In a construction contract, a “pay-when-paid” clause acts as a timing mechanism that obligates a hiring party to pay their subs or suppliers when they are paid, or within a reasonable time. In a recent case out of the California Court of Appeals, the court declared that pay-when-paid clauses that delay payment for an undetermined amount of time are not reasonable (and therefore unenforceable).
Pay-when-paid clauses in California
Contingent payment clauses are contract provisions that establish a “condition precedent” to payment. This essentially means that payment is only due once a certain event occurs. These come in two forms: pay-if-paid and pay-when-paid clauses.
A pay-if-paid clause means the general contractor is not obligated to pay their sub or supplier if and when the owner pays them. A pay-when-paid clause is the less severe of the two. This provision makes the GC liable for payment when the owner pays them, or within a “reasonable time.”
Pay-if-paid clauses in California have been prohibited as being against public policy, but California allows pay-when-paid clauses.
The issue faced by many subs is what exactly constitutes a “reasonable time?” Many contractors include a definition of “reasonable time” within their subcontracts. But even if the contract defines it, will it be considered reasonable? The California Court of Appeals recently dealt with this specific issue.
What is reasonable in a California pay-when-paid clause?
The case in question is: Crosno Construction, Inc. v. Travelers Casualty & Surety Co. of America.
Project Snapshot:
- Owner: North Edwards Water District (District)
- General Contractor: Clark Brothers, Inc. (Clark)
- Bond surety: Travelers Casualty & Surety Company of America (Travelers)
- Subcontractor: Crosno Construction, Inc. (Crosno)
District hired Clark as the general contractor on a California public works project to build an arsenic removal water treatment plant. Clark hired Crosno as a subcontractor to provide steel reservoir tanks for the plant. Within the terms of the subcontract, there was a pay-when-paid clause.
The clause read as follows:
“If the Owner or other responsible party delays in making any payment to the Contractor from which payment to Subcontractor is made, Contractor and its sureties shall have a reasonable time to make payment. “Reasonable time” shall be determined according to the relevant circumstances, but in no event shall be less than the time Contractor and Subcontractor require to pursue to conclusion their legal remedies against the Owner or other responsible party to obtain payment, including (but not limited to) mechanics lien remedies.”
Subcontractor files payment bond claim while the GC & owner are in court
As Crosno was wrapping up work under their subcontract, a dispute arose between Clark (the GC) and the District.
With litigation proceeding between the two, Crosno made a bond claim against Clark’s payment bond (Travelers) for $562,435 in unpaid funds. At trial, Crosno filed a motion for summary judgment on their bond claim. Travelers responded by invoking the pay-when-paid clause as a defense to payment.
The trial court granted Crosno’s motion for summary judgment and enforced the bond claim. The court based its decision on the fact that the provision impaired Crosno’s California payment bond rights. Traveler’s appealed.
Open-ended pay-when-paid clauses are not reasonable
The Court of Appeals agreed with the trial court. Although the subcontract attempted to define “reasonable time” in the pay-when-paid clause, the definition was unreasonable. Under that definition, the time for payment was indefinite, and potentially stretch out for years.
In the Court’s own word:
“If the subcontract’s pay-when-paid clause allows the surety to postpone their payment bond obligations until some unspecified and undefined point in time when Clark’s litigation with the district concluded, that would unquestionably and unreasonably affect or impair Crosno’s right to recover under the payment bond.”
The purpose of a payment bond is to provide sub-tier project participants a quick and reliable means of recovering payment. Allowing this type of pay-when-paid clause would essentially act as a waiver of bond (or lien) rights; which we refer to as “no-lien clauses.” These types of advance waivers are prohibited under California Civil Code Section 8122, which states:
“An owner, direct contractor, or subcontractor may not, by contract or otherwise, waive, affect, or impair any other claimant’s rights under this part, whether with or without notice, and any term of a contract that purports to do so is void and unenforceable.”
Enforcing the subcontract’s pay-when-paid provision would, in its application, allow Travelers “to do indirectly what it cannot do directly.”
The Appeals Court affirmed the lower court’s decision, and awarded Crosno the $562K claimed, along with attorney fees and court costs.
California pay-when-paid clauses must provide a “reasonable time” for payment
This decision doesn’t invalidate the use of pay-when-paid clauses in California, but it certainly limits their applicability. If, as in this case, the clause delays payment to some indeterminate, unspecified time period; the provision will not be enforceable.
Even if the contract defines the term “reasonable time,” the clause can still be held as invalid. A reasonable time period can be found to be unreasonable if it is “open-ended” and delays the subcontractor’s right to payment past the deadlines necessary for a party to pursue their claim against the property owner. California contractors should revisit their subcontract terms. If they include a pay-when-paid clause, the term “reasonable time” should be clearly defined… and reasonable.
Special shoutout to our Expert Center all-star attorney Chris Ng of Gibbs Giden LLP for bringing this case to our attention. He offers a great breakdown of the decision here:
Pay-When-Paid: Courts Hold a “Reasonable Time” Now Has To Be Reasonable