This year’s DRI Fidelity and Surety Roundtable featured some excellent presentations. One that really caught my attention was Ronald Freidberg’s presentation on “pay-if-paid” clauses and recent case law affecting their enforcement in Ohio. Contingent payment clauses can be used to the surety’s advantage in defending payment bond claims. The practical implications of such clauses ensure that the surety will rarely be relying upon these provisions without an active principal. Practically speaking, if the owner or upstream contractor is withholding money from the principal and the principal is using that withholding of money as a defense to a downstream contractor, they are usually going to be actively involved in the litigation related to the project and the defense of the claim. It is rare that a principal will simply walk away from money owed on the project after the work has been performed or the material has been delivered. Still, the surety must be knowledgeable of these defenses. There is no doubt that these clauses can be used to the surety’s advantage in defending payment bond claims.
Several questions arise every time a surety comes across a contingent payment clause. How are these clauses enforced and what are the practical differences between pay-if-paid clauses and pay-when-paid clauses? While there may be headings that designate a certain contractual clause as a “contingent payment provision,” it is rare that the construction contract will be drafted with actual heading titled: “pay-if-paid” or “pay-when-paid.” What happens when there is not an active principal? Can the surety, as a secondary obligor, rely upon this defense just like the other defenses of the principal?
Application of a Pay-If-Paid Clause versus a Pay-When-Paid Clause
Both pay-if-paid and pay-when-paid clauses are “contingent payment clauses.” While their labels are only separated by one word and they are both risk-shifting provisions, their applications can be wildly different.
Generally speaking, a pay-if-paid clause makes payment from the owner or the upstream contractor a condition precedent to payment from the principal to the downstream contractor. A pay-when-paid clause, on the other hand, only deals with the timing of the obligation to pay the downstream contractor. At some point under these pay-when-paid clauses, when it becomes clear that the owner or upstream contractor is simply refusing to pay and is not simply withholding payment, the principal will become liable for the amounts owed to the downstream contractor. This is generally a fact intensive inquiry and can be affected by such circumstances as the length of delay in payment, the reason for non-payment, and the downstream contractor’s performance on the project.
Interpreting a Contingent Payment Clause as Pay-If-Paid or Pay-When-Paid
Whether either clause will be upheld is a very jurisdictionally specific question. Some jurisdictions favor the right to contract and will enforce these clauses as long as the parties clearly establish that they are shifting the risk of nonpayment to the downstream contractor in the construction contract. Others will practically interpret all clauses as pay-when-paid clauses. Still others frown on these clauses altogether.
My home state of Texas is a right to contract state. Therefore, these provisions will be enforced as long as the parties’ intent to shift this risk to the downstream contactor is clear in the construction contract. There is no magic language differentiating a pay-if-paid clause from a pay-when-paid clause. However, most Texas case law interpreting a contingent payment clause as a pay-if-paid clause states that the owner’s or up-stream contractor’s payment is a “condition precedent” to the principal’s liability to the downstream contractor. If this contingency to liability is not clear, the clause very well may be interpreted as a pay-when-paid clause and will only affect the timing of the principal’s liability. If the contingent payment provision is interpreted as a pay-if-paid, then the clause is subject to the “Texas Contingent Payment Statute,” which provides four scenarios which serve as exceptions to the application of these clauses: (1) the owner’s or upstream contractor’s refusal to pay is caused by the principal’s failure to meet its obligations; (2) the contingent payment clause is contained in a sham contract; (3) the downstream contractor provides timely notice objecting to the enforcement of the contingency payment clause; or (4) the enforcement of the clause would be unconscionable. The application of any of these exceptions will depend heavily on the facts and circumstances of the claim.
The Surety’s Ability to rely upon a Contingent Payment Clause
Logically, the surety is entitled to rely upon this defense when it is available to its principal. It is black letter law that the surety, as a secondary obligor, may rely upon all defenses of its principal to any claim under the bond. However, I have had claimants argue that it is void as to the surety based upon public policy. Most statutes requiring a statutory payment bond include language that prohibits the parties from contractually waiving claims under the bond as a matter of public policy. While most sureties will argue that (1) this is not the intent of such prohibitions and (2) a contingent payment clause is only a defense and it is not a waiver of a claim, the wary surety practitioner should know that such arguments are out there. The language in the Texas Contingent Payment Statute also suggests that the surety may rely upon these contingent payment provisions. In discussing the above referenced exceptions, the statute states that “a contingent payor or its surety may not enforce a contingent payment clause to the extent . . . .” The inclusion of the surety in this language, at the very least, suggests that the surety has the right to enforce these clauses whenever these exceptions do not apply.