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Contractual "Pay if Paid" and "Pay when Paid" Clauses? What is a CA Construction Subcontractor to Do

Thursday, December 02, 2021

Read: Contractual "Pay if Paid" and "Pay when Paid" Clauses? What is a California Construction Subcontractor to Do?

Content courtesy of: William L. Porter, Esq., The Porter Law Group, Inc.

The Situation California Construction Subcontractors Face in Obtaining Payment:

California construction subcontractors find themselves faced with a significant payment issue every time they are asked to sign a subcontract on a major project. Invariably, the subcontract the prime contractor presents to the subcontractor for signature will contain a clause by which the prime contractor imposes a condition on payment from the prime contractor to the subcontractor. The condition will be either one or the other of two general types. Either the prime contractor will specify that it never has to pay the subcontractor if the prime contractor itself is not paid by the owner (a “pay-if-paid” clause), or the prime contractor will pay the subcontractor only after the prime contractor has first exhausted all its efforts to obtain payment from the owner through litigation, arbitration or otherwise, possibly delaying payment to subcontractors by months or even years (a “pay-when-paid” clause).

Goal of the Article:

The goal of this article is to draw a distinction between the pay-if-paid and pay-when-paid
clauses, discuss the legality of these clauses in California, the problems these clauses create for subcontractors, advise the reader of helpful recent legal developments in this area of law, address the possibility of a further legislative remedy to address the issue, and discuss what the subcontractor might do to protect itself while awaiting a legislative remedy that may or may not ever arrive.

Legality of the Pay-if-Paid Clause in California:

Fortunately, half of this problem has been solved by the courts. Under the California Supreme Court decision in William R. Clarke Corp. v. Safeco Ins. Co. of America (1997) 15 Cal. 4th 882, the “pay-if-paid” clause has been determined to be “null, void and unenforceable.” This, however, has not stopped some prime contractors from continuing to include pay-if-paid clauses in their subcontracts. This is a mistake on the part of these contractors because the clause may be stricken from the subcontract by a court or arbitrator as illegal and unenforceable, leaving the subcontractor with a contractual right to immediate payment and possible legal entitlement to fees, costs and interest as a result of the contractor’s breach of subcontract for nonpayment.

Status of the Pay-When-Paid Clause in California:

Due to the impact of the Clarke v. Safeco case, noted above, many prime contractors have amended their standard subcontracts to convert an illegal pay-if-paid clause into a legally acceptable pay-when-paid clause. Under a pay-when-paid clause, the prime contractor does not impose a condition that it never has to pay the subcontractor if it is never itself paid for the subcontractor’s work. Rather, the clause usually carefully specifies that it will in fact eventually pay the subcontractor, but only after the prime contractor has
fully exhausted its dispute resolution procedures with the owner. The problem though, is that the process to exhaust remedies between the owner and prime contractor could take many years as the claim winds its way through the court system, including appeals. All the while the subcontractor remains unpaid.

As the subcontractor awaits payment from the prime contractor under the pay-when-paid clause, it is unfortunately unable to pay its own employees, subcontractors, suppliers and its internal operational costs. This leads to an avoidable proliferation of litigation as the subcontractor and all who are unpaid by the subcontractor must record mechanics liens and serve stop payment notices and payment bond claims and then sue to protect their rights to payment within extremely short time limits. This also puts the Subcontractor in a dilemma of being required to sue for breach of contract for its own payment, along with other claims, even though, according to the subcontract terms, the prime contractor has not yet even breached the subcontract because it does not have to pay the subcontractor until it has fully exhausted its remedies with the owner. But the subcontractor cannot wait years to sue the contractor for payment because, among other issues, by that time all the deadlines for pursuing collection remedies will have expired. Under the clause, the subcontractor is forced to sue for breach of contract, when arguably, no breach of contract has technically occurred, or wait for years to sue for breach of contract, at which point it will be too late to make claims for such valuable collection remedies as the mechanics lien, stop payment notice and bond claim. It is a dilemma. Suing right away seems to violate the subcontract. Waiting to sue results in missing claims deadlines.

The Crosno Decision to the Rescue?

The recent case of Crosno Construction, Inc. v. Travelers Casualty and Surety Company of America, (2020) 47 Cal. App. 5th 940, seems to have initiated the process of resolving this untenable dilemma. In Crosno, the Court of Appeals affirmed the trial court’s ruling, finding that, in effect, requiring a subcontractor’s bond claim rights to be delayed for months or years while litigation between the prime contractor and a water district proceeds to a conclusion, is the equivalent of an impermissible “pay-if-paid” provision, declared illegal in the Clarke v. Safeco case, mentioned above. The Crosno court reasoned that “the pay-when-paid provision here, which indefinitely postpones Crosno’s right to recover under the payment bond until Clark’s litigation with the District concludes, is unenforceable under California’s broader anti-waiver statute [Civil Code Section 8122].”

The Crosno court engages in a lengthy discussion of the permissible length of time payment from a contractor to a subcontractor may be delayed before a legal pay-when-paid clause becomes the equivalent of an illegal pay-if-paid clause, discussing another case, Yamanishi v.Bleily & Collishaw, Inc. (1972) 29 Cal.App.3d 457, at length. The discussion seems to conclude with an analysis by the court that since lawsuits to enforce a public works payment bond claim must be filed within six months after the last day on which a stop payment notice must be served, that this same date represents the point at which payment should be made by contractor to subcontractor, and the extent at which permissible “reasonable” delay before payment will become unreasonable. The court sets the allowable delay in payment at six months, because that is when a lawsuit to enforce a payment bond claim must be filed in court.

Extending Crosno to Other Situations:

The Crosno case involved a payment bond on a public works project. The Crosno
court indicated that the six-month deadline for filing a lawsuit to enforce a payment bond claim would be the extent of “reasonable” delay, before which the imposition of further delay by contractual terms would become unreasonable and unenforceable as an illegal
pay-if-paid provision. The payment bond claim, however, is only one of several traditional remedies for collection of construction claims. For example, in private works construction, lawsuits to enforce a “mechanics lien” claim must be fi led no later than 90 days after the mechanics lien is recorded (Civil Code 8460). For both public and private works projects, lawsuits to enforce a “stop payment notice” must be fi led no later than 90 days following the expiration of the period within which stop payment notices must be served (Civil Code §§8550, 9502). Arguably, under the Crosno court’s reasoning, these deadlines should also set the extent of reasonable delay before nonpayment becomes an actionable breach of contract on the part of the contractor. At that point, the subcontractor should have legitimate rights to sue for breach of contract as well as to enforce the mechanics lien, stop payment notice or payment bond claim. This reasoning though has yet to be confirmed by a California Court of Appeal and for that reason is not established as a rule to be followed.

The Need for a Legislative Remedy:

Extending the Crosno decision through a legislative enactment would be a relatively easy task, and one which should be accomplished to establish certainty to this developing area of law. To be brief, here is at least one option to address this situation through a new California Civil Code section which might be proposed. The proposed new Civil Code section might read as follows:

Civil Code [e.g., §8068] Contract Clauses Purporting to Delay Payment Right of Claimant
"Any contract clause which purports to delay payment to a Claimant for any period of time beyond those prescribed in this Part for an action to enforce a lien, stop payment notice or payment bond claim shall be null, void and unenforceable."

Pretty simple. No doubt construction industry trade groups, including the Associated General Contractors, American Subcontractors Association, and others, may wish to weigh in on the issue. Whatever the remedy, it needs to be addressed to impart certainty where uncertainty exists. It would be nice to keep it simple. Something like the above may achieve the task.

What Should the Subcontractor Do While Awaiting Legislative Action?

Until such time as the Legislature acts, subcontractors encountering a clause that looks like a pay-if-paid clause have some options. Here are a few options for consideration. Options such as these are best considered at the subcontract negotiation stage, before a subcontract is signed:

  1. If a clause is clearly an illegal pay-if-paid clause (contractor only pays subcontractor if contractor is paid) the subcontractor might consider leaving it alone since a court will not enforce it, whereas attempting to edit it will only call attention to the clause and cause the contractor to revise the clause to make it enforceable. Leaving the clause alone might be the better option for the subcontractor in such a case.
  2. If a clause is more likely a pay-when-paid clause, or something close to it, subcontractors might cross it out, initial the cross-out and write next to it something like: "Illegal per Clarke v. Safeco." If this edit is not successful, then a subcontractor might alternatively add limiting language on the delay. Something like: “. . . provided that such delay in payment does not extend beyond the deadline for Subcontractor to file an action on a mechanics lien, stop payment notice or payment bond claim.” This is similar to what the Crosno court did.
  3. Another option is to select a further definite deadline. To do this, one might edit the language to add something like: “. . . provided the delay does not extend beyond six (6) months from subcontractor’s billing date.” If this is used, the subcontractor might consider still suing by the statutory deadline, which might arrive earlier than six months from the billing date.
  4. If none of the above options is accepted, then it might be productive to write in the margin, if possible, or in a separate addendum document, if applicable, or in a transmittal document, if all else fails, that you consider the clause to be unenforceable under California law, citing Clarke v. Safeco and Crosno. Then sue by the statutory deadlines for claims if needed at a later time.
Conclusion:

Clauses which purport to delay payment rights to subcontractors indefinitely result in an avoidable proliferation of litigation as all those who are unpaid down the line must make claims and initiate litigation between each other within very short time frames to protect their rights to payment. As a matter of public policy and practicality, litigation should be avoided when possible. By limiting allowed delays in payment to the deadline for initiation of litigation of construction claims, litigation can be avoided in some cases and more quickly resolved in others. The court has opened the door to a change. The legislature should step in to address this need. Until they do so, subcontractors need to revise the subcontracts that contractors send to them in order to protect their rights to payment while they await a future legislative change.