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Jeffrey Frank and Omar Harb Tapped for Hot Topics in Construction and Surety Risk Management

Attorneys Jeffrey Frank and Omar Harb co-authored a discussion of the surety’s ability to rely on contingent payment clauses; this discussion was published in the fall 2020 issue of Surety Bond Quarterly.

Question: What is the current trend regarding the surety’s ability to rely on contingent payment clauses?

Answer: The case law with respect to the enforceability of “pay-when-paid” and “pay-if-paid” clauses is difficult to characterize with any certainty. A typical pay-when-paid clause provides that the contractor will pay the subcontractor “within seven days” of payment from the owner for the subcontractor’s work.

But what happens if the owner never pays for such work, for reasons that have nothing to do with the quality of the subcontractor’s work (such as the insolvency of the owner)? Traditionally, courts have viewed such pay-when-paid provisions as merely timing mechanisms, pursuant to which contractors have a reasonable time (but not an indefinite time) to pay a subcontractor after payment by the owner.

On the other hand, pay-if-paid provisions expressly shift the risk of non-payment by the owner to the vendor. Such provisions typically contain language creating a “condition precedent.”

Courts have been more willing to allow contractors and their sureties to enforce those provisions to deny payment to subcontractors and suppliers. For example, in Berkel & Co. Contractors v. Christman Co., 533 N.W.2d 838, 840 (1995), the court upheld such a clause, holding that “failure to satisfy a condition precedent prevents a cause of action for failure of performance.” Because sureties are typically entitled to assert their principals’ defenses, sureties could avoid payment bond claims on the basis of these provisions.

However, in recent years, there has been a reluctance to allow a surety to rely on pay-if-paid provisions, citing public policy arguments. For example, federal courts have held that a surety cannot avoid Miller Act payment bond liability based on a pay-if-paid clause, as it would constitute an impermissible waiver of Miller Act rights. (See United States ex rel. U.S. Glass, Inc. v. Patterson, 2014 U.S. Dist. LEXIS 13827 (E.D. Pa. Feb. 4, 2014)).

Various states have followed that reasoning in barring the enforceability of these clauses, either through case law or by statute. One of those states is California, which has long held that pay-if-paid clauses are not enforceable, as set forth in Wm. R. Clarke Corp. v. Safeco Insurance Co., 938 P.2d372 (Cal. 1997). More recently, the California Court of Appeals applied the same reasoning to a more traditional pay-when-paid clause in Crosno Construction, Inc. v. Travelers Casualty & Surety Co. of America, 47 Cal. App. 5th 940, 955 (2020).

In that case, the provision allowed the surety’s principal “a reasonable time to pay, which ‘in no event’ would be less than the time required ‘to pursue to conclusion [its] legal remedies against [the Owner].’” The court issued an emphatic opinion indicating that the surety could not delay payment until after pending litigation between the principal and the owner was completed.

Producers and underwriters should keep this trend in mind when reviewing construction contracts and underwriting payment bonds and should confirm how the jurisdiction in question treats contingent payment clauses. To the extent the jurisdiction does not allow a surety to enforce these provisions, a principal (and its surety) could be liable to pay vendors prior to payment from the owner for such work, thereby potentially causing cash flow issues for the principal and increasing the surety’s exposure under the payment bond.

Click here to view article in Surety Bond Quarterly

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