In what some may view as an unexpected development, the California Supreme Court ruled last week that "pay if paid" clauses commonly found in construction subcontracts are unenforceable because they are contrary to the public policy of the State of California. Although the Court in Wm. R. Clarke Corporation v. Safeco Ins. Co. (June 26, 1997) 1997 D.A.R. 8247 was asked to decide a more limited issue - whether a surety could assert a pay if paid clause as a defense to a private works payment bond claim - the Court elected to examine the validity of such clauses. In a divided decision (4-3), the court found that pay if paid clauses are unenforceable in California.The Clarke case stemmed from the insolvency of an owner on a project in Los Angeles. Keller Construction Co., Ltd., which was the general contractor on the job, had relied upon a pay if paid clause in its subcontract with Clarke Electric to deny payment to Clarke for work for which Keller was not paid by the owner. Clarke then brought a claim on the payment bond issued by Safeco, and Safeco defended on the ground that as Keller's surety, it was also entitled to assert the pay if paid clause defense.
Both the trial court and Court of Appeal ruled in favor of Clarke, relying on a clause in the subcontract stating that Clarke had not waived its mechanic's lien rights. Rather than addressing the broader issue of the enforceability of pay if paid clauses, the lower courts interpreted the specific clause in the subcontract to preserve Clarke's payment bond claims.
Going beyond the specific facts of this case, the Supreme Court majority concluded that pay if paid clauses are an indirect waiver of a subcontractor's constitutional right to assert a mechanic's lien when unpaid for labor and material on a work of improvement. Unlike the dissent, the majority did not find a distinction between a payment bond claim and a mechanic's lien claim. Consequently, it did not accept Safeco's argument that a pay if paid clause could bar payment bond claims without affecting a subcontractor's mechanic's lien rights. The majority was apparently also not persuaded by the dissent's view that mechanic's liens are enforceable on the work of improvement and are distinct from a payment bond claim, which is premised on subcontract rights.
The difference of opinion by the justices followed from contrary readings of Civil Code Section 3140, which states that a subcontractor asserting a mechanic's lien may recover "such amount as may be due him according to the terms of his contract." The majority read this to mean that mechanic's lien rights are premised on contractual rights to payment. The majority then reasoned that unless invalidated, a pay if paid clause would extinguish the contractual right to payment that it felt was fundamental to asserting a mechanic's lien right. The dissent, on the other hand, concluded that Civil Code Section 3140 only defined the amount that could be recovered on a mechanic's lien claim and therefore a pay if paid clause had no impact on a subcontractor's mechanic's lien rights.
The majority was also not persuaded by Safeco's argument that striking pay if paid clauses impinged on the parties' right to contractually allocate the risk of owner insolvency. The Court found that any public policy in favor of "freedom of contract" could not override the need to protect constitutionally guaranteed mechanic's lien rights.
The Court also made short work of Safeco's argument that its obligations mirrored Keller's on the subcontract and that the payment bond served only to assure that Keller honored its contractual obligations. Notwithstanding its finding that pay if paid clauses are unenforceable, the court also explained that Keller had "independent liability" on the payment bond. The Court stated that Keller was liable on the payment bond to pay mechanic's lien claims. This conclusion, however, seems to conflict with Civil Code Section 3143, which allows a mechanic's lien release bond to be issued to release liens on a property. If payment bonds secure the payment of mechanic's lien claims, as the Court suggests, a release bond could be viewed as superfluous.
The full impact of the Clarke ruling is yet to be seen, but the invalidation of pay if paid clauses clearly shifts the burden of owner insolvency to general contractors. All contractors will have to rethink their strategy for posting payment bonds on private works projects and, when doing so, will be required to take full responsibility for assuring that significant debt is not incurred on a project because of non-payment by an owner. They also will have to re-examine their form contracts and make revisions that are consistent with Clarke and that guard against the situation Keller and Safeco now face (Clarke reportedly had performed $650,000 of work for which the owner did not pay).
