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A
valid "pay when paid" clause in a subcontract
may be unenforceable if the general contractor is found
to have contributed to the non-payment by the owner or developer.
In addition, a surety may be denied the benefit of the general
contractor's pay when paid clause when sued on the bond.
These were the holdings in a recent case before the 4th
U.S. Circuit Court of Appeals. Moore Brothers Co. v.
Brown & Root, Inc., 207 F.3d 717 (4th Cir. 2000).
The
case arose out of construction of a tollway in Virginia.
Brown & Root was the general contractor and also was
an equity owner in the project. The developer was Toll Road
Investors Partnership II ("TRIP"). Highlands Insurance
Co. ("Highlands") wrote the surety bond on the
project. Moore Brothers ("Moore") was a subcontractor
on the project, and it and another subcontractor, Lane Construction
Corporation, brought the lawsuit against Brown & Root,
Highland and TRIP.
TRIP
hired Brown & Root as the general contractor on the
project. After initial contracts containing significant
cost contingencies were submitted for approval, the lenders
insisted that Brown & Root provide assessments of the
total project cost with a "high degree of certainty."
The contingencies were removed, and the final contract,
absent any scope of work change authorizations, was submitted
to the lenders. Funding was approved.
The
change in scope documents then were included in a side letter
agreement between TRIP and Brown & Root and were included
in a "Policy and Procedures" letter that was not
revealed to the lender, nor incorporated into the final
contract. The fact that the policy and procedures letter
was not part of the final contract was not revealed to the
subcontractors.
Construction
began, and it was discovered that a thicker sub-base for
the asphalt paving was needed -- a change contemplated in
the "Policy and Procedures" letter. The subcontractors
were instructed by Brown & Root to perform the work.
Because the lenders had not been made aware of the change
orders, financing had not been arranged for the extra work.
TRIP was unable to obtain sufficient funding to pay Brown
& Root, thus triggering the pay when paid clause in
the subcontracts. The subcontractors made claims on the
surety bond, but Highland denied the claims, arguing that
the pay when paid clause was enforceable by it as well.
Moore then filed a lawsuit.
Brown
& Root argued, and the court agreed, that its pay when
paid clause was valid. The court noted that prior cases
in Virginia upheld the validity of such clauses. Moore argued,
however, that Brown & Root should be denied the protection
of the pay when paid clause because Brown & Root had
misled the lender, thus causing, at least in part, the inability
of the owner to pay. Because the lender refused additional
funding for the change orders, the owners lacked sufficient
funds to pay Brown & Root, which then did not pay the
subcontractors. This "prevention doctrine" is
a theory of law that precludes the party which causes the
failure of a required event in a contract from occurring
from benefiting from that failure.
The
court agreed with Moore that because Brown & Root's
activities had led to the failure of the owners to pay,
thus bringing the pay when paid clause into play, Brown
& Root was not entitled to the protection of the clause.
Brown & Root argued it could not be shown that the side
letter agreement actually caused the lender to refuse further
financing or the owner's inability to pay the additional
costs. The court noted, however, that such "but for"
proof was not required under Virginia's application of the
prevention doctrine. Rather, Moore need only show that Brown
& Root had in some way hindered performance of the condition
precedent in the contract.
The
court found that Brown & Root had misled the lenders
regarding possible costs of the project. That made it less
likely the lenders would arrange additional financing to
cover the costs of anticipated design changes. Brown &
Root's subterfuge constituted a sufficient hindrance that
Brown & Root should be denied the protection of the
pay when paid clause in the subcontract.
The
second issue was whether the surety should be allowed to
claim the protection of the pay when paid clause. Normally,
the surety stands in the shoes of the principal and is allowed
to assert any defenses available to the principal. The surety
bond here contained a clause stating that the surety, upon
non-payment by the principal within a specified time, would
pay the subcontractors any sums "as may be justly due."
When it was not paid by Brown & Root, Moore made a claim
on the bond, but the claim was denied. Highland stated that
the sums were not "justly due" the subcontractors
because of the pay when paid clause in the subcontract.
The
court disagreed. It noted that the surety bond did not expressly
incorporate the pay when paid clause contained in the subcontract.
According to Virginia law, the surety was bound by the terms
contained in the bond itself. The court noted that the subcontractor
had performed the work set forth in the subcontract, and,
accordingly, the contract price was "justly due."
Consequently, Highland was obligated to pay the subcontractor.
The
court offered two reasons for this conclusion. The first
was that Highland had failed to incorporate the pay when
paid clause into the bond, and there was no indication that
such a clause was intended to be incorporated. The court
stated that the very nature of a surety bond runs counter
to such a clause because the purpose in obtaining such a
bond is to ensure that claimants are paid for work performed
in the event payment is not forthcoming from the principal.
Secondly,
although the issue had not come before the Virginia Supreme
Court, courts in other jurisdictions had refused to extend
the protections of pay when paid clauses to sureties. One
of the primary concepts relied on by those courts was that,
rather than being a suit on the subcontract, suits against
sureties were, in fact, suits on the bond itself. Accordingly,
the protections of pay when paid clauses could not be claimed.
Again, enforcing such clauses in favor of sureties would
defeat the very purpose of the surety bond itself. The court
accepted that reasoning and denied the surety the protection
of the pay when paid clause.
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