The usual construction project has the General Contractor hire the subcontractors who are paid directly by the General Contractor (hereafter “GC”). The GC, in turn, is paid by the owner of the project, whether private or public.
Most construction projects have progress payments in which the GC is paid based on completion of specified portions of the project and also have hold back provisions in which the owner can withhold various levels of payment until final completion or until defective work is corrected.
For many decades GCs would include in their contracts with the subcontractors (hereafter “subs”) and, at times, materialmen who supply construction materials to the project, a provision that the sub or materialman would be paid only if and when the GC was paid. If the provision provided that no payment would be due the sub or materialman if the GC was not paid by the owner, that was a Paid If Paid provision and if the provision also or, instead, provided that the GC only paid the sub or materialman when the owner paid the GC, that was a Pay When Paid provision.
Both provisions are now unenforceable in California, though the Pay When Paid provision can still be used if carefully constructed by the GC. This article shall outline the provision restrictions and the way to avoid voiding the provision.
The Basic Case Law:
PAY IF PAID:
The first case that came down voided the Pay if Paid provision under the theory that it acted as a defacto waiver of the constitutionally protected mechanics lien or bond rights of the subs without their active consent. It essentially allowed the GC, without the subs’ involvement, to reduce or eliminate any sums being due the subs in negotiations with the owner, regardless of the actual fault or breach of duties by the subs.
In 1997, however, the Pay-if-Paid provisions were held illegal in California construction subcontracts. Wm. R. Clarke Corp. v. Safeco Ins. Co. (1997) 15 Cal.4th 882, 886. The court noted that the right to mechanic’s liens was a constitutionally protected right of those involved in construction projects, not just a contractual right, and as such was subject to special protection of the courts. The court wrote, ”…We conclude that pay if paid provisions like the one at issue here are contrary to the public policy of this state and therefore unenforceable because they effect an impermissible indirect waiver or forfeiture of the subcontractors' constitutionally protected mechanic's lien rights in the event of nonpayment by the owner.”
Note that the arguments advanced by the GC that the provision would not actually harm the subs since the amount that the GC would be paid would also be adversely affected if they waived the subs’ rights did not succeed with the court. Put simply, a constitutionally protected right was too important to be waived in this manner.
The Clarke case referred to mechanics liens only, but the issue remained as to payment bond rights in public jobs. Since no mechanics liens are allowed in public works projects, payment bonds take their place as security and have many of the same procedural requirements as mechanics liens. In Capitol Steel Fabricators, the same legal theory was used to prohibit “Pay if Paid” provisions in public works projects. Capitol Steel Fabricators, Inc. v. Mega Construction Co. (1997) 58 Cal.App.4th 1049, 1061.
Motto: In California, the rights of the subs to be paid cannot be contingent on whether the GC is paid.
PAY WHEN PAID:
The second type of provision is a “Pay-When-Paid” clause: the general contractor agrees to pay the subcontractor when the general is paid by the owner. Pay-When-Paid provisions can be enforceable so long as they are drafted in a manner providing that, at the latest, the subcontractor will be paid in a “reasonable amount of time” after completing the subcontract work.
In the recent case, Crosno Construction, Inc. v. Travelers Casualty & Surety Co. of America (2020) 47 Cal.App.5th 940 the California Court of Appeal affirmed a trial court’s ruling that the pay-when-paid provision used in the subcontract at issue was unenforceable because it provided the general contractor with the right to delay payment for an indefinite period of time. In Crosno, the general contractor (“Contractor”) entered into a contract with a water district (“Owner”) to build an arsenic removal water treatment plant. Contractor entered into the subcontract with Plaintiff Crosno Construction (“Subcontractor”) in which the subject pay-when-paid provision stated that the Contractor would pay Subcontactor within “a reasonable time,” which would be determined by “the relevant circumstances,” but that this reasonable time “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.”
Approximately six months into the project, Subcontractor was ordered to stop work because a dispute had arisen between Contractor and Owner. At that point, Subcontractor was owed approximately $562,000 for the work it had completed. Shortly thereafter, Contractor advised Subcontractor that Owner had terminated its contract and that it could not pay Subcontractor. Thereafter, Subcontractor provided the issuer of Contractor’s payment bond (“Surety”) with a written notice of its claim under the payment bond. Surety rejected the bond claim; it asserted that, under the pay-when-paid provision in the subcontract, no funds were due until Contactor’s then-pending lawsuit against Owner was completed. Subcontractor commenced the action against Surety.
Subcontractor filed a motion for summary judgment against Surety. Subcontractor argued that the pay-when-paid provision was unenforceable because it acted as a waiver of its statutory bond rights under Civil Code section 8122. (Cal. Civ. Code § 8122 [Stating that contract provision attempting to waive or impair claimant’s bond rights is void and unenforceable].) The trial court granted Subcontractor’s motion, finding that the pay-when-paid provision in the subject subcontract was void because it violated the antiwaiver policies contained in Civil Code section 8122.
Surety appealed the trial court’s order. On appeal, the court framed the issue before it as whether a payment bond surety could rely upon a pay-when-paid provision in a subcontract to delay payment on the bond “until some unspecified point at which litigation between the direct contractor and project owner concludes.” The appellate court agreed with the trial court and found the pay-when-paid provision in the subject subcontract to be unenforceable because it attempted “to define as ‘reasonable’ an indefinite time period already determined to be unreasonable in” a prior appellate decision. (citing Yamanishi v. Bleily & Collishaw, Inc. (1972) 29 Cal.App.3d 457.) The appellate court also noted that, “…the purpose behind the public works payment bond is to provide subcontractors such as Crosno …`a quick, reliable and sufficient means of payment.'” If Surety was allowed to enforce the pay-when-paid clause as written, it could nullify the bond whenever the general contractor’s litigation with the owner extended beyond the limitations period.
Put simply, “Pay When Paid” is subject to a reasonable time limit at which time payment must be made. An indefinite period will be rejected in California. There must be some reasonable deadline, not some unspecified point in time which can be indefinitely extended.
Pay-When-Paid provisions may still be used in subcontracts, but only if carefully drafted. There is no legally defined definitive line on what constitutes a “reasonable time” and what is an unreasonable time, but the prudent course is to define the outside time period for when the subcontractor will get paid following completion of its work. A key issue: the money must be paid-it cannot be contingent on the GC being paid.
A subcontractor put it well to this writer. “I’m not a baby. I have rights, let me enforce them. The General should not be telling me what I can do to enforce my rights. If I am not owed the money, the court will make that clear to me. I don’t need the GC to take away my rights to enforce my own demands.”
The problem facing many GCs, however, is that the owner requires them in the underlying construction contract to keep the project free of liens or bond claims or the GC is in breach of the agreement. Faced with this threat, many GCs only feel safe if they can make sure the subs have waived such rights. With the cases above, however, the solution is not in the manipulation of rights in the contracts with the subs but altering the provisions in the contracts with the owners of the projects.
The motivation of the owner is to make sure the GC pays the subs and not to alienate the financing institutions on the projects who do not want any liens or bond claims filed. Joint checks could assuage that danger from the owner’s point of view and the GC should simply advise the owner that such clauses are not enforceable in California in any event. One cannot create a contract that violates public policy.
In terms of “reasonable time” for the Paid When Paid clause, that again is simple. Put in a deadline that applies whether or not the GC is paid and which gives the GC sufficient time to promptly enforce its rights but has a limit that is not indefinite…nor years down the road which the court will not find convincing and not based on whether the GC is paid. Assuming there is an arbitration clause in the general contract, one year should easily cover that outside time schedule and a clause providing for payment within thirty days of the final decision of the arbitrator awarding payment or one year from X date, whichever first occurs, should suffice, though there are no guaranties that the court will consider it “reasonable.” The more limits on the time, the greater the chance for enforceability. Six months is better than one year, ninety days better than six months, etc.
The underlying issue is the constitutional nature of lien and bond rights. That matter went to the United States Supreme Court. Indeed, it was our law firm that argued in that forum in 1976 in favor of the constitutional rights inherent in the lien and bond actions. The unique aspect of the construction industry in which relatively small GCs and Subs are purchasing massive amounts of materials or hiring many workers far beyond their credit worthiness is why lien and bond rights were invented. The only way to have small and medium sized contractors and subcontractors is by giving them remarkable rights to enforce their claims and the courts were well aware of that simple economic fact of life. The courts will not let such rights be waived easily, as the cases above demonstrate.