Daily Development for
Wednesday, December 24, 1997

by: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law

CONSTRUCTION LAW; SUBCONTRACTORS; WAIVERS OF CLAIMS: "Pay if paid" provision, under which subcontractor has rights to recover from contractor only if contract is paid, is void as a violation of public policy.

Wm. R. Clarke Corp. v. Safeco Ins. Co. Of America, 54 Cal. Rptr. 2d 578 (Cal. 1997)

The "pay if paid" provision, according to the court, had become the latest fashion in California subcontractor agreements. The provision, according to its proponents, "shifted the risk" of nonpayment to the subcontractors to the extent of their unpaid bills. (The court, however, pointed out that the provisions restricted payment to subcontractors whenever the contractor was not paid, whether due to fault of the owner, contractor, subcontractor or otherwise.)

Although there were some differences in these provisions, most of those in this case included statements that the subcontractor acknowledged that at the time of contracting the developer client had not yet secured committed bank financing and that there was a risk of nonpayment. The parties also provided that the subcontractors, by agreeing to these provisions, did not waive their rights to mechanic's liens. In fact, the language provided that the subcontractors agreed that in the event of nonpayment by the owner their "sole remedy" was the mechanic's lien right.

The underlying actions in this case involved not only subcontractor's claims against sureties that had given payment bonds guaranteeing that the contractor would pay the subcontractor. The court issues a broad holding finding the "pay if paid" provision void in the case of both general contractor and payment bond surety.

The developer went insolvent, did not pay the contractor, and the subcontractors sued the surety and filed mechanic's liens.

The court noted first that authority in other jurisdictions had tended to read "pay if paid" clauses very narrowly, construing them frequently to identify simply the regular time at which the contractor was to pay the subcontractor, and not limiting the subcontractor's collection right. In cases in which the language was inescapable (as it appeared to be here), the court noted that the New York Court of Appeals has ruled that the clause violates public policy (West-Fair Elec. V. Aetna Cas. & Sur Co., 638 N.Y.S. 2d 394, 398 (N.Y. 1995)), and that statutes in Illinois, North Carolina and Wisconsin have invalidated the device.

The court here found the provision void and unenforceable because it violated express policy of state law finding that mechanic's lienholders could not waive their rights. In response to the point that the contracts purported specifically to reserve mechanic's lien rights, the court pointed out that the mechanic's lien statute could not be read to create mechanic's lien rights when there was no contract right against the general contractor. The surety, in fact, supplied the court with the argument when it argued as well that the payment bond was ineffective to protect the subcontractor because it was triggered only when the contractor did not perform a contractual obligation. Here, the surety argued, the terms of the subcontractor agreements did not provide a contractual obligation on the part of contractor if the owner failed to pay.

Because California statutes specifically prohibited contract provision generally waiving the mechanic's lien right (subject to narrow exception), and because these contracts accomplished that result by indirection, the court held the "pay if paid" provisions void as against the contractor. Since they were void, the contractor owed the money to the subcontractors, and consequently the surety by the terms of its agreement, was also on the hook.

Three judges dissented, arguing that the contract provisions did not expressly waive mechanic's lien rights and that policy arguments based upon freedom of contract argued for a construction that preserved mechanic's lien rights but avoided liability of the contractor and surety. The dissenters pointed out that the mechanic's lien law gave a lien for "value," not necessarily contract price, and that there was no need to view the statute as triggering the lien only when the contractor failed to pay the full contract price. Any time the subcontractor fails to receive compensation for the value conferred, in the few of the dissenters, the statute authorizes a mechanic's lien.

With that analysis as a starting point, the dissenters proceeded to analyze the rights against the surety. The surety bond, the majority pointed out, was intended to protect the owner and lender against mechanic's liens, and was triggered whenever mechanic's liens attached. But the dissenters concluded that the fact that the subcontractors had mechanic's lien claims would not necessarily give them rights on the surety bond. The bond, unlike the mechanic's liens, was triggered only when the contractor failed to perform under its contract with the subcontractors. In short, it protected the subcontractors only when the owner paid the contractor, and not otherwise.

Comment 1: The whole notion of mechanic's lien law is that there is not true "freedom of contract" in the negotiation of construction contracts. One, of course, can dispute this claim, particularly in the case of the relationship between subcontractors and general contractors. Often the subcontractors can be much larger, more sophisticated players who have not already committed themselves to the project. The contractors, committed to the owner, to meet a certain price or certain deadline, often have much greater bargaining power.

But the power of the contracting industry is in fact so great that it has lobbied successfully in most states to adopt mechanic's lien laws that follow the stereotypical image of the contractor as a helpless waif in the struggle among owner, lender and other parties with interests in a project. Given the existence of this statutorily declared policy, the court here would be hard pressed to come up with a different result than it did, at least to the extent that mechanic's lien rights were implicated.

Comment 2: The dissenters argue that more than mechanic's lien rights are at stake here, because the voided provision addressed the total contract liability of the contractor to the subcontractor, and not just the "value conferred" protected by the mechanic's lien. But in many jurisdictions this would not be a useful distinction. Although the editor is unfamiliar with California practice, his own experience is that the "value conferred" analysis usually starts and ends with the contract price.

Comment 3: Is there still some middle ground here? Could contractors devise language that in fact preserved the rights of subcontractors under mechanic's liens but nevertheless absolved the contractor from liability if not paid. The editor believes that such language is possible, even under the express analysis of the court here. Perhaps assignments of the contractor's lien rights could be used, or creation of a contracting party for subcontracts which had as a sole asset the enforcement rights of the contractor against the owner. But the majority's stereotype-driven "tilt" in favor of subcontractors may in fact go beyond the mechanic's lien analysis, so the editor cannot predict with confidence that any substitute language would succeed in California.

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