Recent Seventh Circuit Case May Be A Prognosticator of How Washington Supreme Court Will Deal With Pay-If-Paid Provisions

Pay-if-paid and pay-when-paid clauses have been the subject of a number of blogs (including the blogs dated April 26, 2012, April 5, 2011, and March 17, 2008) and fodder for general contractor/subcontractor debates as to the propriety of including a pay-when-paid versus a pay-if-paid clause in a subcontract.

A “pay-when-paid” clause provides that payment to the subcontractor will be made within a certain period of time after subcontractor has performed its work.  Generally, paid-when-paid clauses provide for payment within a reasonable time.  A pay-when-paid clause does not excuse an unpaid prime contractor from all payment obligations to its subcontractors and suppliers when an owner failed to pay. See A+C blog dated March 17, 2008.

By contrast, a “pay-if-paid” clause establishes that payment by the owner to the contractor is a condition precedent to any payment due subcontractors or suppliers.  To be enforceable, the assignment of the risk of non-payment must be clear and unequivocal.  Generally, a pay-if-paid provision contains words to the effect that payment to the contractor by the owner is an express “condition precedent” for subcontractor to receive payment. See A+C blog dated March 17, 2008.  We have also tried to debunk the myth about pay-if-paid clauses. See A+C blog dated April 5, 2011.

A recent Seventh Circuit case, BMD Contractors, Inc. v. Fid. & Deposit Co. of Maryland, the court held that pay-if-paid provisions are not void under Indiana public policy may cast some light on how the Supreme Court in the State of Washington will dispose of the pay-when-paid vs. pay-if-paid debate when that issue reaches the Court’s docket.  The Washington appellate courts have not confronted the pay-if-paid versus pay-when-paid issue head on.  There is one case in the State of Washington where the subcontract’s payment clause clearly did not make payment to the general contractor a condition precedent to payment to the subcontractor and thus, the court placed the ultimate risk of payment and the obligation to make payment, even if the owner failed to pay, on the general contractor. See Amelco Elec. v. Donald M. Drake Co.

In BMD Contractors, Inc., the owner of an automobile transmission manufacturing plant filed for bankruptcy and failed to pay the general contractor. A second-tier subcontractor (BMD) sued on the contractor’s payment bond.  The bonding company for the general contractor took the position that it was not liable for payment under the “pay-if-paid” provision in the subcontract which read as follows:

It is expressly agreed that owner’s acceptance of Subcontractor’s work in payment to the contractor for the Subcontractor’s work are conditions precedent to the Subcontractor’s right to payment by the contractor.

(emphasis added).

In this instance, the court held that the contract was clear that payment from the owner to the contractor was an express condition precedent to the subcontractor’s right to payment from the contractor.  The court rejected arguments that the conditional language in the subcontract should be construed as a “pay-when-paid” clause which governs the timing of payment, but not the ultimate obligation to pay.  The court (sitting in diversity jurisdiction) made its prediction of how the Indiana Supreme Court would decide this case.  The court rejected arguments that pay-if-paid provisions are void under Indiana public policy, given Indiana’s “strong background presumption favoring freedom of contract” and the clearly stated language in the subcontract.  Thus, the court held that the surety could assert all defenses to its principal (the contractor) including the pay-if-paid provision, and thus the surety was not liable under the payment bond.

Considering the present composition of Washington Supreme Court justices who also favor freedom of contract and a literal reading of contract documents, they are likely to follow the same logic as the Seventh Circuit court did in the BMD case, particularly considering the decisions in Mike M. Johnson, Inc.  and Snohomish County Public Transportation Benefit Area Corp. The present Supreme Court seems to favor literal interpretation of construction contracts regardless of the practical implications that such literal reading of the contract has on construction projects. See John P. Ahlers and Lindsay K. Taft Article published in May 2012 WSBA Bar News.

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