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Kevin Schlosser Authors, “Has ‘Pay-When-Paid’ Been Laid to Rest?” for NYLJ

Publication Source: New York Law Journal

Kevin_SchlosserOn Dec. 7, 1995, the New York Court of Appeals rendered its long-awaited decision on whether the “pay-when-paid” clause in construction contracts violates New York public policy.

Although the answer may appear at first blush to strike the death knell for the clause, there may be enough ambiguity in the decision to question the clause’s actual demise. This article discusses the landmark decision and some of the issues and questions that remain unanswered.

The pay-when-paid clause is found in construction contracts between general contractors and their subcontractors (or suppliers). If properly drafted, the clause imposes a “condition precedent” upon the general contractor’s legal responsibility to pay its subcontractor — that is, before the general contractor is legally obligated to pay its subcontractor, it must have been paid by the owner. Such a clause is intended to place upon the subcontractor the risk of the owner’s inability or failure to pay the general contractor.(1) In short, if the owner does not pay for some reason, the subcontractor rather than the general contractor gets stuck holding the bag.

If not properly drafted, a clause purporting to place the risk of an owner’s non-payment upon the subcontractor can be construed merely as fixing a time for the general contractor to pay its subcontractor, rather than an actual condition precedent to such payment. In Schuler-Haas Elec. Co. v. Aetna Casualty & Surety Co., (2) for example, the Court of Appeals held that the contract lacked a “clear expression” of an intention to impose a condition precedent and therefore construed the clause as merely setting a time when the subcontractor could expect to be paid by the general contractor.

In West-Fair Electric Contractors v. Aetna Casualty & Surety Co., (3) two questions of law were certified to the New York Court of Appeals from the Second Circuit Court of Appeals: (1) whether a pay-when-paid provision in a subcontract, which transfers the risk of an owner’s default from a general contractor to a subcontractor, violates New York public policy as set forth in the Lien Law; and (2) whether a surety’s liability is contingent on the duty of a contractor to make payment to a subcontractor when the surety bond created an independent obligation to that subcontractor. (4) The first question was answered in the affirmative and the second was not reached, apparently because of the first answer.

In West-Fair, a subcontractor on the Westchester Pavilion project in White Plains sued the general contractor in the U.S. District Court for the Southern District of New York after the owner became insolvent and the general contractor refused to pay the outstanding balance to the subcontractor for its work.(5) The subcontractor also added as a defendant the surety that issued a payment bond procured by the general contractor, which provided that any subcontractor not paid within 90 days of its work could assert a claim against the bond for full payment.

The general contractor moved for summary judgment before Judge Charles L. Brieant, arguing that it had no obligation to pay the subcontractor because the contract between the parties contained an express condition precedent in the form of a pay-when-paid clause. The surety, in turn, argued that since the principal — the general contractor — on the payment bond was not liable to the subcontractor, no obligation arose under the bond.

The subcontractor moved for summary judgment as well, arguing that (i) judgment should be entered against the general contractor because the pay-when-paid clause merely fixed a time for payment, not a condition precedent to payment; and (ii) the surety should be held liable in any event because it was “unconditonally” obligated to pay under the bond simply because the general contractor failed to pay within 90 days.

Judge Brieant granted the subcontractor summary judgment against both defendants, ruling that (i) insofar as a pay-when-paid clause operates as a condition precedent to payment, it violates New York public policy as contained in the Lien Law; and (ii) the surety was liable under the express terms of the bond. On appeal to the Second Circuit, the court certified the two questions quoted above to the New York Court of Appeals. (6)

Court’s Reasoning

In analyzing the certified questions presented to it, the New York Court of Appeals quickly disposed of the subcontractor’s argument that the pay-when-paid clause did not impose a condition precedent to payment. The Court distinguished that provision from the clause in Schuler-Haas, apparently because it simply said the subcontractor’s payment “is dependent, as a condition precedent,” upon payment from the owner. The Court continued, therefore, to analyze whether this pay-when-paid clause violated public policy as stated in the Lien Law.

In addressing this question, the Court looked to the Lien Law itself to ascertain the applicable “public policy.” It cited §23, which explicitly provides that the law on mechanic’s liens “is to be construed liberally to secure the beneficial interests and purposes thereof,” and §34, which provides: “Notwithstanding the provisions of any other law, any contract, agreement or understanding whereby the right to file or enforce any lien created under [the Lien Law] is waived, shall be void as against public policy and wholly unenforceable.”(7)

The Court also found that the “impetus” behind §34 as described by Senator James H. Donovan, the legislation’s sponsor, was to preserve the protection afforded by the Lien Law to construction contractors, subcontractors and suppliers, who were increasingly being required to waive their rights under this remedial body of law.

The Court noted that the Lien Law grants subcontractors the right to file a mechanic’s lien against the owner’s real property (improved by the subcontractor’s work) and to recover damages to the extent the subcontractor has not been paid and amounts remain outstanding from the owner to the general contractor. Critical to its analysis, the Court assumed, under existing law, that a subcontractor’s right to enforce a mechanic’s lien was dependent upon its “legal right” to be paid by the general contractor. (8)

Thus, the Court concluded that if the subcontractor gave up the right to be paid by the general contractor unless and until the owner paid the general contractor, the subcontractor “effectively waived its right to enforce its mechanic’s lien,” at least where the owner is insolvent as it was in West-Fair.

The Court seermed to place particular significance upon the owner’s inability to pay: As the owner here has become insolvent, the owner may never make another contract payment to the general contractor. Because the lack of future payments by the owner is virtually certain, [the subcontractor’s] right to receive payment has been indefinitely postponed, and [the subcontractor] has effectively waived its right to enforce its mechanic’s liens.

Finally, since it ruled that the pay-when-paid clause before it was thus unenforceable as against public policy, the Court found it was “unnecessary” to determine the second certified question — whether the surety “owes an independent or contingent duty to pay under the payment bond.”

Freedom to Contract

First, it appears the Court could have avoided striking down any pay-when-paid clause by simply construing the Lien Law according to its express language. For example, as noted above, the Court applied prior case law holding that a subcontractor cannot enforce a lien against the owner’s property unless it establishes “the existence of a present amount, due and unpaid . . and owed by the general contractor.” The Lien Law, however, actually provides that the lien extends to “the sum earned [by any subcontractor) and unpaid on the contract,” and that the owner may be liable up to “the value or agreed price of the labor and materials remaining unpaid, at the time of filing [the] liens…’ (9)

Thus, the Court could have easily found that even though the general contractor did not have a ‘legal obligation’ to pay the subcontractor under the pay-when-paid clause, the subcontractor could still enforce its lien against the owner’s real property because it “earned” the contract price and the amount “remained unpaid.” Indeed, this would hardly be unfair to anyone because the subcontractor actually was not paid solely because the owner failed to pay, and the general contractor would not be forced to accept a risk that it sought to avoid by express agreement. Furthermore, all of the remedial rights of the Lien Law afforded to subcontractors — to enforce their claims against the owner’s real property — would be fully preserved.

Unfortunately, instead of giving a natural and literal reading to the Lien Law, which would have clearly extended its “beneficial interests and purposes,” (10) the Court chose to accept without analysis lower court case law and then interfered with the precious right of parties to define their rights and obligations by their own agreement. While under other circumstances it makes sense to require the subcontractor to prove its “entitlement to payment” from the general contractor, i.e., that it performed its work properly and was due the amount claimed, here the Court seemed to pay undue attention to the “legal entitlement” requirement, which simply does not make sense in these circumstances.

Imprecise Language

In describing the rights of subcontractors, the Court also used imprecise, and what appears to be inaccurate and perhaps overbroad, statements of existing law that should not be misconstrued in the future. The Court loosely referred to the subcontractor’s contractual rights against the owner itself, as opposed to its right to enforce the lien against the owner’s real property (and obtain a deficiency judgment if applicable).

For example, the Court stated: “As a matter of contract law, the owner and the general contractor are liable to plaintiff [subcontractor] for the work plaintiff has been authorized to perform, and performed, under the subcontract agreement.” (11) The Court did not, however, cite any provision of the subcontract that would have extended the subcontractor’s contractual rights to the owner, and the Lien Law does not create any contractual right in the subcontractor to be paid personally by the owner itself.

In fact, the case law is quite clear that absent an express contract between the subcontractor and the owner, the mere fact that the subcontractor performs work for the general contractor that improves the owner’s real property, even with the owner’s knowledge and consent, does not create any contractual right to be paid from the owner directly. (12)

The Court’s loose language, therefore, should not be misconstrued to create rights that did not previously exist and, frankly, were not even at issue in the case before it.

Unanswered Questions

Despite the apparent holding of the Court — striking all pay-when-paid clauses that impose a condition precedent to payment — such clauses may not be laid to rest just yet. Some unanswered questions remain that may be food for thought for astute counsel.

What if the subcontract provides that notwithstanding a condition precedent clause, nothing in the subcontract shall be construed to limit or impair the subcontractor’s right to file and enforce mechanic’s liens against the owner’s real property? Thought might be given to rewriting long-established boilerplate contract provisions. For example, the pay-when-paid clause could provide that payment from the owner is a condition precedent to payment from the general contractor, but that the subcontractor retains any and all of its rights under the Lien Law to file and enforce liens against the owner’s real property.

This also might be achieved by a separate agreement between the subcontractor and general contractor whereby the subcontractor agrees to waive an enforceable right to payment from the general contractor. That is, for purposes of the Lien Law, the subcontractor would have a valid and existing “debt” from the general contractor, which it then would simply agree to forbear from enforcing against the general contractor. The “debt” from the general contractor would still exist, but the subcontractor would simply agree not to enforce it. Under these circumstances, the subcontractor may very well preserve its mechanic’s lien rights, while still agreeing to accept the risk of nonpayment from the owner.

What if the subcontractor failed to file a mechanic’s lien within the statutory deadlines (13) or otherwise failed to preserve its claims under the Lien Law and therefore no longer has any rights under the statute? The Court in West-Fair rested its entire analysis upon the subcontractor’s apparent waiver of lien rights afforded by the Lien Law. Indeed, in West-Fair, the subcontractor had preserved those rights by filing a mechanic’s lien. However, if those rights no longer exist because the subcontractor did not otherwise preserve them, the basis for striking down the pay-when-paid clause falls as well.

On the other hand, from the subcontractor’s or supplier’s perspective, the decision in West-Fair underscores the importance of preserving mechanic’s lien rights by filing in a timely manner and taking all the steps necessary to preserve those rights, lest the right to collect against the real property be lost, and possibly the ability to void the pay-when-paid clause as well.

What if the owner is not insolvent or unable to pay, but simply refuses to pay? As noted above, the Court in West-Fair seemed to place special emphasis on the owner’s inability to pay at any time in the future, effectively causing the subcontractor to waive its mechanic’s lien rights because payment would never become due from the general contractor. If the owner had the ability to pay at some point in the future, the clause may indeed be enforceable as between the general contractor and subcontractor.

If the pay-when-paid condition precedent can in fact be salvaged under some of these or other circumstances, the Court has made clear just how to assure that the pay-when-paid clause will be interpreted as a condition precedent rather than merely as fixing the time for payment. The Court confirms that simply referring to it as a “condition precedent” to payment as provided in the contract in West-Fair will suffice.

These and other questions will be fair game for imaginative counsel in the future. Indeed, this landmark decision is certain to engender much more commentary.

(1)  See, e.g., David Fanarof Inc. v. Dember Construction Corp., 195 AD2d 346, 600 NYS2d 226 (1st Dept. 1993).
(2) 40 NY2d 883, 389 NYS2d 348 (1976).
(3) NYLJ, Dec. 8, 1995, at 28, col. 1 (N.Y. Court of Appeals, Dec. 7, 1995
(4) Id.
(5) West-Fair Elec.Contractors v. Aetna Casualty & Surety Co., 872 F.Supp. 1212 (SDNY 1994).
(6) 49 F3d 48 (2d Cir.1995).
(7) N.Y. Lien Law §§23 and 34.
(8) CitingSchiavone Construction Co. Inc. v. Fischer & Porter Co., 181 AD2d 580, 581 NYS2d 322 (1st Dept. 1992).
(9) N.Y. Lien Law §4(1).
(10) Id. §23.
(11) West-Fair; NYLJ, Dec. 8, 1995, at 28. col. 1(N.Y. Court of Appeals, Dec. 7, 1995).
(12) See, e.g., Contelmo’s Sand & Gravel Inc. v. J&J Milano Inc., 96 AD2d 1090, 467 NYS2d 55, 57 (2d Dept. 1983) (owner not liable to subcontractor for breach of contract because “the courts have held that a defendant in an action to foreclose a mechanic’s lien may be held liable on a contract theory only where there would otherwise be contractual liability; the mere filing of a mechanic’s lien does not of itself create such liability”); Greystone Materials Inc. v. Pyramid Champlain Co., 198 AD2d 740, 604 NYS2d 295 (3d Dept. 1993); Bubonia Holding Corp. v. Jeckel 189 AD2d 957, 592 NYS2d 499 (3d Dept 1993); Perma Pave Contracting Corp. v. Paerdegat Boat & Racket Club, 156 AD2d 550, 549 NYS2d 57 (2d Dept. 1989).
(13) See N.Y. Lien Law §§10 (private improvements) and 12 (public improvements).