In a decision filed on January 13, 2011, a Federal District Court in Indiana granted a Motion for Summary Judgment upholding a defense asserted by a surety and its principal based upon a pay-if-pay clause. The case cited with approval two prior cases deciding in New Jersey and West Virginia upholding similar clauses and defenses by the surety.

In the Indiana case, BMD Contractors, Inc., et al. v. Fidelity and Deposit Company of Maryland, Case No. 1:09-cv-0121 (SD Indiana), Getrag Corporate Group (“Getrag”) engaged Walbridge Aldinger Company (“WAC”) as the general contractor for the construction of a manufacturing plant in Tipton, Indiana. WAC had multiple subcontracts with IPS to perform mechanical piping. IPS had a subcontract with BMD Contractors, Inc. (“BMD”) which, in turn, purchased goods and materials from Ferguson Enterprises, Inc. (“Ferguson”). The surety had provided a payment bond with IPS as the principal and WAC as the obligee.

BMD performed virtually all of the work on its contract. In late October 2008, all work on the project ceased, and the owner filed bankruptcy. As a result, cash flow stopped and a number of downstream payments to various contractors, subcontractors and suppliers were missed. When the dust settled, Getrag was owed approximately $40,000,000, IPS was due $11,000,000 from WAC, BMD was owed $1,500,000, and Ferguson was owed roughly $700,000 for its goods and materials. Before the project was closed down, WAC had paid IPS for its work, and those funds had properly flowed downstream. BMD and Ferguson filed mechanic’s liens and also pursued claims under the payment bond. Both IPS and its surety refused payments resulting in the filing of the lawsuit.

The bond had typical language requiring the payments for claims and defined a claimant as an entity having a direct contract with the principal. Further, the bond described the right of a claimant to pursue a claim for sums “justly due” the claimant which had not been paid.

The terms of the bonded contract contained a pay-if-pay clause that read as follows:

It is expressly agreed that owner’s acceptance of subcontractor’s work and payment to the contractor for the subcontractor’s work are conditions precedent to the subcontractor’s right to payments by the contractor.

The contracts also contained a flow down provision. The IPS/WAC contract contained what the court called a “garden variety” pay-if-pay clause which read as follows:

[IPS] acknowledges that it has considered [Getrag’s] solvency and [Getrag’s] ability to perform the terms of the contract with [WAC] before entering into this subcontract. [IPS] acknowledges that it relies on the credit and ability to pay of [Getrag], and not [WAC], for payment for work performed there under [IPS] is entering into this subcontract with the full understanding that [IPS] is accepting the risk that [Getrag] may be unable to perform the terms of its contract with [WAC]. [IPS] agrees that as a condition precedent to [WAC’s] obligation to make any payments to [IPS], [WAC] must receive payment from [Getrag].

As described by the court, the direct issue was the effect and enforceability of the pay-if-pay clause.

The court began its analysis by holding that the construction of a contract is an issue of law and that the parties had a broad freedom to contract. The claimant contended that the language contained in the contract created a pay-when-pay clause, which would be more favorable to the claimant and creates an issue of timing rather than imposing a condition precedent for payment. IPS and the surety, however, argued that the pay-if-pay clause shifted the risk of non-payment downstream and created a clear condition precedent which had not been satisfied and thereby provided a defense to both the principal and the surety.

The court noted that when interpreting pay-if-pay clauses some courts look to the precise language that is utilized, looking for the “condition precedent” language, and in this case the “magic words” were present. The claimant argued that the language in the contract should have included additional language that explicitly shifted the risk of non-payment. The court disagreed, finding that the contract terms were clear and unambiguous. The court rejected the opportunity to engage in “a hyper-technical, unduly-critical construction of the clause and cited to Mid America Construction Management, Inc. v. Mastec North America, Inc., 436 F.3d 1257 (10th Cir. 2006) where similar language was upheld as creating a valid pay-of-pay clause.

The court then turned to the issue of whether the pay-if-pay clause violated any public policy in Indiana. The claimant focused on the statutes in Indiana which invalidated, as a matter of public policy, contractual provisions for the improvement of real estate that required a party to waive a claim against a payment bond, Indiana Code § 32-28-3-16(b). The court noted that this statute did not mention pay-if-pay clauses and specifically required that a party waive claims under a payment bond. The court held that the clause at issue did not require the claimant to waive claims against the surety bond. Further, the surety noted that it was not arguing waiver, and was instead advancing the argument that its liability on the bond had simply not matured since the principal was not in default of any obligation to pay the claimant since the principal had been paid. The second statutory argument focused on a law that voided contractual provisions that prevented the filing or foreclosing of a lien based upon conditions precedent for payment, Indiana Code § 32-28-3-18(c). In rejecting this argument, the court focused on the fact that the statute did not mention bonds and held that the Indiana legislature did not clearly and unambiguously render pay-if-pay clauses unenforceable. The court then reviewed cases which upheld the broad freedom of contract in Indiana.

The next step in the analysis was to decide whether the surety had the right to rely upon this defense, and the court clearly said “yes.” The court began by noting that a surety bond is distinct from an insurance policy. In addition, under Indiana law a surety’s liability parallels that of its principal such that a surety’s duty to pay a claim arises only after there has been a default by the principal. In this case, there had been no default since the pay-if-pay clause was deemed valid and thus the surety was not liable to make payment.

Another issue confronted by the court was whether the bond, which did not expressly incorporate the pay-if-pay clause, permitted the assertion of this defense. While the court acknowledged that the bond did not incorporate by reference that specific clause, the court cited Indiana law holding that a bond and contract should be construed together. Under these circumstances, the court held that “the Indiana Supreme Court would not analyze the Bond in a vacuum, but would instead analyze it in concert with the contracts relating to the undertaking the bond was intended to secure.” (Entry on Motion at p. 16).

In reaching its decision, the BMD Contractors court cited with approval cases in West Virginia (Wellington Power Corp. v. CNA Surety Corp., 614 S.E.2d 680 (W.Va. 2005)) and New Jersey (Fixture Specialists, Inc. v. Global Construction, LLC, 2009 WL 90431 (D.N.J. March 30, 2009)). Based on its analysis, the Indiana court therefore rejected the demand for payment and allowed both the principal and its surety to assert the pay-if-pay clause as a valid defense to the payment bond claims.

In Wellington Power, the West Virginia Supreme Court confronted a similar issue. West Virginia University had engaged Dick Corporation (“Dick”) to construct a life sciences building. Dick engaged Wellington Power Corp. and W.G. Tomko, Inc. as subcontractors. As this was a public project, state law required Dick to provide a payment bond. The contracts between Dick and Wellington and Tomko contained the following pay-if-pay provision:

Contractor [Wellington and Tomko] agrees and acknowledges that payment of the Contract Sum shall be made only form [sic] funds which are due from [WVU] that [Dick] has actually received in hand from [WVU] and designated by [WVU] for disbursement to Contractor. Contractor agrees to look solely to such funds for payment. Contractor understands and agrees that [Dick] shall have no liability or responsibility for any reason whatsoever for any amounts due or claimed to be due to Contractor except to the extent that [Dick] has actually received funds from [WVU] that are due from [WVU] specifically designated for disbursement to Contractor. (614 S.E.2d at 683).

When Wellington and Tomko were not paid, they sued CNA and Dick. The surety and Dick filed motions to dismiss based on the pay-if-pay clause but these motions were denied. The surety and Dick then pursued a motion to certify a question of law to the West Virginia Supreme Court.

The state appellate court began its analysis by citing to the broad right or parties to form contracts, holding that it will enforce a written contract found to express the intent of the parties in plain and unambiguous terms. The first defense asserted against this broad statement of public policy was that enforcement of the clause would violate the public policy found in the public bond statute which is designed to protect suppliers of labor and material on public construction projects. The court rejected this argument, finding that the freedom of contract was “more compelling” than a public policy favoring the payment of subcontractors on public projects. The court held as follows:

Plaintiffs complain that enforcement of the pay-if-pay clause at issue will undermine the public bond statute and render it useless. We disagree. Our holding in the instant case is limited to those circumstances in which subcontractors have voluntarily agreed to an unambiguous pay-if-pay condition precedent provision in their contract with the contractor. Further, even if cases involving pay-if-pay clauses, the public bond statute protects subcontractors when a contractor has received all funds from the public entity but nevertheless fails to pay its subcontractors. (Id. at 687).

The court then examined whether the surety can assert the defense based upon the pay-if-pay clause, and the court answered that question affirmatively. The court found that the surety’s liability is coextensive with that of its principal such that the surety is not liable unless the principal is liable. Based on these findings, the court upheld the assertion of this defense by both the principal and the surety under the pay-if-pay clause.

A similar holding was reached in Fixtures Specialists, Inc. v. Global Construction, LLC, 2009 WL 904031 (D.N.J. March 30, 2009). A private owner engaged Global as the general contractor to construct an apartment complex, and Global engaged Fixtures as a subcontractor. Global had provided a surety bond. The bonded contract contained the following provision:

Pay When Paid – Subcontractor agrees that Contractor shall never be obligated to pay Subcontractor under any circumstances, unless and until funds are in hand received by Contractor in full, less any applicable retainage, covering the work or material for which Subcontractor has submitted an Application for Payment. This is a condition precedent to any obligation of Contractor, and shall not be construed as a time of payment clause. The condition precedent also applies to Contractor’s obligation to pay retainage, if any, Contractor shall never be obligated to pay retainage to Subcontractor until Contractor has received its retainage in hand in full….

The claimant asserted that this provision was invalid and unenforceable pursuant to New Jersey’s contract principles and further that the surety could not assert this clause as a defense to non-payment by its principal.

The court readily acknowledged that courts in other jurisdictions are not uniform in their construction of pay-when-pay clauses. The court noted that New Jersey has followed the reasoning set forth in Thos. J. Dyer Co. v. Bishop Int’l Engineering Co., 303 F.2d 606 (6th Cir. 1962) for the construction of pay-when-pay versus pay-if-pay clauses. Under this precedent, the facts must demonstrate that the parties have shifted the risk of non-payment downstream through express language in the contract. In Fixture Specialists case, even though the term “pay-when-pay” was used, the court found that the language of the contract was sufficiently straightforward and unambiguous to shift the risk of non-payment and establish a condition precedent for the obligation to pay the subcontractor. The court first conducted a freedom to contract analysis similar to that undertaken by the West Virginia and Indiana courts.

The next issue confronted by the court was whether the contract provision violated New Jersey’s anti-waiver statute governing construction liens. The court rejected this analysis finding that a lien could still be filed even though it may not be foreclosed since the liability for payment had not yet arisen.

The final issue confronted by the court was whether the surety could assert the defense based upon the pay-if-pay clause. The surety bond defined its obligation to make payment using language in its bond whereby the payment must be “justly due” the claimant. In opposing this motion by the surety, the claimant presented cases from other jurisdictions which distinguished between the surety’s liability and that of its principal. The New Jersey court rejected those cases, finding that they were decided applying public policy arguments from those particular states. For New Jersey, the court held that a surety bond obligates a surety to answer for the debts of its principal and thus is materially different from an insurance policy. Since the liability of the principle had not accrued, the surety would not be liable for the debt and could assert the defense. The court’s holding stated as follows:

Here, having determined that Section 5.3 creates a condition precedent, Global has no liability for any amounts due to Fixture except to the extent that Global has actually received funds from the Owner. It logically follows that if Global has not received funds in full from the Owner, it has not incurred a debt, nor has it defaulted or miscarried on a debt owed to Fixture. (Citations omitted). Consequently, Liberty [the surety] may pursue its defense that it is not obligated to pay on the surety bond until Global becomes obligated on the debt.

All of the courts acknowledged that pay-if-pay clauses are not necessarily favored in law. At the same time, these courts squarely held that a properly structured pay-if-pay clause can be enforced and, if deemed valid, provide the surety with a defense that it may assert against the bond claimant. One must be mindful, however, of public policy arguments that may be unique to a particular jurisdiction that could undermine the application of these holdings.