March 29, 2016
In the first issue of this newsletter, April 2010, I wrote about subcontractor contracts and provisions that you need to be concerned about. One of those is the pay when paid provision. Most general contractor form contracts have such a provision and under Illinois law it is enforceable.
In essence this provision shifts the risk of an owner’s insolvency to the subcontractor since it provides that the gc only has to pay you if he receives payment from the owner. A recent Seventh Circuit US Court of Appeals decision reaffirms that such a provision is enforceable and can have severe consequences to a subcontractor or material supplier.
The general contractor was under contract with the owner to construct a manufacturing plant near Indianapolis, Indiana. After about a year of construction the owner went bankrupt. There was significant money owed. $40 million to the gc, $11 million to a subcontractor and $1.5 million to a sub-subcontractor. The sub-subcontractor’s contract had a pay if paid clause. The sub-subcontractor perfected it’s mechanic’s lien rights and recovered about half of its money in the owner’s bankruptcy proceedings when the property was sold. A lawsuit was filed by the sub-subcontractor on the payment bond that had been provided by the subcontractor to the general.
The dispute in the lawsuit was whether the clause at issue was a true pay if paid clause or a pay when paid provision. Also at issue was whether the bonding company could assert the pay if paid clause as a defense to the action on the payment bond.
There was little question by the US Court of Appeals that the provision at issue was a pay if paid clause. It provided as follows:
“IT IS EXPRESSLY AGREED THAT OWNER’S ACCEPTANCE OF SUBCONTRACTOR’S WORK AND PAYMENT TO THE CONTRACTOR FOR THE SUBCONTRACTOR’S WORK ARE CONDITIONS PRECEDENT TO THE SUBCONTRACTOR’S RIGHT TO PAYMENTS BY THE CONTRACTOR.”
The Appellate Court held this language was clearly a pay if paid provision and that by agreeing to it the sub-subcontractor assumed the risk of the owner’s insolvency.
The sub-subcontractor argued that because the payment bond did not expressly incorporate the terms of the sub-subcontract that had the pay if paid provision the bonding company could be held liable even though the subcontractor could not be under the contract. The Appellate Court rejected this argument as it contradicts basic principles of surety law. The bonding company is only liable to answer for the debts of its principal and if the principal is not liable then neither is the bonding company. Accordingly, the sub-subcontractor could not recover the balance of its money from either the subcontractor with whom it contracted nor the bonding company.
The decision in this case highlights the importance of perfecting your mechanic’s lien rights. While this case involved Indiana law the law in Illinois is the same. A pay if paid clause in a contract is not a defense to a mechanic’s lien claim. It is a defense to a contract claim. Had the sub-subcontractor not perfected its lien rights that allowed it to recover half of its money in the owner’s bankruptcy it would have lost the entire $1.5 million it was owed. Don’t think that just because a payment bond is in place you are safe. The bonding company has all the defenses that it’s principal has under the contract at issue. Make sure you understand the consequences of a pay if paid clause and always take action soon enough to perfect your lien rights.