California Appeals Court Provides Guidance on ‘Pay-When-Paid’ Provisions in Construction Subcontracts

 

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Ted R. Gropman

Cindy J. Lee

On April 17, the California Court of Appeal decided Crosno Construction, Inc. v. Travelers Casualty & Surety Company of America,1 effectively narrowing the scope of enforceable “pay-when-paid” provisions in construction subcontracts to the extent the subcontractor seeks recovery against a general contractor’s payment bond surety. Although the Crosno case involved a public works project, the rationale and holding should apply with equal force to private works projects. Basing the bulk of its decision on the Wm. R. Clarke Corp. v. Safeco Insurance Co.2 case, the court found that an open-ended “pay-when-paid” provision in a subcontract is not enforceable against a subcontractor that seeks to recover on a public works payment bond claim. This article discusses the Crosno decision and the implications for contractors on both sides of the contract moving forward.

Brief Case Summary

In Crosno, general contractor Clark Bros., Inc. contracted with the North Edwards Water District (the District) to build an arsenic removal water treatment plant. Clark hired steel storage tank subcontractor Crosno Construction, Inc. to build and coat two steel reservoir tanks. Clark and Crosno’s subcontract included a “pay-when-paid” provision, which stated that Clark would pay Crosno within a “reasonable time” of receiving payments from the owner, but “in no event less than the time Contractor and Subcontractor require to pursue to conclusion their legal remedies against Owner or other responsible party to obtain payment.” After Crosno completed its work, a dispute arose between Clark and the District, and the District withheld payment from Clark (including the monies earmarked for Clark’s subcontractors). Clark sued the District for payment, and Crosno filed its own action against Travelers Casualty and Surety Company of America, the surety on Clark’s statutory public works payment bond, for recovery of the unpaid subcontract balance. Travelers rejected Crosno’s bond claim as premature, invoking the “pay-when-paid” subcontract language and pointing to Clark’s pending payment action against the District. The issue on appeal was whether the “pay-when-paid” provision in the subcontract blocked Crosno from recovering under the payment bond from Travelers while Clark’s lawsuit against the District was still pending.

The court found that the “pay-when-paid” language was unenforceable for a number of reasons, primarily because it required the subcontractor to wait for an “indefinite time” until the general contractor and the owner resolved their disputes, citing Yamanishi v. Bleily & Collishaw, Inc.3 The court further reasoned that this open-ended language violated Civil Code section 8122.4 More specifically, the court emphasized that section 8122, which includes the phrase “affect or impair,” is broad enough in its scope to adversely and improperly impact Crosno’s payment rights. In other words, although the pay-when-paid clause in the Clark/Crosno subcontract did not serve as a waiver or release of Crosno’s payment rights against the payment bond surety, it “altered” or “impaired” those rights by creating an indefinite or uncertain time frame for recovery.

Travelers argued, among other things, that a number of existing provisions in subcontracts — e.g., “pass-through provisions, pre-litigation dispute resolution clauses, notice requirements, retention provisions, and liquidated damage clauses” — would be rendered unenforceable by this decision. In response, the court clearly stated that not all pay-when-paid provisions are unenforceable. The court further refused to specifically address “hypothetical” situations presented by Travelers, and reiterated its rationale for deeming this specific pay-when-paid provision — which included an “indefinite” hold period — unenforceable.

Additionally, Travelers argued that subcontractors already have rights to a security that general contractors do not have on public works projects (stop notices), and the holding would “effectively make direct contractors and their sureties ‘financiers of public works projects when the owner delays making payment.’” The court found no issue with that premise, suggesting that there is an “express legislative preference” in favor of subcontractors when it comes to payment remedies. The court concluded by affirming the trial court’s decision and awarding Crosno prejudgment interest.

Finally, while the Crosno decision only addressed the impact of an indefinite pay-when-paid clause on the subcontractor’s remedies against a payment bond surety (and, presumably, other statutory remedies such as stop payment notices and mechanic’s liens, all of which are covered by section 8122), an open question remains as to whether the courts will extend the holding to a subcontractor’s contractual payment remedies against the general contractor.

Impact for General Contractors

For general contractors, the ruling suggests that pay-when-paid language in subcontracts must include a defined time frame instead of leaving it contingent on the occurrence of something else, such as the conclusion of a lawsuit, which may be seen as “unreasonable” and “indefinite.” Additionally, subcontractors may bring payment bond claims and recover on those claims even before a general contractor has been paid, putting an onus on general contractors and undermining pay-when-paid provisions as a whole.

Many current subcontracts with language similar to that of Crosno and Clark’s subcontract may now include unenforceable provisions. As such, direct contractors should review their form subcontracts and, to the extent they contain Crosno-type pay-when-paid language, consider modifying the language by capping the “wait” time to a defined term, such as one year or six months from completion of the project.

Impact for Subcontractors

Subcontractors of public works projects should also review their existing subcontracts to see whether a pay-when-paid provision exists, and whether it complies with the recent holding. If subcontractors have not been paid due to nonpayment by the owner, recovery on a payment bond claim prior to the resolution of the dispute between the direct contractor and the owner may be feasible. It is recommended that any subcontractors in this circumstance ask their counsel about their remedies under Crosno and whether it can open an avenue for payment sooner than later.

Endnotes

1 Crosno Constr., Inc., v. Travelers Cas. & Surety Co. of Am., No. D075561, 2020 WL 1899278 (Cal. Ct. App. Apr. 17, 2020).

2 Wm. R. Clarke Corp. v. Safeco Ins. Co., 15 Cal. 4th 882 (1997).

3 Yamanishi v. Bleily & Collishaw, Inc., 29 Cal.App.3d 457 (1972).

4 “An owner, direct contractor, or subcontractor may not, by contract or otherwise, waive, affect, or impair any other claimant’s rights under this part, whether with or without notice, and any term of a contract that purports to do so is void and unenforceable unless and until the claimant executes and delivers a waiver and release under this article.” Cal. Civ. Code § 8122.