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By: Jim Dash
The problem: An upstream party (i.e., the owner, upstream (sub)contractor), for reasons outside its control, fails to pay for construction work. Here is the dialogue:
Upstream Party: Sorry, but we haven’t been paid yet on this project. We’ll pay you if and when we get paid.
Downstream Party (screaming): But we have a contract!
Upstream Party: Yes. And the contract says that we will pay you only if and when we get paid on this project.
The conversation ends. Downstream Party then picks up the phone and calls its lawyer. Here is the phone call:
Downstream Party: Can they really do this?
Lawyer: I’m afraid so, unless ….
This is the way it will go if the upstream party is reasonably sophisticated. The (sub) contract will have a “Pay When Paid” or “Pay if Paid” clause (the difference is subtle, but existent) because the upstream party would prefer to assign the risk of non-payment to someone else and it likely has the leverage to insert such a provision into most of its subcontracts with downstream trade contractors. And who can blame anyone for wanting to pass along the risk of someone else’s failure to pay, especially when the unpaid upstream party has not been paid for its own account as well as for the accounts of those that it is otherwise obligated to pay? Because we all know what rolls downhill, it is the “poor little schnooky subcontractor” (“PLSS” – with due credit for the phrase to a colleague) who ends up holding the rolling stuff for the longest period of time.
As a matter of pure contract, “Pay When Paid” or “Pay if Paid” clauses generally are enforceable in Illinois so long as the contract makes payment to the upstream party an unambiguous condition precedent to payment downstream. A.A. Conte, Inc. v. Campbell-Low-rie-Lautermilch Corp., 132 Ill. App. 3d 325 (1st Dist. 1985). And if (sub)contractor does not have, or believes that it does not have, the leverage to negotiate the terms of its contract, it often will accept the contract, “Pay When/ If Paid” clause and all, just in order to get the work.
So is every downstream party inevitably stuck with the risk of someone it its chain of contract failing to pay downstream? The answer is “not always”—so long as it is paying attention to its business.
First things first, regardless of where it is in the chain of contract, each party should know which of its contracts has a Pay When/ If Paid clause. Obviously, if you represent the upstream party, you want all of your contracts with those downstream to contain a well-drafted clause. If you represent the downstream party, you would recommend your client not to have one at all and, where circumstances permit the client to negotiate the issue, you would recommend that it should do so. Either way, know your clients’ contracts.
Let’s assume that your client is a PLSS. A customer with whom it has a very profitable relationship insists on a Pay When/If Paid clause. The PLSS agrees because most of the business with this customer is profitable and PLSS does not perceive itself to have sufficient leverage to prevent the customer from going to someone else who will agree to this term. What is a PLSS to do?
First, every downstream party on an Illinois construction project does have the benefit of some legislative assistance. Section 21(e) of the Mechanics Lien Act (770 ILSC 60/21(e)) provides in pertinent part that:
(e) Any provision in a contract, agreement, or understanding, when payment from a contractor to a subcontractor or supplier is conditioned upon receipt of the payment from any other party including a private or public owner, shall not be a defense by the party responsible for payment to a claim brought under Section 21, 22, 23, or 28 of this Act against the party. * * *
In plain English, a Pay When/If Paid clause is not a defense to a mechanic’s lien action. Assuming that the claim for lien is otherwise useful, taking the (relatively inexpensive) steps to perfect a claim for mechanic’s lien can provide significant leverage to a downstream party.
Also, the claimant should know whether there is a payment bond posted for the project. Payment bonds are required on many public works projects above $50,000. 30 ILCS 550/1. Payment bonds may be posted on a private project as well. A federal court in Chicago has held that a Pay When/If Paid clause—at least under the circumstances of that case—may not be a defense to a claim on the bond. Brown & Kerr Incorporated v. St. Paul Fire & Marine Ins. Co., 940 F. Supp. 1245 (N.D. Ill. 1996).
The Brown & Kerr case is worth some discussion. A general contractor on a project, Bucon, had not been paid by the owner. As a result, Bucon did not pay its subcontractors, one of which, BKI, filed suit against Bucon’s surety, St. Paul, after proper notice. St. Paul did not dispute most of Bucon’s debt to BKI but argued, inter alia, the well-established proposition that a surety’s liability is co-extensive with that of its principal and the surety has the benefit of all of its principal’s defenses, including all of the defenses in the principal’s contract. BKI’s subcontract with Bucon contained the following clause:
Final Payment constituting the entire unpaid balance of the Subcontract Sum, shall be made by the Contractor to the Subcontractor when … the Contractor has received final payment from the Customer under the Prime Contract.
Id. at 1249. St. Paul argued that, because its principal, Bucon, had not yet been paid, and because the surety generally is permitted to borrow the defenses of its principal, BKI had no right to payment under the bond.
The federal court, applying Illinois law, disagreed. Judge Wayne Andersen wrote that:
St. Paul has neither cited, nor have we discovered, any authority for the proposition that the inability to proceed against the general contractor because of a “pay when paid” clause in the subcontract necessarily prevents recovery against the surety under the payment Bond. Indeed, such an argument runs counter to the underlying purpose of the payment Bond, i.e., the assurance of payment to subcontractors. See Premier Elec. [Constr. Co. v. American Nat’l Bank, 276 Ill. App. 3 816, 829 (1st Dist. 1995)].
Brown & Kerr, 940 F. Supp. 1249. Further, the court distinguished between a pay when paid clause and a pay if paid clause. The court ruled that, while an unambiguous condition precedent to payment creates the latter, injection of the concept of time creates the former, reducing it to “a timing provision requiring the contractor to pay the subcontractor within a reasonable time.” Id. at 1250 (citing the dissent in A.A. Conte, Inc. v. Campbell- Lowrie-Lautermilch Corp., 132 Ill. App. 3d 325 (1st Dist. 1985)). The court found the clause was merely a timing provision and not an unambiguous condition precedent to payment. The court also held that the “underlying purpose” of the bond would be defeated if the surety was not held liable and, therefore, entered judgment against the surety.1 It should be noted that federal courts in Indiana, applying Indiana law, have declined to follow Brown & Kerr. See BMD Contractors, Inc. v. Fidelity & Dep. Co., 828 F. Supp. 978 (S.D. Ind. 2011), affirmed, 679 F.3d 643 (7th Cir. 2012).
If a (sub)contractor has no possibility of a mechanic’s lien and no bond on which to make a claim, the best strategy may be to make an agreement with its customer to hold off on litigation (perhaps with a waiver of the limitations period) to see if and when the customer gets paid. That could be preferable to throwing good money after bad.
1. In Brown & Kerr, the court appears to have assumed the underlying purpose of the bond was to protect subcontractors from non-payment. Those who require and pay for bonds likely have a different view – that the underlying purpose of the bond, at least in the private sector, is to protect the obligee under the bond (the owner) from having his/her property exposed to mechanic’s liens in the event the original contractor fails to pay. Of course, if the bond is for the owner’s benefit and not the subcontractors’ and the owner brings on the problem him/herself by failing to pay the original contractor, such failure presumably would be a breach of contract that should excuse performance by both the principal and the surety.
This document is intended for informational purposes only and is not legal advice or a substitute for consultation with a licensed legal professional in a particular case or circumstance.
James M. Dash | Real Estate Litigation, including Title Defense, Construction and Mechanic’s Liens
Jim concentrates his practice in real estate-related litigation, with an emphasis on construction (including mechanics lien claims), as well as title insurance defense work. If you need assistance with a related matter, contact Jim.