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Sophisticated contractors know that in California contractual “pay when paid” provisions are enforceable but that “pay if paid” provisions are not.
“Pay If Paid” v. “Pay When Paid” Provisions
A “pay if paid” provision is one in which a higher tier party agrees to pay a lower tier party “if” it is paid in turn by a still higher party. Most commonly they are found in subcontracts between general contractors and subcontractors and provide that the general contractor will pay the subcontractor “if” the general contractor is paid by the project owner. However, they can also be found in subcontracts between higher and lower tiered subcontractors and between subcontractors and material suppliers and equipment lessors. In California, such provisions, which create a condition precedent to payment, namely, a condition that must precede payment to a lower tiered party, are void as a matter of law.
“Pay when paid” provisions, on the other hand, are enforceable. A “pay when paid” provision is one in which a higher tier party agrees to pay a lower tier party “when” it is paid by a still higher tier party. At first blush there doesn’t seem to be much of a difference between a provision that provides that a higher tier party will pay a lower tier party “if” versus “when” the higher tier party is paid by a still higher tier party. But there is. In California, “pay when paid” provisions are enforceable because courts have found that “pay when paid” provisions do not create a condition precedent to payment. In other words, “pay when paid” provisions are enforceable because they do not condition payment to a lower tier party on a higher tiered party receiving payment first from a still higher tier party. Rather, “pay when paid” provisions are enforceable because it merely provides that a higher tier party will pay a lower tier party when the higher tier party receives payment from a still higher tier party, but in no event beyond a reasonable time.
Thus construed, “pay when paid” provisions, despite their language, do not condition payment to a lower tier party on a higher tier party first receiving payment from a still higher tier party at all. Rather, a higher tier party must pay a lower tier party within a “reasonable time” whether the higher tier party is paid or not by a still higher party. However, sophisticated contractors and their lawyers have begun to define what a “reasonable time” is, and when they do, nearly across the board, they define a “reasonable time” as the time it takes for the higher tier party to pursue payment from the still higher tier party. This, of course, could take years given the slow wheels of justice.
This may all be coming to an end, however. In Crosno Construction, Inc. v. Travelers Casualty and Surety Company of America, Case Nos. D075561 and D075562 (April 17, 2020), the 4th District Court of Appeal examined the enforceability of a “pay when paid” provision in the context of a payment bond dispute. The “pay when paid” provision at issue provided that the general contractor would have a reasonable time to pay the subcontractor which “in no event” would be less than the time required for the general contractor “to pursue to conclusion [its] legal remedies against [the project owner.”
The Crosno Construction Case
General contractor Clark Bros., Inc. hired subcontractor Crosno Construction on a public works project owned by the North Edwards Water District. The public works project involved the construction of arsenic removal water treatment plant. Crosno was hired to build and coat two steel reservoir tanks.
Clark’s subcontract with Crosno included a “pay when paid” provision which provided as follows:
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.
After Crosno had invoiced $562,435 of work on the project, a dispute arose, and all work on the project stopped. Crosno filed a stop payment notice on the project, and after Clark informed Crosno that the District had terminated its contract with Clark, Crosno filed a payment bond claim. Clark later filed suit against the District and Crosno filed suit against Clark, the District and Clark’s payment bond surety Travelers Casualty and Surety Company of America for breach of contract, enforcement of its stop payment notice, and claim against Clark’s payment bond.
Roughly a year later, Crosno filed a motion for summary judgment on its payment bond claim against Travelers. In response, Travelers argued that Crosno’s subcontract with Clark included a “pay when paid” provision which defined “reasonable time” as the time for Clark to purse its legal remedies against the District, and because Clark was still in litigation with the District, Travelers had no current obligation to pay Crosno.
The trial court agreed with Crosno finding that the “pay when paid” provision would impermissibly affect or impair Crosno’s statutory payment bond rights under Civil Code section 8122 which provides that “[a]n owner, direct contractor, or subcontractor may not, by contract or otherwise, waive, affect, or impair” a claimant’s rights under California’s construction payment statutes (e.g., right to make a payment bond claim, enforce a stop payment notice, or foreclose on a mechanics lien) and that “any term of a contract that purports to do so is void and unenforceable unless and until the claimant executes and delivers a waiver and release under this article.”
While noting that “pay if paid” provisions were found to be unenforceable by the California Supreme Court in Wm. R. Clarke Corp. v. Safeco Ins. Co. (1997) 15 Cal.4th 882, the Court of Appeal explained that “pay when paid” provisions have found to be enforceable because “[a]s distinguished from a pay-if-paid provision, a pay-when-paid provision is not a true condition precedent and instead ‘merely [fixes] the usual time for payment to the subcontractor, with the implied understanding that the subcontractor in any event has an unconditional right to payment within a reasonable time.”
However, explained the Court of Appeal, “California courts have yet to decide whether an expansive ‘pay-when-paid’ subcontract provision similar to the one here can be invoked as a defense by a surety to a payment bond claim.”
The purpose behind a public works payment bond explained the Court of Appeal, “is to provide subcontractors like Crosno ‘a quick reliable and sufficient means of payment,” and a “pay when paid” provision that that delays payment until a contractor pursues to conclusion its legal remedies, “conflicts with the remedial purpose behind the statutory scheme, which we construe ‘most strongly against the surety and in favor of all persons for whose benefit the bond is given.”
However, the Court of Appeal carefully noted that “[w]e do not suggest that all pay-when-paid provisions are unenforceable against a payment bond claim – just that this one is.”
There’s a lot of interesting stuff in Crosno worth reading, which I won’t get into here, to keep things brief. Arguments by the payment bond surety that: (1) the “pay when paid” provision did not prevent Crosno from ultimately getting paid (true, said the Court of Appeal, but payment was received more than three years after Crosno sought recovery under the payment bond; (2) by invaliding the “pay when paid” provision the Court of Appeal was preferring subcontractors over direct contractors (“that is precisely the point,” explained the Court of Appeal, because the statutory scheme of stop payment notices and payment bond claims recognizes that subcontractors have unequal bargaining power); and (3) a payment bond surety’s obligation should be coextensive with its principal (it is, explained the Court of Appeal, since a surety can raise the same defenses as its principal, such as that the subcontractor performed defective work, but no such defenses were present in this case).
While limited to a public works payment bond claim, my guess is that Crosno is going to be applied to other claims as well, including stop payment notice claims and mechanics lien claims. While Crosno has set the outer bounds for “pay when paid” provisions (i.e., you can’t include a provision defining “reasonable time” as the time it takes to adjudicate a claim through conclusion) it also leaves open when a “pay when paid” provision is enforceable, and this is where us legal draftsmen are going to be grasping blindly.
And for your listening pleasure: