Contractors and their sureties often mitigate financial risks and defend against payment claims by relying on pay-if-paid provisions. However, these provisions may not always provide the ironclad protection contractors and sureties often expect from their use.1
This article explores the varying state-to-state treatment of pay-if-paid provisions as a surety defense, how issues like the prevention doctrine can limit the effectiveness of these provisions, and strategies to effectively use pay-if-paid provisions as a surety and contractual defense.
Suretyship 101
In a payment bond context, suretyship, is a three-party relationship between the principal (contractor), obligee (subcontractor/supplier), and surety. It is a well-settled principle of surety law that the surety company handling a claim, in essence, stands in the shoes of the principal, and, therefore, is entitled to all of the rights and defenses the principal would have against a claimant.
While the pay-if-paid defense is also available to the surety, a number of pitfalls can impair the effectiveness of this defense.
Bonds
The bonds guaranteeing payment to subcontractors and suppliers — namely labor and material bonds and, at times, lien discharge bonds — take center stage in ensuring financial protection for stakeholders.
The pay-if-paid defense is significantly less applicable in a performance bond claim. While a contractor’s failure to pay a downstream subcontractor could be a basis for default under a construction contract, this typically does not activate a surety’s obligations under a performance bond.
It is important to note that the quality of the pay-if-paid defense, and all other surety defenses, matter greatly because a surety expects the principal-contractor to reimburse it for any amounts paid and costs incurred under the bond pursuant to a surety-principal indemnity agreement.
These indemnity agreements typically include provisions requiring a pledge of collateral to secure the surety’s financial risk and can even require the contractor’s owners to bind themselves individually, and their spouses, to such agreements.
In short, the quality of the surety defense is critical to preventing the contractor from paying out-of-pocket for a bond claim.
Pay-If-Paid Provisions: A Conditional Payment Structure
A pay-if-paid provision is a type of condition precedent, meaning that one party’s obligation to pay arises only when a specific condition — the receipt of payment from the owner or another upstream party — has occurred.
For example, if a project owner fails to pay the GC, then that contractor is not obligated to pay its subcontractor where a valid and enforceable pay-if-paid provision is used in the subcontract.
Subcontractors also often use pay-if-paid provisions when contracting with the next tier of subcontractors or suppliers. While these provisions are widely used, states increasingly are proscribing or limiting their use.2
Surety Defense Points
These points serve as a framework to determine if the pay-if-paid provision in a contract can be a viable defense in both a contract and/or surety claim.
Pay-If-Paid vs. Pay-When-Paid
To ensure a pay-if-paid surety defense functions as intended, it requires distinguishing between pay-if-paid and pay-when-paid clauses.
A properly drafted pay-if-paid provision eliminates the obligation to pay the other party until the condition (receipt of owner or upstream payment) has occurred. There are no magic words to creating a pay-if-paid provision, but the provision must clearly demonstrate that the parties intended to shift the risk of non-payment downstream.
For example, in Connelly Construction Corp v. Travelers Casualty & Surety, the Court upheld the following provision as a valid pay-if-paid provision: “if, and only if, … owner pays contractor … which is an express condition precedent to [contractor’s] duty to pay [subcontractor], progress payments shall be due to [subcontractor].”
In contrast, a pay-when-paid clause simply delays payment for a reasonable timeframe after the work is complete or a payment application has been submitted. This is known as a timing mechanism that does not absolve the payer from their payment obligation.
These two terms are frequently misused and misunderstood as interchangeable, but their effects are vastly different. A surety relying on a pay-when-paid defense will face a very different outcome than one using a pay-if-paid defense.
Overlooking this essential distinction can mean the difference between a surety paying out a claim rather than maintaining a viable defense.