I have written in recent years on the growing trend within federal courts to hold payment bond sureties liable to subcontractors for payment even though the owner has not paid the prime contractor and the subcontract contains an enforceable Pay-if-Paid clause.
The rationale employed by courts choosing this approach is generally that allowing sureties to rely on such clauses defeats the purpose of the Miller Act, which is to ensure claimants who perform work are paid in the event the principal fails to pay. However, a recent case in Alabama deciding a payment bond claim on a state project under Alabama’s Little Miller Act takes the more popular approach and allows the surety to rely upon the Pay-If-Paid defense.
Keller Constr. Co. of Northwest Florida, Inc. v. Hartford Ins. Co., 2018 WL 5306918 (Ala. Oct. 26, 2018) involved a project to build a community center for the city of Spanish Fort. At the end of the project, the prime contractor denied the subcontractor’s request for release of its retainage because, for reasons not discussed in the opinion, the owner refused to pay the prime’s retainage. The subcontractor sued the prime’s payment bond surety.
At trial, the subcontractor admitted that the subcontract contained a Pay-If-Paid clause. However, the subcontractor argued the surety was foreclosed from relying on that provision and must nevertheless pay the subcontractor. The trial court rejected that argument and held that the payment bond surety’s liability is coextensive with the prime and is thus liable only if the prime is liable to the subcontractor under the terms of the subcontract. On appeal, the subcontractor first pointed to two prior Alabama decisions where courts held a surety cannot rely upon a Pay-If-Paid clause like the one at issue in this case. However, the Court of Civil Appeals of Alabama distinguished those cases. In both, the appeals court held, the clauses at issue were Pay-When-Paid clauses and merely addressed the timing of payment, not the prospect of owner non-payment. Indeed, the provision in one case provided as follows:
“Final payment constituting the entire balance of the [subcontract] shall be made by [general contractor] to [subcontractor] when [subcontractor’s] work is fully performed . . . the Architect has issued a Certificate for Payment covering [subcontractor’s] completed work, and [general contractor] has received payment from the owner. Final payment shall then be made to [subcontractor] within fifteen (15) days following [general contractor’s] receipt of payment from [the owner].”
Specifically, the court determined that the payment provisions in both of the cited cases lacked the certainty needed to establish payment by the owner as a condition precedent and, consequently, the prime was still ultimately liable to the subcontractor if the owner failed to pay. It was for this reason the courts in those cases found the sureties liable.
In the present case, the appeals court agreed with the trial court’s determination that the payment clause, which included specific “condition precedent” language, gave rise to a duty by the prime to pay the subcontractor only if the owner paid the prime. The court recognized that exculpatory clauses such as the Pay-If-Paid clause are generally disfavored by courts, but the freedom of parties to contract as they desire also is a hallmark of Alabama law. Consequently, when the contract provision clearly and unambiguously creates a condition precedent, it will be enforced. Next, the court addressed the surety’s liability.
The court rejected the rationale of several recent federal court decisions that held a surety cannot assert a conditional-payment clause in a subcontract as a defense to avoid liability. Instead, the court reasoned that “allowing [the subcontractor] to recover from [surety] under the bond when [subcontractor] has no right to recover . . . from [the prime] under the subcontract would violate the . . . principle of surety law that a surety under a payment bond can be liable only to the extent that the principal is liable.”
For the most part, state courts ruling on Miller Act payment bond claims continue to recognize the rule that a surety’s liability is coextensive with that of the principal. However, the trend in federal courts to preclude these surety defenses should be watched closely.