Pay-If-Paid Clauses:  Unfairness in Private Construction?

For this week’s Guest Post Friday here at Musings, and for the 500th post at this little corner of the blogosphere (who would have thought?) we welcome back Rob Pitkin.  Rob (@KCconstrlawyer) is an attorney with Levy & Craig in Kansas City, where he handles Construction disputes and other types of sophisticated business litigation.  Originally from Iowa, he graduated from Wheaton College and Wake Forest University School of Law.  Rob is currently listed in Best Lawyers in America in Construction Law and serves as an Arbitrator on construction cases for the American Arbitration Association. He has been practicing law for 25 years now and focusing on construction law for more than 15 years. 

With the economic downturn resulting in more failed projects, one of the things we see more frequently are pay-if-paid clauses in subcontracts.  As has been discussed in previous posts, the enforceability of these clauses vary from state to state.  For example, pay-if-paid clauses are unenforceable in California, having been stricken as contrary to public policy by the California Supreme Court in 1997, based upon its interpretation of the anti-waiver provisions of the former Cal. Civ. Code § 3262.  See William R. Clarke Corp. v. Safeco Ins. Co., 938 P.2d 372 (Cal. 1997); Cal. Civ. Code §§ 8122, 8132, 8134, 8136, 8138 (formerly Cal. Civ. Code § 3262).  Similarly, pay-if-paid clauses are unenforceable in Delaware on private construction projects.  Del. Code Ann. tit. 6 § 3507(e).  Likewise, pay-if-paid clauses are unenforceable in Nevada, North Carolina, South Carolina, and Wisconsin.  Lehrer McGovern Bovis, Inc. v. Bullock Insulation, Inc., 197 P.3d 1032 (Nev. 2008); N.C. Gen. Stat. § 22C-2; S.C. Code § 29-6-230; Wisc. Stat. § 779.135.Kansas, where I primarily practice (along with Missouri), has never definitively spoken on the enforceability of pay-if-paid clauses.  However, in 2005, the Kansas legislature passed what’s called the “Fairness in Private Construction Act” with the express purpose of dealing with “unfair, one-sided [construction] contracts” that were in use.   Although the Kansas legislature (unlike California, Delaware, Nevada, North Carolina, South Carolina and Wisconsin) did not invalidate pay-if-paid clauses altogether, it expressly made them “no defense” to mechanic’s liens and payment bond claims.  K.S.A. 16-1803(c).  Maryland, Massachusetts, Montana, Illinois, New York, and Missouri have similar statutes that invalidate pay-if-paid provisions in connection with either mechanic’s lien or payment bond claims or both.  Md. Code, Real Property, § 9-113(b);  Mass. Gen. Law 149 § 29E; Mont. Code Ann. § 28-2-723; 770 Ill. Comp. Stat. Ann. § 60/21(e); N.Y. Lien Law § 34; Mo. Ann. Stat. § 431.183.

In a pending case we are handling, the lender pulled the funding in the middle of the private project, resulting in a stoppage of work.  When alternate funding was not obtained, numerous mechanic’s liens were filed, along with a mortgage foreclosure action by the lender.  As a result, the owner filed Chapter 11 bankruptcy.  During the bankruptcy case, the court ruled that the mortgage had priority over the mechanic’s liens, which meant that nothing went to the innocent subcontractors when the property was sold for less than the mortgage balance.  Because a payment bond was provided, many of the innocent subcontractors made payment bond claims, which were consolidated in one case that was removed to federal court in Kansas.   Not surprisingly, the surety asserted that the payment bond claims were barred by the pay-if-paid clauses in the subcontracts.  In response, the subcontractors relied on K.S.A. 16-1803(c) to defeat this defense.

At the district court level, the court ruled in favor of the surety, finding that K.S.A. 16-1806(c) was “clear and unambiguous” and applied only to bond claims “pursuant to the provisions of article 11 of chapter 60 of the Kansas Statutes Annotated, as amended,” which – interestingly – includes public works bonds under K.S.A. 60-1111.  Faith Technologies v. Fidelity & Deposit Company of Maryland, No. 10-2375-MLB, 2011 U.S. Dist. LEXIS 7688 (D. Kan. Jan. 26, 2011).   In other words, the district court held that the Kansas “Fairness in Private Construction Act” applied to a payment bond on a public project bond, but not to a payment bond on a private construction project!

The case is currently on appeal to the United States Court of Appeals for the Tenth Circuit.  The main issues on appeal include:  (a) Are pay-if-paid clauses enforceable in Kansas?  (b) Is the surety’s defense based on the pay-if-paid clauses in the subcontracts between its principal and the claimants barred by K.S.A. 16-1803(c)?  and (c) Regardless of K.S.A. 16-1803(c), can the surety rely on the pay-if-paid clauses in the subcontracts when there is no pay-if-paid language in the payment bond itself?  On this last issue, several courts – including the Fourth Circuit – have held that a surety cannot assert a pay-if-paid defenses where there is no pay-if-paid language in the bond.  See, e.g., Casey Indus., Inc. v. Seaboard Surety Co., 2006 WL 2850652 (E.D. Va. 2006); Moore Bros. Constr. Co. v. Brown & Root, Inc., 207 F.3d 717 (4th Cir. 2000); Brown & Kerr Inc. v. St. Paul Fire & Marine Ins. Co., 940 F. Supp. 1245 (N.D. Ill. 1996).

Appellants’ opening brief is due by April 29, 2013.  Stay tuned!

As always, Rob and I welcome your comments below.  Please subscribe to keep up with this and other Guest Post Fridays at Construction Law Musings.