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Court of Appeal Sets Limits on Enforceability of Pay-When-Paid Clauses

April 24, 2020

by Kathlynn Smith

For over 20 years, California courts have clearly and consistently rejected so-called pay-if-paid provisions in construction contracts that condition a subcontractor’s right to payment on the owner’s payment to the contractor. The seminal case of Wm. R. Clarke Corp. v. Safeco Ins. Co., 15 Cal. 4th 882 (1997) squarely rejected pay-if-paid clauses as an improper infringement of the subcontractor’s mechanics lien rights under the anti-waiver provisions of Civil Code section 8122. And within months of the Wm. R. Clarke Corp. decision, the court of appeal declared pay-if-paid clauses unenforceable on public works projects as well. Capital Steel Fabricators, Inc. v. Mega Const. Co., 58 Cal. App. 4th 1049 (1997). The Court in Wm. R. Clarke Corp. distinguished the use of impermissible pay-if-paid clauses from permissible pay-when-paid clauses that did not condition a payment, but merely impacted its timing to subcontractors. For years, uncertainty has remained about what circumstances a pay-when-paid provision would also run afoul of the anti-waiver provisions in Civil Code. On April 17, 2020, in the decision of Crosno Construction, Inc. v. Travelers Casualty and Surety Company of America, the court of appeal provided some guidance on that issue.

In Crosno, the general contractor, Clark Bros., Inc. (Clark), subcontracted with Crosno Construction (Crosno) to build and coat two steel reservoir tanks as part of an arsenic removal water treatment plant for North Edwards Water District (District). Travelers Casualty and Surety Company of America (Travelers) issued a payment bond as a security in case of Clark’s failure to pay its subcontractors. The subcontract between Crosno and Clark contained a typical, but expansive, pay-when-paid provision that stated that Clark would pay Crosno within a “reasonable time” of receiving payment from the District, which 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.”

Disputes arose between the District and Clark on the project. Although Crosno had performed most of its work, Clark ordered Crosno to stop work on the project. At that time, a large amount remained unpaid from Clark to Crosno. Crosno filed a stop payment notice with the District and gave notice to Travelers of its claim on the payment bond. Travelers rejected Crosno’s claim on the payment bond as premature based on the pay-when-paid clause in the subcontract and claimed that payment to Crosno was not due until the conclusion of the recently filed lawsuit between Clark and the District. Crosno proceeded to file a lawsuit against Clark, the District, and Travelers, which was then consolidated with the pending action filed by Clark. After years of litigation, Crosno filed a motion for summary judgment arguing that the pay-when-paid clause in its subcontract impermissibly interfered with Crosno’s right to pursue and receive the benefits of the payment bond issued by Travelers and, therefore, was contrary to the anti-waiver provisions in the Civil Code. The trial court agreed and granted Crosno summary judgment.

In upholding the trial court’s order, the Crosno court applied the same legal analysis set forth in Wm. R. Clarke and determined that pay-when-paid provisions were subject to the same anti-waiver safeguards of the Civil Code. And while the court reaffirmed that pay-when-paid clauses can be used to set a reasonable time for payment, the clause at issue here allowed the surety to postpone its payment obligation indefinitely, which unquestionably interferes with Crosno’s right to recover under the payment bond. And given that payment bonds are to provide subcontractors a speedy and reliable means of payment, applying a pay-when-paid clause that would permit a surety to defer payments to an indeterminate date was an unreasonable impairment of Crosno’s statutory rights. Accordingly, the court found the provision at issue to be void and unenforceable.

The Crosno decision provides some much needed guidance to the industry on the limits of what constitutes “reasonable time” under pay-when-paid provisions. The court confirmed the propriety of using pay-when-paid clauses as a proper mechanism to regulate the time for payment by a general contractor to a subcontractor, but condemned the abuse of such provisions that operate to defer indefinitely subcontractor payments. While the Crosnos decision clearly sets the outer limits of unreasonable delay in payments, there remain myriad ways contractors and subcontractors can permissibly define payment terms that protect contractors from becoming the involuntary financiers of projects as well as preserving a subcontractor’s right to payment. And, for those of you out there with pay-when-paid clauses in your contracts, now is the time to review those terms and evaluate whether revisions are needed to bring them into compliance with the law.

Kathlynn Smith is a shareholder at Hunt Ortmann with extensive experience representing the construction industry in complex construction litigation and transactional matters. Kathlynn’s practice is devoted to representing owners, developers, contractors, subcontractors, and suppliers on both public and private works of improvement from project inception through trial. For more information or for legal counsel on your contract provisions, please contact Kathlynn at smith@huntortmann.com.

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