General Contractors: The Payment Provisions in Your Subcontracts May Have Just Been Determined to be Unenforceable

Scott Halberstadt | TALG

While it has been more than twenty years since the California Supreme Court determined, in Wm. R. Clarke Corp. v. Safeco Ins. Co., that “pay-if-paid” provisions in subcontracts were unenforceable, following a recent decision from the Court of Appeal, Fourth Appellate District, general contractors, or any other contractors that contract directly with owners, should review their subcontracts to confirm that they do not contain potentially unenforceable “pay-when-paid” provisions.

Following the California Supreme Court’s Wm. R. Clarke decision, many direct contractors (defined by California Civil Code § 8018 as a contractor with a direct contractual relationship with an owner) revised the payment provisions in their subcontracts from “pay-if-paid” (where payment by the owner is a condition precedent for payments to the subcontractor) to “pay-when-paid” (requiring the contractor to pay the subcontractors within a defined period after payment by the owner). In the recent Crosno Construction Inc. v. Travelers Casualty and Surety Company of America decision, the Fourth District Court of Appeal determined that such “pay-when-paid” provisions may be unenforceable if they run afoul of California’s statutory waiver and release statutes (California Civil Code § 8120 et seq.).

In Crosno, the subcontract required the direct contractor to pay its subcontractor in monthly progress payments with the following “pay-when-paid” provision should the owner’s payment be delayed:

If Owner or other responsible party delays in making any payment to Contractor from which payment to Subcontractor is to be made, Contractor and its sureties shall have a reasonable time to make payment to Subcontractor. ‘Reasonable time’ shall be determined according to the relevant circumstances, but 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, including (but not limited to) mechanics’ lien remedies.

While the Crosno court did not appear to question the enforceability of most of this provision, the Court of Appeal determined that the portion of the provision which allowed the direct contractor to delay payment until the conclusion of its mechanics’ lien remedies was unenforceable. The Crosno court’s rationale was that this portion of the “pay-when-paid” provision postponed the direct contractor’s obligation to pay for an indefinite period of time and was, therefore, violative of California Civil Code § 8122’s bar against contractual provisions which “waive, affect or impair” a claimant’s waiver and release rights.

As pointed out by the Crosno court, California law lays out a comprehensive statutory scheme to resolve payment disputes in construction projects (California Civil Code § 8160 et seq. for private projects and California Civil Code § 9000 et seq. for public projects). This statutory scheme is intended to carefully protect against unfair or imprudent waiver of right to payment and a claimant may only waive its statutory remedies by signing one of the four types of statutorily required written waiver and releases (California Civil Code §§ 8132 – 8138). In fact, California Civil Code § 8122 makes any contractual provision purporting to modify the statutory waiver and release scheme unenforceable.

The Crosno court determined that the “but 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, including (but not limited to) mechanics’ lien remedies” portion of the “pay-when-paid” provision in the subcontract violated California Civil Code § 8122 and, thereby, made the provision, as a whole, unenforceable as a matter of law.

Like Wm. R. Clarke, the Crosno case involved a subcontractor’s claims against the direct contractor’s payment bond. Likely, the offending language in the contract (“but 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, including (but not limited to) mechanics’ lien remedies”) was intended to limit claims against the direct contractor’s payment bond. Unfortunately for the direct contractor and its surety, the payment bond obligated the surety, upon default by the direct contractor, to pay amounts due for “work and labor under the contract” between the direct contractor and owner. Seizing on the broad nature of the surety’s obligation and the unenforceability of the “pay-when-paid” provision, the Crosno court, like the Wm R. Clarke court before it, determined that the surety was obligated to pay the subcontractor’s claim regardless of the status of the direct contractor’s mechanic’s lien action against the owner.

The lesson to be learned from Crosno is that, while “pay-when-paid” provisions, in and of themselves, remain enforceable, they must be written in such a way that they neither run afoul of California’s statutory waiver and release scheme nor include patently unreasonable language. As such, we recommend that direct contractors review the payment provision(s) in their subcontractors to confirm that they remain enforceable.

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

Mary A. Salamone | Procopio Cory Hargreaves & Savitch

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.

Conclusion

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.

“Pay-When-Paid”: Is there a “Reasonable Time” for Subcontractors to Wait for Payment Once Contractor-Owner Litigation Ensues?

Christopher M. Wise | The Dispute Resolver

Obviously, subcontractors prefer to be paid within a reasonable time, but the issue of what constitutes a “reasonable time” has been a conundrum many states have tackled over the years. From “pay-if-paid” to “pay-when-paid” provisions, states have either adopted one, both, or neither of these commonly controversial, heavily negotiated provisions. Recently, the California Court of Appeals has ruled on a “pay-when-paid” provision that might set the groundwork for subcontractors in other states arguing that “paid-when-paid” provisions should be against public policy.

Distinguishing Between Provisions

Both “pay-if-paid” to “pay-when-paid” provisions ultimately determine who will bear the financial risk of a construction contract. 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 the work the subcontractor has performed.”1 Under a “pay-if-paid” provision, the risk of non-payment falls on the subcontractor if the owner refuses to pay the general contractor. Many states, including California, have concluded that “pay-if-paid” provisions are unenforceable because they indirectly waive or forfeit the subcontractor’s mechanic’s lien rights in the event of nonpayment by the owner.2

Under a “pay-when-paid” provision, the general contractor agrees to pay the subcontractor within a period of time after the general contractor is paid by the owner.3 Thus, under a “pay-when-paid” provision, the risk of non-payment falls on the general contractor. While a “pay-when-paid” provision is not a condition precedent, there is an implied understanding that the subcontractor has an unconditional right to payment within a reasonable time. While many states depart as to whether “pay-when-paid” provisions are enforceable, the underlining issue for a “pay-when-paid” provision is what constitutes a “reasonable time.”

Crosno Construction, Inc. v. Travelers Casualty & Surety Co. of America

On April 17, 2020, the California Fourth Appellate District Court of Appeals ruled against enforcing a “pay-when-paid” provision that would postpone the plaintiff’s right to recover under a payment bond for an indefinite time period. The underlining issue was whether a surety may defend a public works payment bond action by invoking an expansive “pay-when-paid” provision in a construction subcontract that defers payment for an indefinite period of time.4

North Edwards Water District (District) selected Clark Bros., Inc. (Clark) as its general contractor on a public works project to build an arsenic removal water treatment plant. Clark hired subcontractor Crosno Construction (Crosno) to build and coat two steel reservoir tanks.5 The subcontract contained a “pay-when-paid” provision that stated:

“If Owner or other responsible party delays in making any payment to Contractor from which payment to Subcontractor is to be made, Contractor and its sureties shall have a reasonable time to make payment to Subcontractor. ‘Reasonable time’ shall be determined according to the relevant circumstances, but 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, including (but not limited to) mechanics’ lien remedies.”6

A dispute arose between Clark and District halting the project. Crosno sought to recover payment owned under the public works payment bond that Clark had obtained for the project.

The Court focused on whether postponing Crosno’s right to recover under the payment bond until Clark’s litigation against the District concluded would result in an unreasonable impairment of Crosno’s statutory payment bond remedy. Crosno never executed a waiver and release required to validly “waive, affect, or impair” its payment bond rights. Applying precedent, the court reiterated that postponing payments:

“. . . earned by a subcontractor, itself without fault, until a dispute between the contractor and the owner is resolved, perhaps months or even years later … gives no reasonable assurance that such a dispute would ever be resolved. If the contractor lost the dispute, the contractor would be required to pay his subcontractor creditor from other funds. If the contractor won the dispute, the contractor would be required to apply all or a substantial part of the money he receives toward his subcontract obligations. . . the contractor’s interest would seem more likely to benefit from avoidance of any settlement with the owner.”7

A “reasonable time,” in this case, would include an indefinite timeframe. In fact, the litigation between Clark and District had already reached the two-year mark prior to this ruling. For many subcontractors, managing business in the wake of the COVID-19 crisis is difficult enough. If subcontractors were to be forced to wait until contractor-owner litigation were resolved prior to receiving payment, most subcontractors would fail to survive.

Conclusion

Crosno reminds lawyers representing subcontractors that the purpose behind a public works payment bond is to provide subcontractors a sufficient means of payment. This distinct remedy to public works subcontractors is in addition to the protection payment bonds provide in the event of a defaulting contractor. Moreover, Crosno provides a subtle reminder of the importance of drafting specific waiver and releases. Generally, a waiver and release of payment bond rights can be enforceable to the detriment of the subcontractor. While many states differ on their enforcement of “pay-if-paid” and “pay-when-paid” provisions, arguing the element of reasonableness to protect otherwise disadvantaged subcontractors caught in-between contractor-owner litigation might be your best option.



Wm. R. Clarke Corp. v. Safeco Ins. Co., 15 Cal. 4th 882, 885 (1997).
Id. at 886.
Chapman Excavating Co. v. Fortney & Weygandt, Inc., 2004-Ohio-3867, ¶ 22 (Ct. App.).
Crosno Constr., Inc. v. Travelers Cas. & Sur. Co. of Am., Nos. D075561, D075562, 2020 Cal. App.at *8-9 (Ct. App. Apr. 17, 2020).
Id. at 1-2.
Id. at 4-5.
Id. at 17-18 (citing Yamanishi v. Bleily & Collishaw, Inc., 29 Cal. App. 3d 457, 463 (1972).

Be Careful with Good Faith Payments

Christopher G. Hill | Construction Law Musings | November 25, 2019

Sometimes doing the expedient thing and what looks good at the time can come back to bite you.  Just ask 3M Company.

In Faneuil, Inc. v. 3M Co., the Virginia Supreme Court considered a customer services subcontract between Faneuil and 3M relating to a toll collection contract 3M entered into with ERC.  The subcontract had a “pay if paid” clause in it requiring payment to 3M from ERC before ERC was required to pay Faneuil, a written change order provision and a base monthly payment to Faneuil for the services that could be reduced in the event of less than expected toll collections.  Further, the subcontract stated that if either party settled 3rd party claims, that settlement would not bind the other party to the subcontract absent consent or Court order.

Faneuil was then alleged to have been required to provide “Special Services” relating to manual identification of license plates and other information necessary for toll billing due to 3M’s alleged failure to provide adequate imaging services.  Faneuil requested (without written change order) and 3M promised to pay extra for these services.  When 3M was slow to pay for the special services, Faneuil did what you would expect and threatened to stop providing them.  Instead of contesting the right to the work, 3m made sporadic “good faith” payments to induce continued Special Services from Faneuil.  Eventually 3M’s issues caused ERC to stop payments and thus 3M stopped paying Faneuil.  3M then settled the payment claims with ERC and still failed to pay Faneuil.

Faneuil did what any subcontractor in this position would do and sued for 5 categories of damages, including for base payments.  After a bench trial, the Circuit Court dismissed all of the claims by all parties because Faneuil had not obtained a written change order for the Special Services (ignoring the other claims for damages) and that 3M had failed to follow the proper procedures for reducing the monthly payments.  The Virginia Supreme Court reversed.  It held that damages for the Special Services were off the table for a lack of written change order and that 3M’s counterclaims were in fact barred by the subcontract.

While those two holdings are interesting, the Court further went on to say that 1. the settlement between ERC and 3M satisfied the pay if paid requirement, and the reason for the title of this post, 2. 3M was not entitled to the benefit of its good faith payments to induce Faneuil to continue the special services.  The Court held that under Virginia law, these types of non-legally required voluntary payments are not recoverable.  The Court put the holding as follows:

[w]here a person with full knowledge ofthe facts voluntarily pays a demand unjustly made upon him … it will not be considered as paid by compulsion, and the party thus paying is not entitled to recover back the money paid, though he may have protested against the unfounded claim at the time ofpayment made. Where money has been paid under a mistake ofthe facts, or under circumstances of fraud or extortion, or as a necessary means to obtain the possession of goods wrongfully withheld from the party paying the money, an action may be maintained for the money wrongfully exacted. But such action is not maintainable in the naked case of a party making a payment ofa demand rather than resort to litigation. Williams v. Consolvo, 237 Va. 608, 613 (1989)

Thus, despite doing what was seemingly the expedient and correct business action at the time to keep the contracted work moving, 3M was required to pay the full base compensation without credits for its prior good faith payments.

Situations analogous to this occur on the construction site all the time.  Deals are struck to keep the flow of work moving.  Most of the time, these sorts of “on the fly” deals are helpful.  However, before taking such action, remember 3M and consult your local Virginia construction attorney before taking such steps.

The Real Lemon in the Bunch: Understanding Pay-If-Paid Clauses in Construction Contracts

Matthew DeVries | Best Practices Construction Law | November 22, 2019

As you may be aware, one of the greatest risks on a construction project involves the payment process. Just like my kids expect to be paid for the lemonade they sell, contractors and subcontractors expect to be paid on a timely basis once the work has been performed.

Contractors have a means of shifting the risk of non-payment by the owner to its subcontractor by including a certain payment provisions in the subcontract agreement.  The enforceability of these types of clauses may be limited by your particular state or jurisdiction.

In Universal Concrete Products Corp. v. Turner Construction Company, the U.S. Court of Appeals for the 4th Circuit concluded that a “pay if paid” clause in a subcontract was not ambiguous and, therefore, enforceable against the subcontractor.  The work involved the construction of the Granby Tower Project in Norfolk, Virginia. The subcontract between the general contractor and the concrete subcontractor contained the following clause:

“The obligation of contractor to make payment under this agreement, whether a progress or final payment, or for extra or change orders or delays to the work, is subject to the express condition precedent of payment from the owner.”

The owner ultimately lost its construction financing on the project and abandoned the development. Since the contractor had not been paid for its work, it refused to pay the subcontractor’s work.  In a payment dispute between the subcontractor and contractor, the contractor argued that the “pay if paid” clause provided an absolute defense to payment. (Again, it should be noted that some states limit the enforceability of these clauses by either statute or case law. However, in Virginia, these types of clauses are enforceable so long as they are clear and unambiguous.)

The subcontractor argued that the prime contract between the owner and the contractor defined the cost of work to include “payments made” to subcontractors. Accordingly, the subcontractor argued that the contractor would, under the normal scenario, be paying its subcontractors and submitting the invoice to the owner as a “payment made” by the contractor. Both the trial court and the Court of Appeals disagreed, finding that payment from the owner was a condition precedent to payment from the contractor to the subcontractor.

Courts across the country vary in their treatment of these issues. For example, in the Universal Concrete Products case, the 4th Circuit reasoned that Virginia courts favor the freedom to contract and that parties are freely able to negotiate and draft these types of provisions. However, in Thomas J. Dyer v. Bishop International Engineering, the 6th Circuit refused to enforce a “pay when paid” clause because the court determined that the clause was sufficiently ambiguous. In that case, the contract stated that “no part of payment shall be due until 5 days after the owner shall have paid the contractor.”  Other jurisdictions, such as California, New York, Nevada and North Carolina, have expressly ruled that the “pay if paid” clauses are unenforceable as a violation of state public policy.

So, what should your contracts provide?  What should you do to determine the enforceability of a “pay if paid” clause in your state?

  • Contact an attorney to determine whether there are any limitations of the enforcement of these type of clauses.  Since each state differs dramatically, it is in your best interest to determine the applicable standard in your state or the applicable law where the project is located or the governing law of the contract to determine this information.
  • Determine as between the parties who should bear the risk of non-payment. If you are a general contractor, you should make sure that your subcontracts include clear and unambiguous language placing the risk of loss for non-payment on the subcontractor. In addition to putting a timing mechanism on payment of funds to the subcontractor following a certain number of days after payment by the owner, it is also advisable to include a clause that “payment by the owner to the contractor is a condition precedent to payment by the contractor to the subcontractor”. In addition, you can make your subcontracts explicitly clear by stating that “the subcontractor assumes the risk of non-payment by the owner due to insolvency or other inability to pay”.

For the contractors out there, Universal Concrete Products is a good reminder of the importance of drafting clear and unambiguous contact terms between the parties.  It is worth the effort to seek legal advice from an attorney in your jurisdiction about these issues prior to drafting and executing contracts with other parties.