Bond claim on desk

If you’re unpaid on a construction project, you usually have mechanics lien rights and/or the right to recover under a payment bond. The magic of mechanics lien or bond claim rights is that it empowers subcontractors and suppliers to get paid regardless of what happened with finances “upstream,” such that if a general contractor doesn’t get paid, or if a general contractor misappropriates funds and doesn’t pay an upstream subcontractor, it really makes little difference because the mechanics lien or bond claim rights themselves would furnish to the unpaid party a cause of action against the property itself, and the property owner.

What happens, however, when the unpaid party doesn’t have a right to be paid?  This is frequently the case whenever a “pay when paid” clause exists.

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The United States Court of Appeals for the 7th Circuit decided this issue just last week in a case before it on diversity jurisdiction, BMD Contractors Inc v. Fidelity and Deposit Company of Maryland; the case applied Indiana law.

For the time being in Indiana, pay-if-paid provisions (not pay-when-paid provisions) can eliminate a claimant’s bond claim rights, but will not reduce the rights to file a mechanics lien. However, the answer may be different in every state depending on the state’s public policy in favor of mechanic lien and bond claim filings and the jurisprudence related to pay-when-paid clauses.

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Explaining Pay-When-Paid and Pay-If-Paid Contract Provisions

It’s important to quickly define and discuss these contractual clauses before addressing in detail how they fit into a state’s mechanics lien framework. The court in the BMD Contractors case gives a really great summary of why these clauses exist and what they are:

Contractors and subcontractors have developed tools to manage the possibility that some “upstream” contracting party will become insolvent or otherwise default in payment, raising the question of which “downstream” parties bear the risk of nonpayment….

A pay-when-paid clause governs the timing of a contractor’s payment obligation to the subcontractor, usually by indicating that the subcontractor will be paid within some fixed time period after the contractor itself is paid by the property owner…In contrast, a pay-if-paid clause, as the name suggests, provides that a subcontractor will be paid only if the contractor is paid and thus ensures that each contracting party bears the risk of loss only for its own work.

Just because these two distinct types of contract provisions exist (pay if paid and paid when paid) doesn’t mean every state distinguishes them in meaning and effect. In fact, the opposite is true, with only some states requiring the more specific “pay-if-paid” language to exist within a contract before upstream payment becomes a condition precedent to payment along to a subcontractor or supplier. In these states that do not require this specific language, saying “pay-when-paid” is enough to create the condition.

I’m fond of a few articles I wrote a few years ago on Wolfe Law Group’s Construction Law Monitor blog about these two types of payment provisions that discuss them in more detail, all viewed at the Pay-If-Paid Tag.

The Indiana Pay-If-Paid Case And What It Means

Now let’s talk about what happened in Indiana last week, thus affecting the mechanics lien and surety law in that state and maybe foreshadowing how other states may handle this fairly common issue.

The 7th Circuit Court of Appeals examination of the issue was in a natural order. First, decide whether the contractual provisions was a “pay when paid” or a “pay if paid” clause.  Second, decide if and how this affects the claimant’s bond claim rights. The court was not called upon to address mechanics lien rights, but they do make a note about it, which is worth discussing.

Is The Provision A Pay-When-Paid or Paid-If-Paid Clause?

As briefly mentioned above, not every state has distinguished between pay-when-paid and pay-if-paid provisions. Some states consider pay-when-paid provisions strong enough to absolutely require payment upstream before there is a payment obligation downstream. As discussed in “Problems Can Arise When Using One Contract In Multiple States,” this is the case in Virginia, where a simple pay-when-paid provision is sufficient to create the absolute condition of payment upstream before downstream payment is due. A contractual provision can get more specific (as is required in states like Louisiana), but it is not necessary.

Prior to the BMD Contractors case, Indiana law considered “pay when paid” clauses as not a complete bar to payment, instead providing a “timing” guide to the parties as to when payment was due. If payment was never received, payment would be due downstream within a reasonable time. Importantly, however, Indiana courts had not “squarely addressed pay-if-paid clauses” prior to the BMD Contractors decisions.

Anyone interested in construction contract language and law would be happy to read the BMD Contractors opinion because it goes into great detail as to what makes the contract in that case the “pay-if-paid” variety, examining the language and arguments for and against the interpretation. There’s no need to go into detail here, as it’s sufficient to note the court eventually found that the provision was the “pay-if-paid” variety.

When confronted with a mechanics lien that contradicts a party’s contractual payment obligations, the first question any court should address is whether the provision is a pay-if-paid – totally barring payment – or a pay-when-paid provision.  If the former, mechanics lien rights are in greater jeopardy. If the latter, there is much more hope for lien claimants.

How Strong Is The Public Policy To Protect Mechanics Lien Claimants?

The next question the court will wrestle with is what prevails:  The state’s public policy interests in favor of mechanics lien claimants and getting claimants paid…or the state’s public policy interests in allowing parties to freely contract with one another.  In other words, does the state’s public policy void the “pay-if-paid” language?

I think this could potentially be answered differently within a single state depending on circumstances.

The plaintiffs were able to enforce their mechanics lien rights in the face of a valid pay-if-paid provision because Indiana is one of those states that value mechanics lien rights higher than the rights to freely contract.  I can envision a state’s courts upholding a “pay-if-paid” clause if a mechanics lien claim has not been filed, because the state’s public policy interests in allowing parties to freely contract with one another would outweigh the interest in having contract performers get paid for their work. However, once a mechanics lien claim is filed, there are some states who have strong public policy favoring these lien claims, and I can envision those states reversing course when confronted with a lien claim because the mechanics lien policy will outweigh the right to freely contract policy. An example of where this MAY (but has not yet) play out is in California, where the right to a mechanics lien is within the state’s Constitution.

The US 7th Circuit doesn’t squarely address this wrinkle in the BMD Contractors case, but it does give us enough information to draw the conclusion that the mechanics lien rights in Indiana trump any “pay-if-paid” contract provisions. This is understood from the BMD Contractors decision because the plaintiffs in the case had filed a mechanics lien, foreclosed upon it and been paid, all before this dispute arose for the remainder of the amounts due to the plaintiffs.

The plaintiffs were able to enforce their mechanics lien rights in the face of a valid pay-if-paid provision because Indiana is one of those states that value mechanics lien rights higher than the rights to freely contract in this instance.  Just like some “lien waivers” are void against public policy, so too is any restriction (in Indiana) to restrict a party’s “right to record or foreclose a lien.”  Indiana Code § 32-28-3-18(c).

Does Pay-If-Paid Provision Eliminate Bond Claim Rights Under Payment Bonds?

This BMD Contractors case is an excellent case study for pay-when-paid and pay-if-paid contract provisions as they relate to mechanics lien and bond claim rights because on this particular construction project both bond claim and mechanics lien claim rights existed. The court, therefore, was able to comment on how a pay-if-paid contract provision would impact both remedies.

As examined above, the public policy in favor of mechanics lien claims ranked higher than the public policy interest in favor of allowing parties to freely contract. What about a claimant’s rights under a payment or surety bond, however?

This presents a real legal paradox, and candidly speaking, it’s one of those legal issues that could go either way, and likely will go both ways depending on each state’s preferences.

[pullquote style=”left” quote=”dark”]The legal paradox is that pay-if-paid contractual provisions are designed to shift the risk of non-payment downstream, so that suppliers and subcontractors bear the risk of a property owner going insolvent. However, payment bonds are posted for the very purpose of shifting the risk of non-payment and insolvency on the surety.[/pullquote] The legal paradox is that pay-if-paid contractual provisions are designed to shift the risk of non-payment downstream, so that suppliers and subcontractors bear the risk of a property owner going insolvent. However, payment bonds are posted for the very purpose of shifting the risk of non-payment and insolvency on the surety. So, how do these conflicting risk-shifting actions reconcile with one another?

In Indiana, the answer is that pay-if-paid provisions do restrict a claimant’s rights under a payment bond.  The 7th Circuit US Court of Appeals makes a lot of sense with its decision, highlighting that basic principles of surety law is that “a surety must answer only for the debts of the principal and cannot be liable where the principle is not.”  Since pay-if-paid provisions are not void and against general public policy in Indiana, and this case presented a pay-if-paid clause, the surety’s principal did not have an obligation to pay the claimants, and therefore, neither did the surety.

While the law in Indiana significantly reduces a party’s right to make a claim against a payment bond when a pay-if-paid contract provision exists within a contract, there are three circumstances that may distinguish this result from your case and allow you to recover.  These three circumstances are:

1) Outside of Indiana, if you perform work or furnish materials in a state that considers “pay-if-paid” clauses generally void and against public policy in all circumstances;

2) Inside or outside of Indiana, if you have a “pay-when-paid” clause rather than a “pay-if-paid” clause in your construction contract. The 7th Circuit even addressed this situation in the BMD Contractors case, distinguishing it from another Indiana opinion when bond claim rights were preserved in the face of a pay-when-paid provision (Culligan v. Transamerica Insurance Company); and

3) The Indiana court does not explicitly state what would happen if this issue had arisen on a state or federal construction project, where the payment bond claim acts a lot more like a mechanics lien claim.  An opposite result could be contemplated under this circumstance.