Seventh Circuit Holds That Sureties May Rely on “Pay-If-Paid” Clauses To Not Pay Subcontractors’ Payment Bond Claims.

October 18, 2016 Firm News

A Laurie & Brennan article featured in the Construction Law Corner Winter 2013 eNewsletter.

by Chad J. Shifrin

Payment bonds guarantee payment obligations owed by a contractor to its subcontractors if a subcontractor performs work and is not paid for its work.   When a subcontractor performed work and was not paid due to the owner’s insolvency and subsequent failure to pay the general contractor, the subcontractor made a claim on the contractor’s payment bond.   The surety, however, refused payment relying on a “pay-if-paid” clause in the contractor/subcontractor agreement.   The subcontractor sued the surety in federal court under diversity jurisdiction in the case entitled BMD Contractors, Inc. v. Fidelity and Deposit Company of Maryland, 679 F.3d 643 (7th Cir. 2012).

In BMD Contractors, a large-scale construction project stopped in its tracks upon an owner’s filing for bankruptcy, leaving over $40 million dollars owed to the general contractor and its subcontractors.   BMD, a sub-subcontractor, demanded payment for the work it had performed for its upstream subcontractor, Industrial Power Systems, Inc.   Industrial Power refused to pay and BMD sought payment from Industrial Power’s surety, Fidelity, on the payment bond.   After Fidelity refused payment on the bond, BMD filed a lawsuit against Fidelity.

Addressing an issue of first impression under Indiana law, the Seventh Circuit held that a surety can rely on and enforce a contractor/subcontractor’s “pay-if-paid” clause and is not obligated to pay on a payment bond when an upstream contractor has not been paid for the subcontractor’s work.   The appellate court rejected the subcontractor’s argument that non-payment for work performed alone is sufficient to trigger a surety’s obligations under a payment bond.   The court held that a surety may rely on a contractor/subcontractor’s “pay-if-paid” clause because a surety is entitled to the same defenses as the principal on the bond.

What is a Payment Bond?

A payment bond guarantees the payment of subcontractors by the contractor.   A surety — a third-party – guarantees that the contractor will comply with its payment obligations.   Many owners demand payment bonds on projects to ensure that subcontractors are paid the amounts owed to them and to avoid liens from unpaid subcontractors.   Whether owners should insist on payment bonds on projects is an issue we addressed in a recent newsletter article.   Payment bonds are not insurance agreements.   The bond merely guarantees a contractor’s payment obligations.

What is a “Pay-If-Paid” Clause?

A “pay-if-paid” contract clause provides that a subcontractor will only be paid if the contractor is paid.   A “pay-if-paid” clause allows a contracting party to transfer the risk of non-payment for its work if an owner or other upstream contractor fails to pay due to insolvency or otherwise.   That risk is transferred to downstream contracting parties.   Without a “pay-if-paid” clause, a contractor bears significant risk of payment to all downstream subcontractors, in addition to the loss of payment for its own work, if it is not paid by an owner.

On the other hand, a subcontractor that agrees to a “pay-if-paid” clause forfeits its right to payment for work under its contract if an owner or other upstream contractor does not make payment to the party with whom the subcontractor has an agreement.   Of course, as discussed below, a subcontractor may still pursue its lien rights for its improvements to real property.

A “pay-if-paid” clause is different from a “pay-when-paid” clause.   Courts have stated that a “pay-when-paid” clause addresses the timing of payment to a subcontractor, not the contractor’s obligation to pay.   Therefore, a “pay-when-paid” clause does not eliminate the obligation to pay, leaving a contractor ultimately liable for payment to the subcontractor even if the contractor is never paid by the owner.

Are “Pay-if-Paid” Clauses Enforceable?

The majority of states enforce “pay-if-paid” clauses.   In BMD Contractors, the Seventh Circuit predicted that the Indiana Supreme Court would follow the majority of states and enforce “pay-if-paid” clauses.   Addressing whether “pay-if-paid” clauses are enforceable under Indiana law, the Seventh Circuit found that the clause did not run afoul of Indiana public policy.   In the Seventh Circuit’s view, and the majority of states, contracting parties’ voluntary agreement to shift the risk of non-payment by owners or other upstream contractors is permissible.

Moreover, the Seventh Circuit held that “pay-if-paid” clauses did not violate Indiana’s statute voiding contract provisions that waive claims against payment bonds.   The court reasoned that the “pay-if-paid” clause was not a waiver of BMD’s right to make a claim on the bond and rejected BMD’s argument that the “pay-if-paid” clause made the bond illusory.   The Court noted that BMD could have been paid under the payment bond if the contractor was paid and BMD was not.

Sureties Can Rely on “Pay-If-Paid” Clauses

In reaching its holding protecting sureties from payments to subcontractors when an owner defaults and a contractor has a “pay-if-paid” clause, BMD Contractors relied heavily on two long-standing principles in surety law.   First, that the surety stands in the shoes of its principal and holds the same rights and defenses as the principal.   In this case, the surety assumed the obligations of the contractor that failed to make payment.   Because the “pay-if-paid” clause did not obligate the contractor to make the requested payment, the surety had no obligation to pay on the bond.

Second, sureties are not insurers.   A surety does not insure against the event of whether a subcontractor is paid.   The surety is only obligated to perform on behalf of the contractor to the extent the contractor does not perform its contracted-for obligations.

What Can a Subcontractor With a “Pay-if-Paid” Clause Do To Make Sure It is Paid For Its Work?

Due to the highly competitive bidding atmosphere over the past several years, many subcontractors are finding themselves forced to accept “pay-if-paid” clauses in their subcontracts.   Subcontractors with “pay-if-paid” clauses should do at least the following to ensure payment for their work.   First, subcontractors should closely monitor the finances of those projects.   That includes timely submitting pay applications, confirming that timely payments are received and, where allowed by applicable contracts, requesting evidence of adequate project financing.

Second, subcontractors must diligently protect their lien rights.   Ultimately, if a subcontractor is not paid due to a “pay-if-paid” clause, its only legal recourse may be its lien rights.   Every state strictly enforces a subcontractor’s lien rights.   As such, subcontractors must ensure timely satisfaction of each and every requirement under the state’s mechanic’s lien statute that it is performing work in.   Of course, if financing of a construction project fails, such as in BMD Contractors, there is a high likelihood that the proceeds from a lien foreclosure action will not fully compensate the subcontractor for work performed or that the subcontractor’s lien will be junior to others with claims or encumbrances against the real estate.