Pay-When-Paid Contract Clause Loses in California Appeals Court
A California appellate court ruling on an industry standard “pay-when-paid” contract could have major implications about how and when subcontractors are paid for project work. The April 17 judgment held that the pay-when-paid clause violated state public policy and did not provide for payment within a reasonable time.
In the case of Crosno Construction Inc. v. Travelers Casualty, the Fourth District California Court of Appeals found the clause on a public works contract to be “unenforceable,” unreasonably delaying payment to the subcontractor until some “undefined, unspecified point in time.”
The case arose after subcontractor Crosno Construction was hired by general contractor Clark Bros. Inc. to add coating on steel reservoir tanks on a project to build a plant to remove arsenic from drinking water.
When Crosno’s work was nearly finished, the project stopped due to a dispute between Clark and the owner, North Edwards Water District in Kern County. Crosno then sued Clark and its surety, Travelers Casualty and Surety Company of America, to receive payment for its work under Clark’s public works payment bond.
Travelers argued that Crosno didn’t need to be paid until Clark was paid by the water district. A trial court disagreed and found that Crosno should be paid while the dispute between Clark and the district was ongoing. After an appeal by the surety, the Court of Appeal affirmed the ruling of the trial court.
'Ruling is a Big Deal'
“This ruling is a big deal because it means that subcontractors can pursue payment on a bond in public works jobs even before the prime contractor has finished pursuing recovery from the owner,” says Daniel F. McLennon, a partner with law firm Smith, Currie & Hancock LLP. “This is big because it will put pressure on prime contractors to make payments to subcontractors before they have the money in hand from the owners.”
McLennon, who also serves as government relations chair for American Subcontractors Association of California, says the ruling in effect makes prime contractors part-financers of the project. “And this is a major concern for prime contractors because if they have to be funding the money, they have to have great capitalization, and it costs them money to get the money.”
The pay-when-paid clause in the Crosno contract said Clark would pay Crosno within a “reasonable time” after receiving payment from the water district. The subcontract further stated that this “reasonable time” “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…”
The Crosno case echoes the California Supreme Court decision in the landmark 1997 case, Wm. R. Clarke Corp. v. Safeco Ins. Co. which found “pay-if-paid” clauses to be unenforceable in construction subcontracts.
Scott Holbrook, who wrote briefs on behalf of one of the subcontractors in the Clarke case, and also argued for Crosno, says the recent court ruling reaffirms subcontractor rights.
“As I argued before the court of appeals in the Crosno case, ever since the Clarke decision, [prime] contractors have tried to redefine when a subcontractor should be paid in a longer and longer time frame,” says Holbrook, a partner with Crawford & Bangs, LLP. “And this ruling puts a much shorter limit on the ‘when.’ You can’t have an indefinite payment period; it has to be definitive, and it has to be within the statutory time frame.”
Wade Crosno, president of Crosno Construction, says for a subcontractor, waiting until the conclusion of litigation between an owner and the general contractor can be a long time.
Sub 'Pleased' With Decision
“Under the pay-when-paid provisions in my case, the payment bond surety to this day would have no duty to pay faultless subcontractors sums due in 2014, because litigation between the owner and the general contractor is still pending,” he says. “I don’t think that’s right, and we’re pleased that the judge agreed with us.”
Crosno says subcontractors who successfully bid a public works project in California are faced with a dilemma after they are given their scope of work and then presented with a contract containing payment terms.
“If the subcontractor refuses to sign the contract, they face substitution for failing to sign an ‘industry standard’ contract. The pay-when-paid terms in my case came from the AGC form subcontract,” says Crosno. “In that event they may face a lawsuit from the general contractor seeking to recover any difference between their bid and that of the substitute subcontractor. If they sign, they face risk that they did not factor into their bid, which is the possibility that they may properly and timely perform their work, yet remain unpaid for an undetermined amount of time. In my case, it has been years. Hopefully our case will solve this problem.”
Matthew B. O’Hanlon, a partner in Los Angeles office at law firm Barnes & Thornburg, says the Crosno case demonstrates how important it is for all parties in a construction process to be mindful of relevant contractual language and its enforceability under the evolving case law.
“This case represents a cautionary tale about how an open-ended pay-when-paid clause ran afoul of California law and public policy,” he says. “I think the key implication is that a general contractor can’t necessarily rely on a pay-when-paid clause to defer payment issues with subcontractors pending litigation with an owner or otherwise.”