Pay-when-paid clauses are commonly included in subcontracts by many general contractors. The stated effect of these clauses is to permit the general contractor to withhold payment from its subcontractor for work performed until such time as the general contractor is paid by the owner. During the last three decades, the question of whether such clauses are payment timing mechanisms or establish a condition precedent to the general contractor's payment obligation has been strenuously contested. Often, the resolution depends upon the wording of the particular contract provision in conjunction with other facts or circumstances. In recognition of the fact that many small contractors cannot remain in business without payment within a reasonable amount of time following performance of work, some states' legislatures have imposed statutory limitations on the operation of this clause. A common judicial limitation is to hold that the general contractor is required to pay the subcontractor within a reasonable time. Some courts have held that the clause does not allow non-payment for an indefinite period, but rather, that the subcontractor must be ultimately paid, regardless of whether the general contractor has been paid. These courts may interpret the payment clause's pay-when-paid language as merely a timing provision, rather than a condition precedent.
Related Payment Bond Issues
On most construction contracts, general contractors and the major subcontractors often furnish payment bonds. Consequently, a payment bond surety may seek to avail itself of pay-when-paid language as a defense to an otherwise valid payment bond claim. The case of Moore Brothers Construction Company v. Brown & Root, Inc., 962 F.Supp. 838 (E.D. Va. 1997), is one recent case to address these clauses in relation to payment bond sureties. The case involved a private project, construction of the Dulles Toll Road Extension. The general contract was awarded to Brown & Root, Inc. ("Brown & Root"). Brown & Root's surety, Highlands Insurance Company ("Highlands") issued a payment bond on the project. Subcontractors included Moore Brothers Construction Company ("Moore") and the Lane Construction Company ("Lane"). Both Moore and Land sued Brown & Root for the remaining balance on their contracts and for extra costs. Brown & Root and the owner disputed the extra costs. The claims ended up in arbitration with an award being granted to Brown & Root for the benefit of Lane & Moore. The award was affirmed in Virginia circuit court; however, the owner failed to pay and was, at that point, unable to pay. Moore and Lane then brought suit against Highlands under the payment bond to recover the amounts awarded in the arbitration. It is undisputed that Highlands was not a named party in the arbitration.
The subcontracts with both Moore and Lane contained pay-when-paid clauses. Highlands asserted the clauses as a defense to payment under the bond. The federal district court refused to allow the defense on several bases. The first was Highlands' failure to expressly incorporate the terms of the subcontract into the bond. In reaching this conclusion, the district court adopted the reasoning of a Florida Supreme Court case, OBS Company v. Pace Construction Corp., 558 So.2d 404 (Fla. 1990). In that case, the bond contained language identical to the bond issued by Highlands.
The Virginia Supreme Court has not yet dealt with the issue of pay-when-paid clauses asserted as a defense for a surety. However, Virginia has expressly recognized the validity of pay-when-paid clauses contained in subcontracts. In Galloway Corp. V. S.B. Ballard Construction Company, 464 S.E.2d 349 (Va. 1995), the court held that "pay-when-paid" clauses may be enforced as written. However, the intent to shift risk of insolvency of the owner to the subcontractor must be clearly expressed. In that case, the court found the contract to be ambiguous due to lack of a provision dealing with insolvency. Parol evidence and course of conduct lead the court to conclude that the pay-when-paid provision had been waived.
The Moore Brothers court recognized the Galloway decision permitted the enforcement of pay-when-paid clauses but distinguished the case on the basis that the claim was not asserted against a surety. In the absence of an express incorporation of the pay-when-paid clause into the bond, the question of whether the Virginia Supreme Court will allow the clause to operate as a defense for the surety remains open. However, even the express incorporation of the clause may not be sufficient to provide a defense to sureties. The federal district court in Moore Brothers cited a 1996 Northern District of Illinois opinion for the proposition that allowing the surety such a defense runs counter to the purpose of payment bonds. The court also cited a United States Court of Appeals Fifth Circuit decision denying such a defense to a surety providing a bond under the Miller Act.
Comment: It should be noted that, in addition to denying the defense, the court found Highlands to be bound by the arbitration award as a party in privity with a party to the arbitration. The Virginia federal district court adopted a strict interpretation stance with regard to surety liability under payment bonds. Caution should always be exercised, however, in determining surety liability. Each state has its own rule and the result may depend upon the language of the particular pay-when-paid clause. In drafting or negotiating payment terms, both parties to the contract or purchase order must consider the effect of a payment bond on their rights and liabilities.