Pay-if-Paid Clauses in California Construction

In many states, courts are required to determine whether a pay if paid, or pay when paid contract clause functions as a risk-shifting clause, or merely a timing mechanism. This can be a tough challenge. Fortunately, pay if paid clauses in California are easy to figure out: they are unenforceable as a matter of public policy.

Pay If Paid Clauses in California

The leading opinion on pay if paid clauses in California contracts was issued by the Supreme Court of California in 1997 for the case Wm. R. Clarke Corp. v. Safeco Insurance Company (15 Cal.4th 882).

Before even discussing the facts that led to the dispute in Clarke, the court gives us a really impressive overview of how pay if paid provisions are interpreted in other states. The court devotes a lot of attention to New York, South Carolina, Illinois, and Wisconsin, where pay if paid provisions “have been declared void and unenforceable” either by statute or as a matter of public policy by the courts. Since this was the first time the Supreme Court of California had ruled on the enforceability of a pay if paid clause, the choice the court had to make was clearly an important one: Should pay if paid clauses be permitted or prohibited in the state?

In 1990, the owner of a commercial building hired Keller Construction Co., Ltd. (Keller) as general contractor on a project to rehabilitate the building. Keller then subcontracted with a wide variety of parties, including the plaintiff, Wm. R. Clarke Corp. (Clarke). At the owner’s insistence, Keller obtained a payment bond from Safeco Insurance Company (Safeco).

Once “substantial work” was done on the project, the owner stopped sending money to the general contractor, Keller then refused to keep paying the subcontractors, including Clarke. As a result, the subcontractors, again including Clarke, filed mechanics liens on the property and later sued to foreclose on them.

At trial (and later on both appeals), Safeco argued that it had no duty to pay any of the subcontractors since it was protected by the “pay if paid” clauses in each of the subcontracts, the language of which is recounted below:

Contractor shall have no obligation, legal, equitable or otherwise, to pay Subcontractor for Work performed by Subcontractor unless and until Contractor is paid by the Owner for the Work performed by Subcontractor. Furthermore, in the event Contractor is never paid by Owner for Subcontractor’s Work, then Subcontractor shall forever be barred from making, and hereby waives, in perpetuity, any claim against Contractor therefor.

Both lower courts disagreed with Safeco’s argument and instead sided with the subcontractors on contractual grounds. After Safeco appealed the judgment against it twice, the matter came before the Supreme Court of California.

The California Supreme Court affirmed the lower courts’ judgments against Safeco, but this time the decision was made on public policy grounds.  In the court’s own language:

We conclude that pay if paid provisions like the one at issue here are contrary to the public policy of this state and therefore unenforceable because they effect an impermissible indirect waiver or forfeiture of the subcontractors’ constitutionally protected mechanic’s lien rights in the event of nonpayment by the owner.

In the court’s eyes, subcontractors have a constitutional right to be able to utilize a mechanics lien in order to get paid. Any contractual provision that attempts to take away that right is against California public policy, and as such, in not allowable.

Pay If Paid Clauses on California Public Projects

Although the Supreme Court of California has not ruled explicitly on pay if paid provisions on public projects, several California courts of appeal have.  The leading case in the context of pay when paid clauses is Capitol Steel Fabricators, Inc. v. Mega Construction Co. (58 Call.App.4th 1049) and the resulting opinion issued by the California Court of Appeal, Second District, Division 5. Much like the holding in Clarke, the court concluded that pay when paid clauses violate public policy and are not enforceable.

The court of appeals first discussed how pay if paid clauses are interpreted in more than 20 jurisdictions, including federal and state courts from all over the country.  Finally, after discussing how the pay if paid clause attempted to create a condition precedent to Capitol getting paid, the court concluded that Safeco’s arguments were “unpersuasive” and that, extending the holding in Clarke, held that:

the general contractor’s liability to its subcontractor for work performed on a public works project may not be made contingent on the governmental entity’s payment to the general contractor.

Thus, in California, no matter if the contract is public or private, it is against the state’s policy to make subcontractor payment contingent upon payment from the owner to the contractor. The take-away is clear: In California, the contractor is responsible for paying all subcontractors, even if the owner never pays the contractor.

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