By Rebecca S. Glos
Changes related to the COVID-19 crisis and the construction and surety industries are still occurring; some data in this article may have changed from the time of article submission and the publication date.
Just when everybody thought the issue of the enforceability of pay-if-paid clauses and pay-when-paid clauses was well settled, a recent decision by the California Fourth District Court of Appeal in Crosno Construction, Inc. v. Travelers Casualty and Surety Co. of America, 47 Cal. App. 5th 940 (2020), has added a new wrinkle, keeping contractors and sureties alike on their toes.
Historical Framework for Pay-If-Paid and Pay-When-Paid Provisions in Subcontracts
Prior to the Crosno holding, one of the seminal California construction payment cases was the California Supreme Court decision in William R. Clark Corp. v. Safeco Insurance Co., 115 Cal. 4th 882 (1997): a pay-if-paid provision in a California construction contract is not an enforceable defense to a payment claim by a subcontractor as it is against public policy. Consequently, the court in Wm. R. Clarke held that a prime contractor must pay the subcontractor regardless of whether the prime contractor has been paid by the owner.
Notwithstanding the decision in Wm. R. Clarke, courts have generally distinguished “pay-when-paid” clauses may be enforceable so long as the time affixed for payment to the subcontractor is a “reasonable” time. The issue faced by many subcontractors is what exactly constitutes a “reasonable time”? Even if the subcontract in question includes a definition of “reasonable” time (and, often, they do not), will it be considered reasonable as a matter of law? While subcontractors would like to have the question of reasonableness quantified more precisely (for instance, whether 60 days, 180 days, or even one year could be considered reasonable), the answer often depends upon the factual situation particular to each given case.
Crosno Appellate Court: An Indefinite Amount of Time Is Not “Reasonable”
The issue addressed in Crosno is whether a pay-when-paid provision that allows the contractor not to pay the subcontractor until the contractor has concluded its pursuit of legal remedies against the owner is a “reasonable” timeframe for payment to the subcontractor. In Crosno, the general contractor, Clark Bros., Inc. (Clark), was hired by the North Edwards Water District (District) as its general contractor to build an arsenic removal water treatment plant. Clark, in turn, hired subcontractor Crosno Construction, Inc. (Crosno) to build and coat two steel reservoir tanks. The subcontract included a “pay-when-paid” provision allowing Clark to pay Crosno within a reasonable time of receiving payments from the District, but “in no event shall be less than the time [Clark] and [Crosno] require to pursue to conclusion their legal remedies against the [District] or other responsible party to obtain payment ….” (Emphasis added.) After it had supplied and fabricated labor and materials in excess of $500,000, Crosno was ordered to stop work because a dispute had arisen between Clark and the District. The District subsequently terminated Clark, and a lawsuit arose thereafter.
Crosno filed its own lawsuit against Clark and its surety, Travelers Casualty and Surety Company of America (Travelers), to receive payment for its work under Clark’s public works payment bond. Travelers argued it was entitled to rely upon the pay-when-paid provision, which allowed Clark to withhold payment from Crosno until litigation between Clark and the District had concluded. The trial court granted Crosno’s motion for summary judgment on the basis that the pay-when-paid provision was unenforceable because it violated the policies underlying California Civil Code § 8122, which required a waiver and release before a subcontractor’s payment bond claims would be “waive[d], affect[ed], or impair[ed].” Travelers subsequently appealed on the issue of whether it was liable for prejudgment interest and attorneys’ fees under the payment bond (the District had interpleaded funds to satisfy the outstanding principal judgment in favor of Crosno on its payment bond claim).
Having acknowledged the constitutional and statutory basis for payment bonds, the court of appeal agreed with the trial judge’s finding that the pay-when-paid provision, which set a potentially lengthy and uncertain period during which a subcontractor would not be permitted to enforce its statutory right to recover the value of its work and materials, was void as a violation of the public policy underlying Civil Code § 8122. The court determined that, while explicitly providing for payment to be delayed for an “unspecified and undefined” period after completion of the work, the provision conflicted with the purpose behind the payment bond of providing subcontractors with an expedient means of recovery. For this reason, the court held that Travelers was precluded from relying upon this provision in order to avoid payment under the payment bond, in the same manner it was precluded from inserting a condition in its bond limiting a subcontractor’s bond recovery to those claims as to which litigation against the owner had concluded.
The court equally rejected Travelers’ argument that its obligation on the bond was coextensive with Clark’s obligation, thereby entitling it to assert the same defenses as Clark. The court found that Travelers’ obligation as the bond surety was independent of the pay-when-paid provision in the subcontract. Because a public works payment bond is statutory in nature, the court held that specific statutory protections applied, including those under Civil Code § 8122.
Crosno’s Impact on Enforceability of Pay-When-Paid Provision
The holding in Crosno may be the first in a long line of cases defining permissible terms to include within a pay-when-paid provision. Along these lines, it is important to note that the decisive issue in Crosno was not the enforceability of pay-when-paid provisions, but rather what is considered a reasonable—and, therefore, permissible—amount of time a subcontractor may be required to wait to be paid. Indeed, the court in Crosno emphatically stated that not “all pay-when-paid provisions are unenforceable against a payment bond claim – just that [the one in the subcontract between Clark and Crosno] is.” (Emphasis added.) Specifically, the court rejected the expansive language in the provision allowing Clark to defer payment to Crosno for an indefinite period of time while the former litigated its claims against the District. While it did not set a maximum time period a subcontractor could be made to wait, the court seemed to suggest that the statute of limitations for initiating an action against a surety on a payment bond (that is, within six months of when a stop notice may be filed) should serve as the outer limits of a reasonable period.
Based upon this reasoning, the court may have ruled differently had: (1) the pay-when-paid provision specified the maximum amount of time that payment to Crosno could be deferred while Clark litigated its claims against the District; and (2) such period not extended beyond the statute of limitations to initiate an action against a payment bond surety. Unfortunately, the court offered no insight one way or another.
In conclusion, pay-when-paid clauses remain enforceable so long as the language contained within does not set an indefinite duration of time before the subcontractor may be compensated, or does not condition payment to the subcontractor on an event that takes place in the indefinite future (that is, conclusion of litigation between the general contractor and owner). As pay-when-paid provisions become more finely tuned, contractors and sureties can anticipate this issue becoming the subject of future judicial authority. Until then, general contractors should review the pay-when-paid clauses in their subcontracts and revise where necessary. For subcontracts where the work is ongoing, general contractors may wish to negotiate a “reasonable” duration to include within such provisions to avoid complications that may arise in the future.
Although parties are permitted to contract and negotiate terms as they see fit, to the extent the enforcement of any provisions interfere with longstanding rights, such provisions may be deemed to violate public policy and, therefore, may be declared void. The Crosno decision is a good reminder for general contractors and sureties to understand and protect themselves from owner actions that could potentially result in the general contractor, or its surety, funding change orders and other subcontractor costs while the owner wrongfully withholds payment. Knowing the risk that a pay-when-paid provision may potentially be unenforceable should influence how general contractors and their sureties react to an owner’s non-payment for base contract work or reluctance to commit to payment for extra work.
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Rebecca S. Glos is a partner in the Irvine, California office of Watt, Tieder, Hoffar, & Fitzgerald, LLP. Glos has specializes in surety and construction law, representing clients throughout the United States and internationally. She has tried cases in state and federal courts and in arbitration forums. Glos has represented sureties and bond principals in their negotiations with the federal government, including the United States Army Corps of Engineers (USACE). She has negotiated directly with the USACE in securing waivers and releases for sureties and settling affirmative claims. She can be reached at [email protected] or 949.852.6700.