment is made to the general or prime contractor; (3) Makes subject to payment by the owner the obligation of a contractor and its surety under any payment or performance bond to make any payment to a claimant under such bond; or (4) States that a contractor relies on the credit of the owner and not on the credit of the general or prime contractor or of a bonding company; is contrary to the public policy of this State and shall be void and unenforceable. 44 Public contracts are expressly excluded from this statute. Departing from traditional suretyship principles, in Maryland, where courts have permitted general contractors to assert pay-if-paid clauses as a defense to paying their subcontractors, 45 the legislature has enacted statutes for both public and private contracts, which preclude the general contractor s surety from asserting a like defense. These statutes provide: For Public Contracts: A provision in an executory contract between a supplier and a contractor or subcontractor that is related to a construction contract and that conditions payment to the supplier on receipt of payment by the person from a public body or other third party, may not abrogate or waive the right of the supplier to sue on payment security under this subtitle. 46 For Private Contracts: 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 44 Del. Code Ann., tit 6, 3507 (2011). 45 See Gilbane Building Co. v. Brisk Waterproofing Co., 86 M.D. App. 21, 585 A.2d 248, 252 (Md. Ct. of Spec. Apps. 1991) ( Since the insolvency of the project owner rendered impossible the satisfaction of the condition precedent, Gilbane [the general contractor] was not obligated to tender final payment. ) 46 MD Code Ann., State Finance & Procurement, (d)(2) (West 2011). Supplier is defined as a person who supplies material or labor, which would appear to include subcontractors. MD. Code Ann., State Finance & Procurement, (e)(1) (West 2011). 13

14 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) Claim a mechanics' lien; or (2) Sue on a contractor's bond. 47 THE CAUSE OF THE OWNER S DELAY IN PAYMENT AFFECTS HOW PAY-WHEN- PAID AND PAY-IF-PAID CLAUSES ARE INTERPRETED (i) Pay-When-Paid Clauses: General Contractors Generally Must Pay Their Subcontractors While Claims Are Pursued That Are Unrelated to the Subcontractor s Work Of course, an owner might refuse to pay a general contractor for reasons other than insolvency. For example, the owner may feel that the general contractor, or a subcontractor other than the subcontractor seeking payment, performed defectively. The owner may claim that the general contractor completed the project late, entitling the owner to an offset of liquidated damages against the contract balance. Similarly, the general contractor may intentionally delay filing its final payment requisition with the owner, while deciding whether to pursue or waive claims against the owner. In situations where a dispute between the general contractor and the owner, not involving the subcontractor s work, holds up payment to the subcontractor, courts are likely to find that the general contractor s payment obligation has arisen under a pay-when-paid clause, notwithstanding that the general contractor has not been paid by the owner. For example, in Eastern Heavy Constructors, Inc. v. Fox, 48 the subcontract provided that final payment was due to the subcontractor within ten days after final payment by the owner to the general contractor. The general contractor and owner became involved in a dispute unrelated to the subcontractor s work, and final payment by the owner was withheld. The Maryland court ruled in favor of the subcontractor who had satisfactorily performed its work, holding that a general contractor may not perpetually postpone payment to its subcontractors, while it litigates with the owner, or neglects to take steps necessary to secure final payment for itself. 49 Under similar circumstances, a federal court permitted a subcontractor to recover against a general contractor s payment bond surety after payment had been withheld from the subcontractor while the general contractor and owner were involved in a dispute. In Culligan Corp. v. Transamerica Insurance Co., 50 the subcontractor payment clause provided that final payment must be paid to the subcontractor (Culligan) within 30 days after completion of Culligan s work and acceptance by the architect. Culligan satisfactorily completed its work, but a dispute between the general contractor and the owner delayed final acceptance by the architect. Culligan sued the general contractor and its surety, then moved for summary judgment solely against the surety. Transamerica argued that, at the very least, there was a fact question as to whether Culligan s work was accepted by the architect. In affirming judgment for Culligan, the Seventh Circuit ruled that: 47 MD Code Ann., Real Prop (b) (West 2011) A.2d 286 (Md. 1963). 49 Id. at F.2d 252 (7th Cir. 1978). 14

15 Since Culligan did not request or obtain summary judgment against Gerodetti, these questions are relevant only if the Labor and Material Payment Bond incorporates the acceptance requirements of the subcontract and general contract as conditions precedent to recovery. The district court found such acceptance was not a condition precedent to recovery, and even if acceptance was required, the facts showed implied acceptance. We believe the district court was correct in reaching this conclusion. 51 Similarly, in Avon Bros., Inc. v. Tom Martin Const. Co., Inc., 52 the owner (New Plan) withheld payment to the general contractor (Tom Martin), who in turn withheld payment to two subcontractors, Avon and 18 Glass. The subcontractors sued both Tom Martin and New Plan for the amounts outstanding on their subcontractors. New Plan and Tom Martin asserted cross-claims against each other, which had nothing to do with the work of Avon and 18 Glass. The trial court entered summary judgment in favor of the subcontractors, but enforcement was stayed, while the owner and the general contractor resolved their cross-claims. The New Jersey Appellate Division held that the trial court erred in staying enforcement of the subcontractors judgments. Continuing the stay, and therefore postponing payment to subcontractors indefinitely, would effectively shift the collection risk to the contractor, which could not be countenanced under the terms of the pay-when-paid clause of the subcontracts. 53 (ii) Pay-if-Paid Clauses: The General Contractor Cannot Benefit from a Pay- If-Paid Provision If He Hinders The Occurrence of the Condition Under the prevention doctrine, when a general contractor materially contributes to the failure of a condition limiting the duty to perform under a contract, the general contractor may not rely on that failure as a defense to its performance of its contractual obligations. 54 For example, in Moore Brothers Co. v. Brown & Root, Inc., 55 which involved a construction project of a privately owned toll-road, the Fourth Circuit refused to permit a general contractor to assert an otherwise valid pay-if-paid clause as a defense to paying a subcontractor pursuant to the prevention doctrine. 56 There, the prime contract between the owners (TRIP) and the general contractor (Brown & Root), provided for additional payments to Brown & Root when substantial design changes changed the scope of the project. Early drafts of the prime contract included specific design change illustrations to clarify when Brown & Root would be entitled to additional payment. One of these illustrations was a change in the thickness of the pavement subbase material. However, the project lenders wanted to contain costs on the project and therefore were hesitant to enter into a contract that contained specific illustrations of design changes that would warrant additional payment. Therefore, Brown & Root and TRIP 51 Id. at WL , *7 (N.J. Super. App. Div. 2000). 53 Id. at *8. 54 Aarow Equipment & Services, Inc. v. Travelers Cas. and Surety Co. of America, 2011 WL at *5 (4th Cir., March 18, 2011) F.3d 717 (4th Cir. 2000). 56 Id. at

16 agreed to delete the illustrations to placate the lenders and assured the lenders that no additional work would be necessary. 57 After deleting the illustrations from the prime contract and without telling the lender, TRIP and Brown & Root entered into a side agreement that included the change-in-scope illustrations. At the same time, Brown & Root concealed from the subcontractors that the design change illustrations and potential need for additional change in scope work were hidden from, and therefore not adequately funded by, the lenders. 58 Not surprisingly, plaintiffs/subcontractors were eventually ordered to install thicker pavement subbase, and when the owner was not able to fund this extra-work because it did not secure additional financing, the subcontractors sued Brown & Root, and its payment bond surety. These circumstances lead the court to preclude Brown & Reed from asserting the payif-paid clause of its subcontract pursuant to the prevention-doctrine, even though the condition (payment by the owner) never occurred. The doctrine requires that the conduct of the promisor contributed materially to the non-occurrence of the condition. But for causation (i.e. the condition would have occurred but-for the promisor s conduct) is not a prerequisite, but rather, under Virginia law, all that is required is a showing that the promisor has hindered performance of the condition. Thus, the Fourth Circuit found that the contractor prevented the occurrence of the condition by concealing from the lenders the expectation that an increase in paving would be required. 59 SURVEY OF SELECTED STATES TREATMENT OF PAY-WHEN-PAID AND PAY-IF- PAID CLAUSES: New York: Pursuant to West-Fair and Blandford, pay-if-paid clauses are void and unenforceable as against the public policy expressed in New York s Lien Law. Under Welsbach, however, parties are permitted to choose the law of a state other than New York to govern their agreement and to the extent that pay-if-paid clauses are enforceable as conditions precedent in the agreed upon jurisdiction, they will be enforced. One commentator found that the effect of Welsbach has been tempered by the New York Prompt Payment Act, which voids choice of law provisions that seek to make the law of another state the governing law of a construction contract. Among other exceptions, the Prompt Payment Act does not apply to public contracts. 60 New Jersey: Under Seal Tite, pay-when-paid clauses merely permit payment to be postponed for a reasonable time, and under Avon, contractors may not indefinitely postpone payment to subcontractors, while the general contractor resolves its dispute with the owner. Pay-if-paid clauses appear to be valid and enforceable by both the general contractor and the surety, provided the clause unequivocally conditions the general contractor s payment to the subcontractor upon receipt of payment from the owner. 57 Id. at Id. 59 Id. at Richard P. Dyer, et al., New York Court of Appeals Upholds Pay-if-Paid Clauses as Enforceable and Not Contrary to Public Policy When Contract is Governed by Out-of State Law, The Construction Lawyer, Spring 2007, p

17 Pennsylvania: Pennsylvania courts have taken a traditional approach to pay-when-paid clauses, which are deemed to merely create a timing mechanism for a contractor s payment to a subcontractor and do not condition payments to a subcontractor on the contractor s receipt of those payments from the project owner. For example, in O Brien & Gere Engineers, Inc. v. Talghani, where the agreement provided that [defendant] shall make payments to [plaintiff] in the amount of said $157, within fifteen days of the availability of funds, the court held that such language created an unconditional promise, permitting the defendant a grace period or reasonable time within which to pay. 61 It has also been held that "Pennsylvania courts construe contract clauses that condition payment to a subcontractor on the contractor's receipt of funds from the owner of the project as 'pay-if-paid' clauses that do not require the contractor to pay a subcontractor until the contractor has received those funds from the owner of the project. 62 For example, the Superior Court held that a subcontract, which provided that Builder shall be under no obligation to make any payments to contractor for...work performed by contractor unless and until Builder is first paid by the owner, conditioned the builder s obligation to pay the contractor upon the builder being paid by the owner. 63 Connecticut: In Connecticut, courts have enforced pay-if-paid clauses in favor of the surety under certain circumstances. For example, in Lindade Construction, Inc. v. Continental Casualty Co., 64 where the principal s subcontracts provided that the obligation of the principal and its surety were contingent upon receipt of funds from the owner, and the subcontractors agreed that they were relying primarily for payment for work performed on the credit and ability to pay of the owner, the plaintiffs/subcontractors motion for summary judgment against the surety as to liability was denied. 65 In Crow & Sutton Assocs., Inc. v. C.R. Klewin Northeast, F. Supp. 1114, (E.D. Pa. 1982). 62 LBK Skysystems (USA), Inc. v. APG-America, Inc., 2005 WL (E.D. Pa. Aug. 31, 2005). 1981). 63 C.M. Eichenlaud Co. v. Fidelity & Deposit Co. of Md., 293 Pa. Super. 11, 437 A.2d 965 (Pa. Super. Ct WL (Conn. Super. Feb. 25, 2009). 65 Id. at *7. Lindade provided a very good example of an effective pay-if-paid provision in a subcontract: Progress payments to the Subcontractor for satisfactory performance of the Subcontractor's Work shall be made only to the extent of and no later than fifteen (15) working days after receipt by the Contractor of payment from the Owner for the Subcontractor's work. The Subcontractor agrees that the Contractor shall be under no obligation to pay the Subcontractor for any Work until the Contractor has been paid by the Owner. The payment provisions of this Agreement are subject to the condition that the Contractor receive, in good funds from the Owner, progress payments in at least the amounts payable to the Subcontractor on account of Work done by the Subcontractor on this Project. The Subcontractor expressly acknowledges and agrees that payments to it are contingent upon the Contractor receiving payment from the Owner. The Subcontractor expressly accepts the risk that it will not be paid for Work performed by it if the Contractor, for whatever reason, is not paid by the Owner for such Work. The Subcontractor states that it relies primarily for payment for Work performed on the credit and ability to pay of the Owner and not of the Contractor, and thus the Subcontractor agrees that payment by the Owner to the Contractor for work performed by the Subcontractor shall be a condition precedent to any payment obligation of the Contractor to the Subcontractor. The Subcontractor agrees that the liability of the surety on 17