A pay-if-paid (PIP) clause in a construction contract says “I, the general contractor, will only have to pay you, the subcontractor, if the owner – the guy I contract with – pays me.” Substitute “when” for “if” in the above example and you have a pay-when-paid clause. Both of these clauses are standard in multi-layered construction projects (ones that involve multiple contractors and contracts).
Neither term can be used to defend a mechanics’ lien foreclosure suit, though. Section 21(e) of the Illinois Mechanics’ Lien Act (770 ILCS 60/21(e)) prevents a general contractor from using pay-if-paid or pay-when-paid provisions as a defense to a subcontractor’s mechanics’ lien claim. But the terms are valid defenses to regular breach of contract claims.
BMD Contractors, Inc. v. Fidelity and Deposit Company of Maryland, 679 F.3d 643 (7th Cir. 2012), examines whether a third party (i.e., a guarantor or surety) can use a PIP clause in defense of a subcontractor’s payment bond claim. Under Indiana law, the answer is yes.
Facts: When an Indiana manufacturer declared bankruptcy, it caused a chain reaction of defaults starting with the prime contract between the owner and the general contractor and cascading down to lower tier subs.
When the entity that hired plaintiff failed to pay, plaintiff sued the subcontractor’s bonding company under a payment bond. The bonding company moved for summary judgment because of a PIP clause in the sub-subcontract.
The bonding company said that since the subcontractor – the bonding company’s principal – wasn’t paid by the general contractor, the subcontractor didn’t have to pay the plaintiff. The District Court agreed and granted summary judgment. The plaintiff appealed.
Held: District Court affirmed.
The Court defined a PIP clause as one that provides a subcontractor will be paid only if the contractor is paid by the owner; with each contractor bearing the risk of loss. By contrast, a pay-when-paid (PWP) clause denotes a timing issue: the general contractor is obligated to pay the subcontractor – but only when or within a fixed time after the contractor is paid by the owner. (p. 648).
The Court, looking to other jurisdictions, held that the term “condition precedent” in a construction contract usually signals a PIP provision. And viewing the unambiguous language of the operative contracts, the plaintiff’s right to payment was only triggered if the subcontractor was paid by the general contractor. (pp. 649-650)
Public Policy and Surety (Guarantor) Liability
The Court found that PIP terms don’t violate Indiana public policy reflected by two statutes that (1) prohibit contractual waivers of payment bond claims and (2) prevent conditioning a contractor’s right to record a lien on first receiving payment from a third person. Indiana Code 32-28-3-16(b), 18(c).
The Seventh Circuit held that these statutes didn’t apply to whether a contractual PIP term was a defense to a breach of contract suit. Based on Indiana’s strong policy favoring freedom of contract, and because no statute outlaws PIP provisions as a breach of contract defense, the PIP term didn’t violate public policy. BMD at 652.
Summary judgment for the bonding company was also proper based on the general rule that a surety’s (the person guaranteeing another’s debt) obligations mirror those of its principal. A surety can have no greater liability than its principal (the person whose debts are being guaranteed).
In Indiana, payment bonds and the contracts they secure are construed together. BMD at 654. And since the subcontractor didn’t have to pay the plaintiff unless the subcontractor was paid by the general contractor, the bonding company’s obligations weren’t triggered and it didn’t have to pay the plaintiff.
(1) if a contract contains “condition precedent” (to payment) or similar language, this will signal a pay-if-paid clause and it will present a valid defense to a breach of contract suit;
2) lower-tier subcontractors should actively monitor the financial health of the project so they aren’t caught off-guard by an owner’s or higher-tier contractor’s default.