It is a truism that construction is a risky business. Construction contracting is an exercise in dealing with these inherent risks. One common way involves allocating these risks among the various project delivery team members. Many contract clauses will allocate by shifting risk from one party to another on the pretense that the party being assigned the risk is better able to absorb or control it; more likely, it is that the party shifting the risk does not want to have to deal with it. Examples of typical risk-shifting clauses found in construction contracts include: no-damages-for-delay clauses; indemnification clauses; special dispute resolution procedures; performance guaranties; and pay-if-paid clauses. For projects requiring performance and payment bonds, sureties likely will be held to these clauses in carrying out their obligations. Likewise, sureties may be able to rely on such clauses to the same extent their principal can when faced with bond claims.
One example of a risk-shifting clause with potential risks and benefits to the surety is the pay-if-paid clause. This provision, commonly found in contracts between the general contractor and its trade subcontractors, shifts the risk of Owner non-payment from the general to the subcontractor. Simply put, the general contractor’s payment obligation to its subcontractor only arises if the Owner pays the general contractor for the corresponding work. Such a clause can be an extremely powerful tool for the general contractor and an extremely risky proposition for the subcontractor.
At its extreme, if the Owner never pays the general contractor, then the general contractor might avoid altogether its payment obligation to the subcontractor. As a result, most states have scrutinized these clauses very carefully and found them to be enforceable only in instances where the applicable language clearly and unequivocally states that payment by the Owner to the general contractor is an express condition precedent to the general contractor’s obligation to pay the subcontractor and that the parties mutually intend for this condition to be in place. Further, many states have refused to enforce such provisions if the general contractor has taken some action to prevent the condition (Owner payment) from occurring.
With the existence of such a risk-shifting clause, the payment bond surety for the general contractor might want to assert this as a defense to a claim of non-payment by a subcontractor. Here, the underlying premise would be that, while the payment bond obligates the surety to answer for the debt, default, or miscarriage of its principal, such obligation does not arise until payment becomes due. Whether the surety can rely upon this defense will depend on several factors. Each of these factors is discussed further below.
First, is the bond at issue one for a private construction project or for a public construction project? For construction projects in which a local or state government agency, or the federal government, is the procuring entity, bond requirements are established by statute. At the federal level, this statutory scheme is known as the Miller Act. Most states have comparable statutory bonding requirements, commonly referred to as “Little Miller Acts.” Payment bonds issued for publicly-owned construction projects would be subject to these statutes. As a general rule, sureties cannot rely upon any pay-if-paid provision in a subcontract covering public works construction projects as a defense to their obligations to the unpaid subcontractor. Two recent cases illustrate this.
In the 2011 case of Glencoe Education Found., Inc. v. Clerk of Court & Recorder of Mortgages for Parish of St. Mary, the Court of Appeals of Louisiana was asked to determine “whether a surety, which has issued a statutory bond governed by [Louisiana’s] Public Works Act, may rely on a ‘pay if paid’ clause in a principal’s subcontract as a defense to payment of sums owed to subcontractors which have performed work on a public construction project.” The Glencoe court found that the surety could not rely upon a pay if paid provision in the principal’s subcontract, as such reliance would render meaningless the statutory “protections afforded laborers and suppliers on public works projects[.]”
In the 2014 case of U.S. ex rel. XLE Metals, Inc. v. Patterson, No. 12-2634, a federal district court determined that the surety could not rely upon a pay-if-paid clause in the principal’s subcontract as a valid defense to a subcontractor’s Miller Act claim. In so ruling, the court looked at numerous cases from other federal district and appellate courts to find that this principle is a “well established or well settled point of law[.]” There, the court reasoned that allowing such a defense would delay Miller Act payment bond claims beyond the Act’s one-year statute of limitations, amounting to a waiver by the subcontractor of its Miller Act rights. The XLE Metals court concluded that implied “waivers are void under the express terms of the Miller Act[.]” Second, is the pay-if-paid clause enforceable under the law governing and interpreting the contract? For bonded private construction projects, the law of the state governing the underlying contract (that is, the common law) will likely determine whether a payment bond surety can rely upon a pay-if-paid clause in the principal’s contract as a defense to a subcontractor’s payment bond claim. Many states recognize that, where a pay-if-paid clause is enforceable, the surety may assert this as a defense to a subcontractor’s payment bond claim if the principal has not been paid for corresponding work, thus excusing the principal from its payment obligation to the subcontractor. In many instances this is true even if the payment bond does not expressly incorporate the subcontract into the bond.
Other states (for example, North Carolina and Ohio) have determined that pay-if-paid clauses are void as against public policy. Here, the underlying theory is that a contractual requirement shifting the risk of Owner non-payment is too great a risk for a subcontracting party that has no control over, or contractual rights against, the party withholding payment. For bonded projects in such jurisdictions there would, therefore, be no conditional payment defense available to the principal or the surety.
Third, and related to the enforceability issue, even if the pay-if-paid clause is enforceable, can the payment bond surety rely on this defense to the same extent as its principal? Some states accept, or enforce, a pay-if-paid clause but may not permit the surety to rely upon this defense unless the bond clearly and unequivocally states that it is a conditional payment bond. Here, a court, under applicable state law, would be required to read the principal’s subcontract and the payment bond separately. When issuing a payment bond in such a jurisdiction (for example, Florida), and where the principal wants to shift the risk of Owner non-payment to its subcontractors, the surety would be well served to include conditional language in its bond.
Risk-shifting clauses in construction contracts may serve in some instances, such as a pay-if-paid clause, to benefit the surety, under the theory that the surety assumes no greater risk than the principal. As discussed above, whether the surety will enjoy that benefit will depend on many factors. Understanding the surety laws applicable to the type of project being bonded and the jurisdiction where the bonded work will be performed is critical.