Another court has struck subcontract clauses that attempt to condition the subcontractor's right to payment upon the general contractor's receipt of payment from the owner. The high court of New York refused to enforce so-called "pay-if-paid" clauses in a 1995 decision, and several states passed legislation outlawing the clauses. Now, California has followed suit in a recent decision by the California Supreme Court holding that conditional payment clauses are void as against public policy. Wm. R. Clarke Corp. v. Safeco Ins. Co. of America (1997) 15 Cal.4th 882 [64 Cal.Rptr.2d 578].
Conditional payment clauses have become a popular tool used by prime contractors to shift to subcontractors the risk of the owner's insolvency or non-payment. These clauses go beyond language governing the mere timing of the payment, and provide that receipt of payment from the owner is a "condition precedent" to the prime contractor's obligation to pay subcontractors. In other words, conditional payment clauses attempt to provide that if the owner never pays the prime contractor, then the prime contractor never has to pay the subcontractors. These clauses are now typical in custom subcontracts developed by many general contractors, and are making their way into industry- drafted subcontract forms. The AGC of California, for example, includes a "pay-if-paid" clause in its Long Form Standard Subcontract.
Conditional payment clauses are controversial, and have been under attack by subcontractor groups. Several states, including Illinois, North Carolina, and Wisconsin, have passed legislation declaring conditional payment clauses unenforceable. See, e.g., 770 Ill. Comp. Stat. Ann. 60/21; N.C. Gen. Stat. Â§ 22C-2 (1991); Wis. Stat. Â§ 779.135. New York state's highest court struck down conditional payment clauses as violating public policy. West-Fair Elec. Contractors v. Aetna Casualty & Surety Co., (1995) 87 N.Y. 2d 148, 157 [661 N.E. 2d 967, 971; 638 N.Y.S. 2d 394, 398]. A bill was introduced last year in California to abrogate conditional payment clauses, but failed to garner the necessary support. In a 4-3 split decision, the California Supreme Court has done what the legislature could not, ruling "that a general contractor's liability to a subcontractor for work performed may not be made contingent on the owner's payment to the general contractor." Clarke v. Safeco, supra, 64 Cal.Rptr.2d at 587.
THE CLARKE CASE
The Clarke case arose out of a commercial building project in Los Angeles. The contracts between the general contractor and the subcontractors contained true "pay-if-paid" clauses, which read, in part: "Receipt of funds by contractor from owner is a condition precedent to the contractor's obligation to pay subcontractor under this agreement, regardless of the reason for owner's non-payment, whether attributable to the fault of the owner, contractor, subcontractor, or due to any other cause."
The owner required the general contractor to obtain a labor and materials payment bond, and Safeco Insurance Company was the surety on that bond. During the course of construction, the owner became insolvent and stopped making payments to the general contractor. Relying on the conditional payment language in the subcontracts, the general contractor stopped paying the subcontractors. The subcontractors filed mechanic's liens and sought to enforce claims against the payment bond.
In defense of the payment bond claims, Safeco argued that its obligation, as surety, was coextensive with the obligation of the general contractor. The conditional payment clauses in the subcontracts provided on their face that the general contractor did not owe the subcontractors funds that were not paid by the owner. Until the condition -- the owner's payment to the general contractor -- was satisfied, neither Safeco nor the general contractor was responsible to pay the subcontractors, Safeco argued.
The California Supreme Court rejected Safeco's defense. The Court focused on language in the California Mechanic's Lien Law that prohibited parties to a contract from including language in the contract that waived or impaired lien rights. (Civil Code section 3262.) Further, the Court noted that mechanic's liens were limited to "only such amount as may be due [the claimant] according to the terms of his contract". (Civil Code section 3140.) Since the lien right is dependent on the contract right to payment, the "pay-if-paid" clauses providing that the subcontractors had no contract right to payment unless payment was made by the owner could be construed to impair the subcontractor's mechanic's lien rights. Therefore, the clauses ran afoul of the prohibition on advance lien waivers in contracts. The Court found this to be the case even though some of the subcontracts at issue contained an addendum expressly reserving lien rights. Because the conditional payment clauses violated the public policy against waivers of mechanic's liens, the Court held that they were void and unenforceable.
Regarding Safeco's argument that its obligation on the bond was not triggered because its principal was not in default on the subcontracts until the owner made payment, the Court held that Safeco and the general contractor, as parties to the payment bond, incurred liability to subcontractors and suppliers independent of the obligations of the subcontract. The Court characterized the general contractor's liability on a payment bond as a "separate and independent liability... measured by the terms of the bond and the statutes referenced in the bond." Clarke v. Safeco, supra, 64 Cal.Rptr.2d at 585. With the pay-if-paid provisions stricken, the subcontractors had mechanic's lien rights that were an independent liability for which coverage was provided under the bond.
DEALING WITH ENHANCED RISK
While good news for subcontractors, the California decision is an obvious setback to prime contractors desiring to transfer the risk of the owner's default or insolvency. The Supreme Court's decision makes this risk-shifting through the use of conventional "pay-if-paid" clauses virtually impossible in California. The Supreme Court's decision may not, however, be the last word on conditional payment in California. The AGC of California has vowed to push legislation changing, at least in part, the Court's ruling. In the meantime, however, California prime contractors will not be able to rely upon conditional payment clauses as a defense to subcontractor payment claims, but will have to consider employing other risk-shifting devices to allocate to subcontractors the risk of the owner's payment default.
Some commentators have predicted that the Clarke decision will result in more construction management contracting arrangements, in which the trade contractors contract directly with the owner, and the general contractor manages the project for a fee. While this arrangement successfully removes the payment risk from the general contractor/construction manager, many contractors find that the loss of leverage over the subcontractors makes this arrangement unworkable. Similarly, owners may prefer to deal with a single general contractor rather than multiple trade contractors, and may not consent to this arrangement.
There are a few steps general contractors can take to mitigate the payment risk short of altering the contracting scheme with a construction management arrangement. Careful contractors will include clauses in their owner agreements that require the owner to verify the adequacy and existence of project financing before work commences. Where feasible, contractors may want to explore payment procedures that give the contractor more control than standard owner or lender financing, such as letter of credit financing or advance deposit of the construction funds into a joint control account. Contractors may also attempt to negotiate suspension of work clauses, entitling them to suspend performance of the work in the event the owner is delinquent in payment.
It should be noted that the Clarke Court expressly did not address "pay-when-paid" clauses, which merely fix the usual time for payment of the subcontractor. These clauses have been construed in California to require payment no later than a "reasonable time", whether or not the general contractor receives payment from the owner. See, Yamanishi v. Bleily & Collishaw, Inc., 29 Cal. App. 3d 457, 462-63 (1972). They may still give the contractor some defense in a late payment (as opposed to total failure of payment) situation, and are of value to contractors.