The Pay-if-Paid clause is widely used in the construction industry and essentially eliminates a prime contractor’s liability for payments to subcontractors in the event the owner does not pay the prime.
These clauses are generally enforced although a few states have, either by statute or legal precedent in the court system, proclaimed them to be against public policy. Let me also provide clarification on the proper terminology regarding timing-of-payment clauses. A Pay-when-Paid clause merely states the subcontractor will be paid at some point after the prime receives payment from the owner—it does not condition the prime’s duty to pay the subcontractor on the prime’s receipt of an owner payment. The general rule is that under a Pay-when-Paid clause, the prime will eventually have to pay the subcontractor if the owner fails to pay the prime. Conversely, a Pay-if-Paid clause provides that the prime’s duty to pay does not arise until and unless the prime receives payment from the owner. So, what about a prime contractor’s surety? Can it rely upon a Pay-if-Paid clause in the prime’s subcontract in defense of a subcontractor’s claim under a payment bond?
The general rule has always been that a payment bond surety is bound by both the language of the bond and the underlying subcontract, which must be read together. Applying this rule, the surety can use the Pay-if-Paid defense—the logic being that since the prime contractor is not liable under the terms of the subcontract, the surety also is not liable. Enter the case Moore Bros. Co. v. Brown & Root, Inc., 207 F.3d 717 (4th Cir. 2000), which turned the industry on its head when the U.S. Circuit Court of Appeals for the Fourth Circuit held that permitting the surety to use the Pay-if-Paid clause as a defense would defeat the underlying purpose of the payment bond—i.e., to provide protection to subcontractors against prime contractor non-payment. Many in the industry wondered whether the rationale of Moore Bros. would catch on with other courts. To the delight of many, it has not.
More recently, in Travelers Cas. & Sur. Co. of America v. Sweet’s Contr’g, Inc., 450 S.W.3d 229 (Ark. 2014), the Arkansas Supreme Court overturned a trial court that prohibited a surety from asserting the Pay-if-Paid defense. Although the payment bond in question in that case was posted to gain release of a mechanic’s lien rather than to insure payments to subcontractors and vendors under a prime contract, the analysis was the same as if it were the latter. In particular, the court looked at the terms of the bond, the mechanic’s lien statute and the subcontract and read them together. The court reasoned that since the prime contractor is not liable to the subcontractor by the terms of the subcontract, it follows that the surety is not liable under the bond.
Other courts have been critical of the Moore Bros. case. For example, in BMD Contractors, Inc. v. Fidelity and Deposit Co. of Maryland, 679 F.3d 643 (7th Cir. 2012), the U.S. Court of Appeals for the Seventh Circuit had the following to say when asked by a subcontractor to follow the rational of Moore Bros.:
First, the decision is weak on the merits. The main point made by the Moore Bros. majority was that it would “defeat the very purpose of a payment bond” to let the surety assert the pay-if-paid clause as a defense against recovery. This mistakenly assumes that the purpose of a payment bond is to insure subcontractors against nonpayment under any circumstances, rather than when payment is in fact due under the relevant contract . . . Virginia law specifically allows subcontractors to bear that risk, and the subcontractors here agreed to do so. The Moore Bros. majority relied chiefly on a line of reasoning that we have rejected.
The court’s approach in the BMD Contractors case is consistent with the reaction of other courts to Moore Bros. By my count only three courts—in Florida, Illinois and the Virgin Islands—have sided with the reasoning in Moore Bros. However, it could be reasonably argued that there were significantly different circumstances existing in those cases and, therefore, those decisions are not as far-reaching as Moore Bros. Contractors need to keep current on the approach taken by courts in the states in which they operate because Moore Bros. effectively renders Pay-if-Paid provisions void. R&B