Caution: Pay-When-Paid Clauses Are a Danger Zone in California

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Subcontracts often contain payment provisions to deal with the issue that a general contractor wants to be paid by the project owner before the general contractor has to pay its subcontractors. Two common subcontract provisions that are used to address this issue are: (1) pay-if-paid clauses, and (2) pay-when-paid clauses. In California, pay-if-paid clauses have been unenforceable since 1997. Pay-when-paid clauses are still enforceable in California, but must be carefully drafted or they will be invalidated for the same reasons pay-if-paid clauses are no longer legal.

Pay-If-Paid Clauses Are Unenforceable in California

Pay-if-paid clauses dictate that a general contractor is only required to pay a subcontractor for completed work if the general contractor is paid by the project owner. If the general contractor is never paid for the project, the general contractor does not have to pay the subcontractor. In 1997, the California Supreme Court held that pay-if-paid clauses are unenforceable in Wm. R. Clarke Corp. v. Safeco Ins. Co. (1997) 15 Cal. 4th 882. The Court explained that California subcontractors have a state constitutional right to utilize mechanics liens to ensure payment for completed work. Pay-if-paid clauses, the Court reasoned, circumvent that right by conditioning the subcontractor’s right to be paid for completed work on whether the general contractor is paid, which is contrary to California public policy. Therefore, the Court invalidated pay-if-paid clauses in California contracts.

As a practical note, general contractors should not include language in a California subcontract conditioning a subcontractor’s right to payment on whether the general contractor is first paid by the project owner and subcontractors should note any such provisions in their subcontracts are invalid. Subcontracting parties should also be aware that California courts have been extending Wm. R. Clarke Corp. v. Safeco Ins. Co.’s reasoning to invalidate pay-when-paid clauses that condition the subcontractor’s right to payment.

Pay-When-Paid Clauses Must Be Carefully Drafted To Be Enforceable

Pay-when-paid clauses establish the timing by which a general contractor will pay a subcontractor after receiving payment from the project owner. Pay-when-paid clauses that merely fix the time for the subcontractor’s compensation MAY be enforceable. See, e.g., Capitol Steel Fabricators, Inc. v. Mega Construction Co. (1997) 58 Cal. App. 4th 1049; Yaminishi v. Bailey & Collishaw, Inc. (1972) 29 Cal. App. 3d 457. But to be valid, a pay-when-paid clause must provide that the subcontractor will be paid within a reasonable amount of time after the subcontractor completes the subcontract work regardless of whether the project owner pays the general contractor. Without that guarantee, the subcontractor would never receive payment if the general contractor is not paid, and that pay-when-paid clause would amount to an unlawful condition precedent equivalent to a pay-if-paid clause. Indeed, California courts have found that pay-when-paid clauses that defer payment to a subcontractor until the general contractor is paid by the project owner are invalid. The provision that conditions the subcontractor’s right to be paid on payment from the owner violates the same public policies as pay-if-paid clauses. See, e.g., Capitol Steel Fabricators, Inc. v. Mega Construction Co. (1997) 58 Cal. App. 4th 1049.

Conclusion

Pay-if-paid clauses are void in California. General contractors should not include these clauses in California subcontracts. Otherwise, they risk other potentially valid provisions being tossed out in later litigation with a subcontractor. One way that may reduce this risk is for the general contractor to have a severability clause in its subcontract. Subcontractors should be aware in contract negotiations that any pay-if-paid clause is unenforceable. Pay-when-paid clauses are trickier. They are enforceable when carefully drafted to provide that, at the latest, the subcontractor will be paid in a “reasonable amount of time” (which term could be defined in the subcontract), after completing the subcontract work regardless of when the general contractor is paid by the owner.

Kelly C. Smith has passed the State Bar of California and is awaiting receipt of her bar number.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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