Overview

Who bears the risk of nonpayment on a construction project if the owner becomes insolvent or otherwise fails to pay for the work done? A recent court decision, BMD Contractors Inc. v. Fidelity Deposit Company of Maryland, 679 F.3d 643 (7th Cir. 2012), shows that a properly drafted pay-if-paid clause can pass the risk of loss from an owner’s nonpayment down the construction ladder to virtually every level of subcontract and supplier working on a project, even if a payment bond appears to secure payment for subcontractors and suppliers.

A “pay-if-paid” clause typically provides that the higher-tier party must pay the other party only if the higher tier party itself receives payment under its contract. For example, in the BMD Contractors case a subcontractor to the general contractor on a manufacturing plant in Indiana entered into a subcontract with BMD Contractors, Inc. to perform part of the subcontractor’s piping work. The subcontractor’s sub-subcontract with BMD included a “pay-if-paid” clause that stated a condition that the subcontractor was obligated to pay BMD only if the general contractor paid the subcontractor. The owner of the plant filed for bankruptcy a year into the project, causing the general contractor not to pay the subcontractor and the subcontractor not to pay BMD.

BMD sued the subcontractor’s surety for payment. The trial court held that the “pay-if-paid” clause was valid under Indiana law and denied BMD’s claim for payment under the surety bond. In denying BMD’s appeal, the court of appeals concluded that the “pay-if-paid” clause was clear and enforceable; not void under Indiana law as a violation of public policy; and, because the “pay-if-paid” clause nullified BMD’s claim under the subcontract, the subcontractor’s surety was not liable to pay BMD’s claim for nonpayment under the subcontractor’s surety bond.

The “Pay-If-Paid” Clause Was Enforceable

The Court of Appeals held that the “pay-if-paid” clause was enforceable because the clause plainly and unambiguously stated that the subcontractor had to pay BMD only if the subcontractor itself was paid. The “pay-if-paid” clause stated that acceptance of BMD’s work and payment to the subcontractor for that work were “conditions precedent” to BMD’s right to be paid. The court defined “condition precedent” as an event that must occur before a duty to perform, such as a promise to pay, can be enforced. The court emphasized that a majority of courts who have decided the issue have held that a “condition precedent” phrase in a pay-if-paid clause clearly and unambiguously means that a lower-tier sub, such as BMD, has a right to payment only if the higher-tier party is paid first.

The court in BMD Contractors noted that the “condition precedent” language separates “pay-if-paid” clauses from similarly worded “pay-when-paid” clauses, which are read to apply to the timing of payment, rather than to the duty to pay. For example, the court stated that a clause providing that the “contractor shall pay subcontractor within seven days of contractor’s receipt of payment from the owner” addresses the timing for payment, but not the obligation to make the payment. Courts will enforce “pay-if-paid” clauses that clearly and unambiguously condition payment on receipt of payment. The court stated that the unambiguous wording of phrases, such as the “condition precedent” phrase found in the “pay-if-paid” clause in BMD Contractors, to be the key to interpreting such provisions.

The “Pay-If-Paid” Clause Was Not Voidable

BMD also argued that the “pay-if-paid” clause should be voided as contrary to Indiana public policy. The Court of Appeals rejected that argument because Indiana law sets a strict standard which allows a court not to enforce a contract as against public policy only when the contract violates a statute that clearly and unambiguously states a legislative intent that the courts should not be available to either party to enforce a contract violating that statute. The court held that BMD failed to cite a statute meeting this standard of legislative intent.

Even though BMD failed to void the “pay-if-paid” clause on public policy grounds under Indiana law, some states have enacted statutes that address the enforceability of “pay-if-paid” clauses or limit their enforcement. Such statutory provisions are often found in prompt-payment statutes that restrict the enforceability of nonpayment clauses in construction contracts. For example, North Carolina’s prompt payment statute provides:

“Performance by a subcontractor in accordance with the provisions of its contract shall entitle it to payment from the party with whom it contracts. Payment by the owner to a contractor is not a condition precedent for payment to a subcontractor and payment by contractor to a subcontractor is not a condition precedent for payment to any other subcontractor, and an agreement to the contractor is unenforceable.”

“Pay-If-Paid” Clauses and Surety Bond Claims

BMD argued three grounds against allowing the subcontractor’s surety to use the “pay-if-paid” clause as a defense to BMD’s bond claim for nonpayment: 1) the “pay-if-paid” clause, which was included only in the subcontractor’s contract with BMD, should not be read into the surety’s bond; 2) the surety’s bond was ambiguous and should be read strictly against giving the surety a defense to a bond claim; and, 3) the court should follow cases holding a surety cannot rely on a “pay-if-paid” clause to defend against a payment claim under its bond. The Court of Appeals, rejecting BMD’s arguments, held that the “pay-if-paid” clause excused payment by the subcontractor under the subcontract, and therefore basic surety-law principles also excused payment under the subcontractor’s bond.

The Court of Appeals held that it was irrelevant that the “pay-if-paid” clause was included only in the bonded contract, and not in the bond itself, because the bond clearly was given to cover only the obligations under the subcontract. This meant that, even though the surety’s bond does not expressly incorporate the bonded subcontract, the surety is generally liable only for a subcontractor’s obligations set out in the bonded subcontract. Therefore, the surety had no obligation to pay BMD because the subcontract’s “pay-if-paid” clause excused any obligation to pay BMD.

The court found BMD’s ambiguity argument unconvincing because the “pay-if-paid” clause unambiguously excused the subcontractor from paying BMD if the subcontractor itself was not paid. Since there was no ambiguity on that point in the subcontract, and since the bond covered only the subcontractor’s duties under the subcontract, the surety had no duty to pay under the bond. Finally, the court rejected the case law on which BMD relied because those cases were either inapplicable as they involved a “pay-when-paid” clause rather than a “pay-if-paid” clause or were unpersuasive because they represented a minority view that misinterpreted the basic principal that a surety is liable only for a failure of its bonded principal to perform the duties under the bonded contract. In this case, because the “pay-if-paid” clause nullified any duty to pay BMD when the bonded subcontractor itself was not paid, the surety similarly had no liability.

Summary

The BMD Contractors case touches on most of the key points in determining whether a contract clause will be enforced as a “pay-if-paid” clause. First, the clause must include a “condition precedent” phrase, or similarly clear wording that payment to a lower-tier party will occur only if the higher–tier party it contracted with receives payment. Second, the "pay-if-paid" clause may be voidable as against public policy, contrary to a statute (such as a prompt-payment statute) or by a court decision. Thus, parties to a contract with a “pay-if-paid” clause should check for such statutes or court decisions in the state whose law applies to the contract. Finally, in states or jurisdictions that follow the majority rule, an unambiguous pay-if-paid clause in a bonded contract may be relied upon by a surety as a defense to a payment bond claim.