For the Construction Community, the End of the “Pay-When-Paid” Clause as We Knew It
A contract provision requiring a subcontractor to wait until the direct contractor concludes its litigation with the owner before it can seek payment on a payment bond was held unenforceable and against public policy in a recent appellate court decision, Crosno Construction, Inc. v. Travelers Casualty and Surety Company of America 2018 WL 4183622 (Cal.App. 4 Dist.). This case constitutes perhaps the most significant decision affecting pay-when-paid clauses since the seminal case establishing the enforceability of such clauses was decided in 1972.
“Pay-When-Paid” Versus “Pay-if-Paid” Clauses
California law distinguishes between “pay-when-paid” clauses and “pay-if-paid” clauses. If a clause is merely a “pay-when-paid” clause, it is enforceable, but only for a reasonable time. Once that time has passed, the subcontractor must be paid. Yamanishi v. Bleily and Collishaw, Inc. (1972) 29 Cal.App.3d 457. The court in Yamanishi held that a "pay-when-paid” clause was merely a covenant governing the time for payment, rather than an express condition precedent governing the right to recover any payment at all. But Yamanishi left open whether a provision, the terms of which purported to create a true condition precedent, would be enforceable.
“Pay-if-Paid” Clauses Held Unenforceable
The California Supreme Court decided that issue 25 years later in William R. Clarke Corp. v. Safeco Ins. Co. of America (1997) 15 Cal.4th 882. The Court held that a “pay-if-paid” clause—one that made the prime’s receipt of payment from the owner a condition precedent to its duty to ever pay the subcontractor at all is unenforceable because it effects an impermissible indirect waiver or forfeiture of the subcontractors' constitutionally protected mechanic's lien rights in the event of nonpayment by the owner.
The Clarke decision was made in the private works context; however, within a few months after Clarke, its holding was extended to public works subcontracts as well in Capitol Steel Fabricators, Inc. v. Mega Construction Co., Inc. (1997) 58 Cal.App.4th 1049.
“Pay-When-Paid” Clauses Must Have a “Reasonable” Payment Duration
The Crosno case arose out of a Water System Improvement Project, Proposition 84 Project No. 84-1510052-003, for construction of an arsenic water treatment plant in North Edwards, California (“Project”) owned by North Edwards Water District (“NEWD,” “District” or “Owner”). Clark Bros., Inc. (“Clark”) was the prime contractor on the Project and principal on the payment bond. Crosno Construction, Inc., (“Crosno”) was a subcontractor to Clark. Travelers Casualty and Surety Company of America (“Travelers”) was the payment bond surety and was jointly obligated with Clark under a public works payment bond.
The Subcontract between Crosno and Clark (The AGC Short Form Subcontract) has a “pay-when-paid” clause that provided if NEWD delays in paying Clark, then Clark and its surety:
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.
Clark was terminated from the Project, and as a result, was not able to pay Crosno in full. Clark brought an action against the owner. Before Clark’s action against the owner had concluded, Crosno moved for summary judgment against only Travelers on the payment bond.
In its motion, Crosno argued the “pay-when-paid” clause was in violation of Civil Code §8122, preventing advance waivers and releases of lien claims, which rendered the time the parties agreed upon for payment in the subcontract unenforceable. The Court granted summary judgment to Crosno against Travelers, which provided in part:
[A] provision that requires Crosno to wait until the contractor’s litigation with the public entity has ended before it can seek payment on the bond is against public policy as unreasonably affecting and impairing Crosno’s rights under the payment bond where no waiver and release [under Civil Code §8122] has been provided.
On April 17, 2020, the appellate Court affirmed the judgment of the trial court as follows:
After carefully considering the parties' arguments, we agree with the trial court's sound analysis. Enforcing the pay-when-paid provision found in Crosno's subcontract would postpone Crosno's right to recover under the payment bond for an indefinite time period until Clark's litigation against the District concludes. Such a result would unreasonably affect or impair Corson’s statutory payment bond remedy (§ 8122) and is unenforceable for the same reasons expressed in Wm. R. Clarke.
Although the Crosno case concerns the above “pay-when-paid” language as it relates to a claim against a surety on a payment bond, it will likely be argued as an analogue against a direct contractor’s use of the same “pay-when-paid” language to delay payment under a subcontract as an impermissible waiver of claimants mechanics’ lien statutory scheme rights.
A Little Nuance: To “Waive” Versus to “Affect” or “Impair”
The lynchpin of the above cases is that both the “pay-if-paid” clause and the “pay-when-paid” clause, with an unreasonably long payment duration, run afoul of the statutes governing waiver and release of a claimant’s mechanics lien statutory scheme rights. The only acceptable way for a claimant to waive its mechanics lien statutory scheme rights is by using the release language found (since a 2012 revision) at Civil Code sections 8132, 8134, 8136, and 8138. Under these statutes, at Civil Code section 8122, an owner, direct contractor, or subcontractor may not “waive, affect, or impair” any other claimant's rights to mechanics lien statutory scheme remedies unless the claimant executes and delivers a waiver and release in substantially the same form as that shown in these sections.
In short, a “pay-if-paid” clause impermissibly effectuates a “waiver” of mechanics lien statutory scheme rights, while a “pay-when-paid” clause (not a pre-condition, and ergo not a clear “waiver”) impermissibly “affects or impairs” such rights when the duration for payment extends too long. Extrapolating from the Crosno holding, the terms “affect or impair,” being more elastic than the term “waive,” successfully extends this statute’s prohibitions to the “softer” “pay-when-paid” clause.
What Does the Crosno Case Hold for the Future of “Pay-When-Paid” Clauses?
In conclusion, “pay-when-paid” clauses remain enforceable, but a reasonable time would have to be something short of “the time Contractor and Subcontractor require to pursue to conclusion their legal remedies against Owner . . . .” We anticipate that further judicial authority would provide more guidance as to what a reasonable time would be. But the reasoning behind the Crosno holding would suggest a good starting place to search for a “reasonable time” would be the statute of limitations period for a claimant to enforce its mechanics lien statutory scheme remedies. Of course, this analysis assumes delayed payment to the Subcontractor does not arise from any defective or untimely work on the part of the Subcontractor.
What Should Contractors Do?
Direct Contractors should review and revise their “pay-when-paid” clauses in their subcontracts or master subcontracts accordingly. Subcontractors should review “pay-when-paid” clauses in their current subcontracts for enforceability and should negotiate a “reasonable” duration for “pay-when-paid” clauses for all future subcontracts. Please call your AALRR attorney to review and revise your subcontracts accordingly.