'Pay-When-Paid' Revisited

Publication Source: New York Law Journal

In 1995, the New York Court of Appeals rendered a landmark decision in West-Fair Electric Contractors v. Aetna Casualty and Surety Co.¹, striking down the well-known “pay-when-paid” clause in construction contracts because it violated New York public policy as specifically promulgated in the Lien Law.² Questions unanswered by West-Fair have finally made their way through the courts, resulting in one of the first important Appellate Division decisions providing further guidance in evaluating issues relating to the “pay-when-paid” concept in construction contracts.

In West-Fair, two questions of law were presented to the New York Court of Appeals: (1) whether a pay-when-paid provision in a subcontract, which transfers the risk of an owner’s default from a general contractor to a subcontractor, violates New York public policy as set forth in the Lien Law; and (2) whether a surety’s liability is contingent on the duty of a contractor to make payment to a subcontractor when the surety bond created an independent obligation to that subcontractor.³ The Court of Appeals needed to answer only the first question to resolve the issues before it, ruling that, among other things, Sections 23 and 34 of the Lien Law rendered the pay-when-paid clause void because it would have prevented the subcontractor from establishing it was entitled to payment from the general contractor, thereby abridging the right of the subcontractor to file a mechanic’s lien against the owner’s real property as specifically preserved by the Lien Law.⁴

In addition to leaving open the second question presented to it, the Court of Appeals in West-Fair raised a number of other unanswered issues.⁵ The Appellate Division, First Department, has now rendered a significant decision answering some of those questions and, along the way, expressing quite a bit of judicial hostility towards attempts to avoid the public policy considerations against pay-when-paid clauses.

In Blandford Land Clearing Corp. v. National Union Fire Insurance Company of Pittsburgh, PA,⁶ the Court was asked to analyze provisions in subcontract agreements that were signed immediately after the Court of Appeals’ decision in West-Fair. In an apparent attempt to avoid the public policy objections promulgated in West-Fair, the subcontracts provided that (i) for purposes of payment from the prime contractor to the subcontractors, the prime contractor was acting solely as “agent of the owner” and (ii) a condition precedent to payment by the prime contractor to the subcontractor was the receipt of funds by the prime contractor from the owner. The subcontract further provided that the subcontractors acknowledge that they were 'relying solely on the credit of the owner and not the credit of' the prime contractor for payment of the work performed. In an attempt to avoid the specific prohibitions of the Lien Law, the subcontract further provided that the subcontractors’ rights to file mechanic’s liens against the owners’ interest in the project were expressly preserved.

The prime contractor had procured a surety bond containing an unqualified promise to make payment to any “claimant” that had “a direct contract with the contractor. . . to furnish labor, materials or equipment for use in the performance of the contract.” The surety bond further provided: “The Contractor and surety, jointly and severally, bind themselves, their heirs, executors, administrators, successors and assigns, to the Owner to pay for labor, materials and equipment furnished for use in the performance of the Construction Contract, which is incorporated herein by reference.”

After the subcontractors had failed to receive payment for “both the work specified in their respective contracts and certain extra work,” they commenced an action in Supreme Court, Bronx County, “against defendant [surety] on the payment bond it issued to [the prime contractor] pursuant to the terms of the [prime contractor’s] contract with the owner.” The surety moved for summary judgment to dismiss the complaint alleging that its obligation under the payment bond was only as broad as the contractor’s responsibility to pay the subcontractors and because the contractor was not obligated to pay the subcontractors, the surety had no liability under its bond. By decision dated May 29, 1998, the Supreme Court, Bronx County, granted the surety’s motion for summary judgment and dismissed the complaint. That decision was appealed to the First Department, which reversed.

The First Department in Blanford noted that it was addressing the unanswered second question raised by the West-Fair decision, whether a surety’s liability was contingent on the duty of a contractor to make payment to a subcontractor when the surety bond created an independent obligation to that subcontractor. In determining that the surety indeed was liable under such circumstances, the First Department used the opportunity to express a great deal of skepticism at attempts to avoid the pay-when-paid public policy objections articulated by the Court of Appeals in West-Fair.

The First Department understandably rejected the surety’s attempt to circumvent its obligations under the payment bond, analyzing the specific wording of the bond itself. The Court simply was not convinced that by designating the prime contractor an 'agent for the owner' for purposes of payment to the subcontractors, the prime contractor was never obligated to make any payment and, therefore, the surety could not be expected to pay the subcontractors because its obligations extended only so far as the prime contractor's. Indeed, although the Court did not explicitly say it, it appears that the payment bond would be rendered virtually meaningless if it only required the surety to pay when the prime contractor was obligated to pay the subcontractors because the prime contractor would never be obligated to pay under the interpretation of the contract argued by the surety. Although the Court's opinion could have stopped there, the First Department continued by adding additional bases for its determination.

Among other things. the Court analyzed the specific provisions of the subcontract under basic contract principles, finding that the provision designating the prime contractor as soley the agent for the owner should not be interpreted to permit the prime contractor to avoid an obligation to pay the subcontractors. Recognizing that the subcontract agreements had, for all other purposes, looked like ordinary subcontracts, the Court found that the provision exempting the prime contractor from liability for payment would create an 'illusory' contract by vitiating the consideration for the subcontractor's performance. Thus, the Court interpreted the subcontract to require the prime contractor to pay the subcontractors, notwithstanding the explicit provisions to the contrary.

Finally, after concluding as a matter of contract law and pursuant to the very terms of the payment bond itself that the surety was indeed obligated to pay the subcontractors, the First Department in Blandford took the opportunity to comment that even if it interpreted the contract as written, it "would" still find that the provisions in the subcontracts violated the Lien Law for the reasons stated by the Court of Appeals in West-Fair.

The Court reasoned that since the rights of subcontractors are derivative of the rights of general contractors against the owner, a provision exempting the general contractor from having to pay the subcontractors would result in the general contractor not being entitled to any payment from the owner for the work performed by the subcontractors.⁹ Thus, the subcontractors would have no rights against the owner that could form the basis of a mechanics lien. A careful analysis of this reasoning, however, indicates that there would be no violation of the Lien Law under these circumstances. For example, if the “subcontractors” in fact had direct contractual rights against the owner, they could certainly argue that their rights were not derivative of the general contractor’s rights, but, rather, stood on their own with no respect to the owner. Thus, their rights to file a lien against the owner’s real property would derive from their direct relationship with the owner, as contractors themselves. Indeed, these subcontracts specifically preserved the rights of the subcontractors to file such liens to the extent they were due money from the owner. Thus, the “public policy” as expressed in the Lien Law - preserving the right to file a lien - would not have been implicated. Nevertheless, the Court’s reasoning gives clear warning that attempts to replace or substitute similar “pay-when-paid” provisions analyzed by the Court in West-Fair will be given strict judicial scrutiny.

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Kevin Schlosser is a Shareholder at Meyer, Suozzi, English & Klein, P.C., where he is Chair of the Litigation and Alternative Dispute Resolution Department which has a full roster of available private judges from virtually all disciplines of law. Mr. Schlosser also authors the popular blog, “New York Fraud Claims,” which analyzes the latest developments concerning civil fraud claims under New York law.