Many contracts contain a “pay-if-paid” clause in a direct contractor’s agreement with its subs. Typically, the clause provides that the direct contractor is required to pay its subcontractors “ONLY IF” the direct contractor has been paid by the owner for that particular subcontractor’s work. It doesn’t take a rocket scientist to figure out that this practice could prove to be a disaster for the subcontractor(s). They are basically consenting to a risk that the owner may, at some point, not pay the direct contractor. Should this happen, the “Pay-if-Paid” clause would, in theory, relieve the direct contractor from its obligation to pay those subcontractors even if the work was timely completed and in conformance with the contract.
Despite the fact that many contracts contain “Pay-if-Paid” clauses; in California they are not enforceable. That has been the case since June 1997, when the California State Supreme Court invalidated “Pay-if-Paid” clauses in construction subcontracts. The court ruled in Wm. R. Clarke Corp. v. Safeco Insurance Company (15 Cal.4th 882), that a general contractor’s liability to a subcontractor for work performed may not be made subject to the owner’s payment to the general contractor.
In Clarke, the owner of a commercial building hired general contractor Keller Construction Co., Ltd. (Keller) to rehabilitate a building. In turn Keller subcontracted with various parties, including Wm. R. Clarke Corp. (Clarke). Keller obtained a payment bond from Safeco Insurance Company (Safeco). As is often the case, initially the owner paid Keller. However, once a considerable amount of work was completed, the owner stopped paying Keller who then stopped paying the subcontractors.
These subcontractors, including Clarke, filed mechanics liens on the property and later sued to foreclose on them. The payment bond surety, Safeco, argued that it had no duty to pay any of the subcontractors since it was protected by the “Pay-if-Paid” clauses in each of the subcontracts. Both lower courts disagreed with Safeco’s argument and instead sided with the subcontractors on contractual grounds. After Safeco appealed the judgment against it twice, the matter came before the Supreme Court of California. The California Supreme Court affirmed the lower courts’ judgments against Safeco. In the court’s eyes, subcontractors have a constitutional right to be able to utilize a mechanics lien in order to get paid. Any contractual provision that attempts to take away that right is against California public policy, and is not allowable.
Several California Courts of Appeal have ruled on pay when paid provisions on public projects, as in, Capitol Steel Fabricators, Inc. v. Mega Construction Co. (58 Call.App.4th 1049). The court concluded in this case that pay when paid clauses violate public policy and are not enforceable, as in the Clark case above.
It does not matter if the contract is public or private in California – it is against the state’s policy to make a subcontractor’s payment contingent upon payment from the owner to the direct contractor. If the subcontractor’s work is timely completed and in conformance with the contract, the direct contractor is responsible for paying the subcontractor even if the owner never pays the direct contractor.