General Contractors: The Payment Provisions in Your Subcontracts May Have Just Been Determined to be Unenforceable

While it has been more than twenty years since the California Supreme Court determined, in Wm. R. Clarke Corp. v. Safeco Ins. Co., that “pay-if-paid” provisions in subcontracts were unenforceable, following a recent decision from the Court of Appeal, Fourth Appellate District, general contractors, or any other contractors that contract directly with owners, should review their subcontracts to confirm that they do not contain potentially unenforceable “pay-when-paid” provisions.

Following the California Supreme Court’s Wm. R. Clarke decision, many direct contractors (defined by California Civil Code § 8018 as a contractor with a direct contractual relationship with an owner) revised the payment provisions in their subcontracts from “pay-if-paid” (where payment by the owner is a condition precedent for payments to the subcontractor) to “pay-when-paid” (requiring the contractor to pay the subcontractors within a defined period after payment by the owner).  In the recent Crosno Construction Inc. v. Travelers Casualty and Surety Company of America decision, the Fourth District Court of Appeal determined that such “pay-when-paid” provisions may be unenforceable if they run afoul of California’s statutory waiver and release statutes (California Civil Code § 8120 et seq.).

In Crosno, the subcontract required the direct contractor to pay its subcontractor in monthly progress payments with the following “pay-when-paid” provision should the owner’s payment be delayed:

If Owner or other responsible party delays in making any payment to Contractor from which payment to Subcontractor is to be made, Contractor and its sureties shall have a reasonable time to make payment to Subcontractor.  ‘Reasonable time’ shall be determined according to the relevant circumstances, but in no event shall be less than the time Contractor and Subcontractor require to pursue to conclusion their legal remedies against Owner or other responsible party to obtain payment, including (but not limited to) mechanics’ lien remedies.

While the Crosno court did not appear to question the enforceability of most of this provision, the Court of Appeal determined that the portion of the provision which allowed the direct contractor to delay payment until the conclusion of its mechanics’ lien remedies was unenforceable.  The Crosno court’s rationale was that this portion of the “pay-when-paid” provision postponed the direct contractor’s obligation to pay for an indefinite period of time and was, therefore,  violative of California Civil Code § 8122’s bar against contractual provisions which “waive, affect or impair” a claimant’s waiver and release rights.

As pointed out by the Crosno court, California law lays out a comprehensive statutory scheme to resolve payment disputes in construction projects (California Civil Code § 8160 et seq. for private projects and California Civil Code § 9000 et seq. for public projects).  This statutory scheme is intended to carefully protect against unfair or imprudent waiver of right to payment and a claimant may only waive its statutory remedies by signing one of the four types of statutorily required written waiver and releases (California Civil Code §§ 8132 – 8138).  In fact, California Civil Code § 8122 makes any contractual provision purporting to modify the statutory waiver and release scheme unenforceable.

The Crosno court determined that the “but in no event shall be less than the time Contractor and Subcontractor require to pursue to conclusion their legal remedies against Owner or other responsible party to obtain payment, including (but not limited to) mechanics’ lien remedies” portion of the “pay-when-paid” provision in the subcontract violated California Civil Code § 8122 and, thereby, made the provision, as a whole, unenforceable as a matter of law.

Like Wm. R. Clarke, the Crosno case involved a subcontractor’s claims against the direct contractor’s payment bond.  Likely, the offending language in the contract (“but in no event shall be less than the time Contractor and Subcontractor require to pursue to conclusion their legal remedies against Owner or other responsible party to obtain payment, including (but not limited to) mechanics’ lien remedies”) was intended to limit claims against the direct contractor’s payment bond.  Unfortunately for the direct contractor and its surety, the payment bond obligated the surety, upon default by the direct contractor, to pay amounts due for “work and labor under the contract” between the direct contractor and owner.  Seizing on the broad nature of the surety’s obligation and the unenforceability of the “pay-when-paid” provision, the Crosno court, like the Wm R. Clarke court before it, determined that the surety was obligated to pay the subcontractor’s claim regardless of the status of the direct contractor’s mechanic’s lien action against the owner.

The lesson to be learned from Crosno is that, while “pay-when-paid” provisions, in and of themselves, remain enforceable, they must be written in such a way that they neither run afoul of California’s statutory waiver and release scheme nor include patently unreasonable language.  As such, we recommend that direct contractors review the payment provision(s) in their subcontractors to confirm that they remain enforceable.