Insufficiently Definite Pay-When-Paid Provisions Are Not Enforceable

In the early and mid-1990s, general contractors began utilizing provisions within their subcontract agreements that allowed the general contractor to delay payments to subcontractors, sometimes indefinitely, until and unless the general contractor was paid by the owner. These clauses became known as “pay-if-paid” (“PIP”) provisions. For the most part, PIP provisions provide that the owner’s payment to the general contractor is a condition precedent to the general contractor’s obligation to pay the subcontractor. Despite the conditional language in the agreements, many courts, including those in California, did not construe PIP provisions as establishing a condition precedent, but instead as fixing the usual time for payment, with the implied understanding that the subcontractor had an unconditional right to payment within a reasonable time. Clauses so construed were referred to as “pay-when paid” (“PWP”) provisions.

In 1997, the California Supreme Court held that true PIP provisions, i.e., ones that cannot reasonably be construed as PWP provisions, are unenforceable on the grounds that they are against public policy because “they effect an impermissible indirect waiver or forfeiture of the subcontractors’ constitutionally protected mechanic’s lien rights [specifically, California Civil Code (“CC”) § 8120 et seq (formerly 3262)] in the event of nonpayment by the owner.” Wm. R. Clarke Corp. v. Safeco Ins. Co. (1997) 15 Cal.4th 882, 886. Notably, Clarke involved a private project on which the owner insisted the general contractor obtain a payment bond; and not surprisingly, shortly after the Clarke decision, an appellate court applied the rule to the public works project context. Capitol Steel Fabricators, Inc. v. Mega Const. Co. (1997) 58 Cal.App.4th 1049, 1062.

In the wake of Clarke, PWP provisions became widespread in the construction industry. And until recently, courts had not addressed the enforceability of expansive PWP provisions that defer payment indefinitely. Crosno Const., Inc. v. Travelers Cas. and Surety Co. of America (2020) WL 1899278, however, confronted this very issue, and general contractors will want to know how this case will impact its contracts and surety-general contractor dynamics going forward.

In Crosno, the project’s owner cancelled its contract with Clarke, the prime contractor, when Crosno, the subcontractor, was nearly finished with its work. Clarke owed Crosno approximately $560,000 but asserted that it was unable to pay Crosno because the owner had not paid them. Clarke sued the owner, and Crosno initiated a claim under the payment bond issued by Travelers, Clarke’s surety. Travelers denied the claim, concluding that the PWP provision in the subcontract rendered the bond claim premature. The PWP provision provided that if Clarke was not paid, Clarke would have a “reasonable time” to pay Crosno, and that a reasonable time included the time required to fully pursue legal remedies against the owner.

Crosno argued that such a provision impaired Crosno’s bond rights in contravention of CC § 8122, which generally proscribes such a waiver. Travelers argued that the provision simply set the time-frame for payment and did not, therefore, implicate the policy concerns underlying CC § 8122. The trial court found for Crosno, and the District Court of Appeal for the Fourth District agreed.

The Court affirmed the trial court’s ruling that the PWP provision at issue was void and, therefore, unenforceable under CC § 8122, reasoning that “[i]f Travelers could invoke the subcontract’s [PWP] clause to postpone its payment bond obligation until some unspecified and undefined point in time when Clark’s litigation with the district [, the owner,] concluded, that would unquestionably and unreasonably affect or impair Crosno’s right to recover under the payment bond without either an express waiver or full payment required by sections 8124 and 8126.” Moreover, the Court reasoned that the purpose of the payment bond is to ensure “quick, reliable, and sufficient means of payment,” a purpose that would be thwarted if expansive PWP provisions were enforced.

Crosno raises some interesting issues for general contractors and sureties going forward. Notably, Crosno involved a public works project. That begs the question whether the same reasoning could be applied to PWP provisions in general and in the private works context. The Court in Crosno did not expressly extend its holding to a hypothetical involving a private, non-bonded project, but the reasoning in Crosno and Clarke arguably applies. Crosno explains that although there are different remedies available in the public and private construction contexts, the statutes pertaining to each “deal with the same specific subject, and are to be construed together.” This text suggests, therefore, that although the remedies are different, courts analyze the payment bond and mechanics lien remedies similarly, which in turn suggests that Crosno’s reasoning may very well apply in evaluating the enforceability of PWP provisions in general and in the private construction context.

Interestingly, Clarke, on which the Crosno court relied, was itself a decision that dealt with a private construction project. One wrinkle (noted above), however, is that the owner there insisted on a payment bond, which unlike public projects is not the norm in private contracts. Nevertheless, the Court’s analysis focuses on mechanics liens as much as it does payment bonds. The intertwined analysis appears to underscore how the two remedies are “construed together,” and further demonstrates the likelihood that Clarke and Crosno could and should be applied to PWP provisions in the private construction context, whether there is a payment bond or not.

Another issue is how exactly this holding affects surety law generally. Historically, a surety’s rights and obligations have been coextensive with the obligations of the principal, including the ability to assert contractual defenses. Therefore, if a general contractor could rely on a PWP provision to show its obligation to pay had not been triggered, the surety could do the same. Travelers (the defendant in Crosno) asserted this very argument—i.e., that if the general contractor was not yet in default on account of the “reasonable time” language in the PWP, then it had no obligation to the subcontractor. But, relying on Clarke, the Court soundly rejected the argument. Specifically, the Crosno court distinguished the direct contractor’s obligation under the subcontracts and its independent liability under the payment bond, stating “[t]he fallacy of [Traveler’s] reasoning, our Supreme Court explained, was that it considered only the [the former] while ignoring [the latter].” The Court further explained that “the action upon the statutory bond is not in any sense based upon the personal liability of the contractor but is based upon the obligation of the bond, since the bond provides a separate and distinct statutory remedy. The obligation of the bond, therefore, is enforceable without reference to any contract between the contractor and the [subcontractor or] materialman.”

At first glance this might appear to have wide-reaching implications for sureties and general contractors looking to avoid the exposure of having to promptly pay subcontractors long before the general is paid by the owner. For instance, most, if not all, payment bonds require a general contractor to indemnify the surety for payment bond claims. So by initiating a bond claim (instead of a direct claim with the general contractor), the subcontractor can theoretically avoid the effects of the PWP provision in the subcontract and obtain payment from the surety. Meanwhile, the general contractor still has the ultimate exposure to pay the surety for any and all amounts it incurs pursuant to the indemnity obligation contained within the bond.

There are, however, some important ways in which the Court appears to limit its holding to the facts in Crosno, each of which may prove a saving grace for general contractors and sureties. First, the Crosno Court appears to rely on the fact that the payment bond at issue did not reference the agreement with the relevant subcontractor. This was the case in Clarke as well. For general contractors looking to insulate themselves from what one might call Crosno-PWP liability (by way of the payment bond’s indemnity provision), it would be advisable to work with sureties to draft payment bonds so that they do reference the subcontracts, especially the PWP provisions therein. It is not entirely clear how this distinction would affect a future court’s analysis of the enforceability of a PWP provision, but it would arguably allow a general contractor to avoid the indemnity obligation owed to its surety, which is, after all, the very risk the PWP provision is meant to protect against. It could also pave the way for renewed reliance on the principle that a surety’s obligations are coextensive with that of the principal (the general contractor). In other words, including an express reference to the PWP provision in the payment bond may enable general contractors and sureties alike to actually rely on PWP provisions to delay paying a subcontractor when an owner fails to pay the general contractor. Moreover, it will do so without exposing the general contractor to back-end indemnity liability in the event the subcontractor initiates a bond claim against the surety.

Second, the Court is careful to point out that it is not ruling that all PWP provisions are per se unenforceable as contrary to public policy. Rather, it was just this particular PWP, which the Court held “attempt[s] to define as a ‘reasonable time’ a period previously construed by courts as unreasonable,” that the Court ruled unenforceable. Accordingly, as an alternative (or in addition) to drafting payment bonds that incorporate by reference the subcontract (as described above) general contractors and sureties would be advised to consult with counsel to ensure that future subcontract agreements include a sufficiently definite time-frame within which subcontractors will be paid. A concrete time-frame may not provide as much leeway as those PWP provisions that put off payment until the end of litigation (like the PWP in Crosno), but a shorter time-frame that is enforceable may be preferable to a longer one that is not.

Finally, the Court clarifies that it is not proscribing defenses that might otherwise be available to a surety on different facts. For example, the Court stated that “Travelers could still assert other defenses to the bond claim if . . . Crosno [had] failed to timely and properly perform its scope of work.” But “Crosno’s right to payment is undisputed. We simply conclude that Travelers cannot convert a broad obligation under the payment bond to an unreasonably narrow one via the pay-when-paid provision in Crosno’s subcontract.” That is, Travelers might have prevailed if there were other viable bases for contesting Crosno’s claim. None of those were addressed in the Court’s holding. Accordingly, if a surety has another basis for contesting a subcontractor’s claim, that basis may prove sufficient to avoid the outcome Travelers faced in Crosno. General contractors should, therefore, consult with counsel to identify all available defenses that may enable the general contractor to address the outcome in Crosno.

In sum, in the wake of Crosno, there are multiple steps general contractors and/or sureties should potentially consider. First, they should draft payment bonds to include reference to the subcontract agreements, especially the PWP provisions therein. Second, they should ensure that existing and future contracts contain a sufficiently definite time-frame for subcontractor payment such that it will not be deemed unenforceable under Crosno. Finally, they should consider whether their specific situation gives rise to other defenses that were not available to Travelers in Crosno.

The attorneys at Huguenin Kahn are available to assist with each of these items, as well any other business, employment, and litigation needs.Please call us at (916) 367-7098 or e-mail us at info@hugueninkahn.com. You can also follow us on social media @hugueninkahn.

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