When a public contractor’s payment bond surety is confronted with a claim from an unpaid subcontractor, it typically may assert any defense that is available to the prime under the subcontract.
Over the last 10 years or so, this rule has eroded slightly, especially as prime contractors began inserting “Pay-If-Paid” clauses in their subcontracts.
The first wave of cases involving Pay-If-Paid clauses involved their enforceability as between the prime and subcontractor. Some states, either through court decisions or legislation, have refused to enforce these provisions, whereas many others treat them as fully enforceable. Courts in states that enforce Pay-If-Paid clauses soon began to experience a second wave of cases involving whether a surety may assert Pay-If-Paid clauses as a defense to payment bond claims. Like the cases on the general enforceability of these clauses, courts have come out on both sides on the issue.
Consequently, in some of these states a Pay-If-Paid clause is a valid defense for both prime contractors and their sureties, while in others only the prime contractor may rely upon the clause. Those who argue that sureties should benefit from Pay-If-Paid clauses point out that such a result is consistent with the underlying objectives of payment bond protection to provide security when a prime fails to fulfill its payment obligations. They argue that sureties that cannot avail themselves of all terms of the subcontract are essentially being asked to expand upon the prime’s payment obligations. Those on the other side of the issue argue that allowing sureties to hide behind Pay-If-Paid clauses circumvents the intention of public contracting laws that require bonds on public projects.
One recent case in point, Glencoe Education Foundation, Inc. v. Clerk of Court, 2011 La. App. LEXIS 626, involved an astute Louisiana prime contractor on a public-school construction project that, no doubt, had taken notice of the manner in which courts have decided these cases. The prime contractor included in its subcontracts a typical Pay-If-Paid provision, but also specified that “no payment, partial or final shall be due or owed to the Subcontractor from Contractor’s surety unless and until, as a condition precedent, Contractor receives payment for Subcontractor’s work from Owner.” The prime apparently believed that by expressly naming the surety in the Pay-If-Paid clause, a court would more likely agree that the surety could benefit from it. Before this case, courts in Louisiana had ruled that a prime may rely upon a Pay-If-Paid clause, but had not directly addressed whether a surety may assert the Pay-If-Paid defense.
In the end, the court refused to extend Pay-If-Paid clause protection to the surety. In doing so, it relied principally upon a provision in the relevant public contracts statute prohibiting contractors or sureties from inserting provisions in the prescribed bond form or within underlying contracts that “diminish . . . or otherwise modify the obligations of the bond.” While this approach did not work in Louisiana, it might work elsewhere.
The cases I have reviewed on this issue seem to overlook one significant fact that deserves consideration. When a prime contractor procures a payment and performance bond from a surety, it agrees to indemnify the surety from all claims and losses arising out of such bonds. This means that, except in the case where a prime is insolvent or bankrupt, the prime ends up paying the payment bond claimant, not the surety. Admittedly, there are many instances where payment bond claims are made as a result of insolvent prime contractors, but in these cases the owner has typically paid the prime and thus the Pay-If-Paid defense is not applicable. Nevertheless, courts that rule that sureties may not avail themselves of the Pay-If-Paid defense are, in effect, ruling that the prime cannot as well—even if the clause is otherwise enforceable for the prime as it was in the Glencoe case.
