Kansas Federal District Court Clarifies the Interplay Among “Pay-If-Paid” Clauses, Surety Bonds and the Kansas Fairness in Private Construction Contract Act
In the case of Faith Technologies v. Fidelity & Deposit Company of Maryland, No. 10-2375-MLB, 2011 WL 251451 (D. Kan. Jan. 26, 2011), United States District Judge Monti Belot issued an interesting opinion discussing the effect, or lack thereof, of the Kansas Fairness in Private Construction Contract Act upon a bond surety’s obligations in the case of private payment bonds. The Court considered and denied motions for summary judgment by two subcontractors on their claims against the general contractor’s bond surety. The decision is of interest, not only to sureties, but also to project owners, general contractors and subcontractors.
The material facts were few, and can be summarized as follows:
• An owner hired Brown Commercial Construction Company (Brown) to construct a project in Overland Park, Kansas.
• Fidelity & Deposit Company of Maryland (F & D) issued payment and performance bonds on behalf of Brown.
• Brown hired Lithko and ARR Roofing (the Subcontractors) to perform subcontract work on the project.
• The subcontracts contained a “pay-if-paid” clause.
• The project was shut down due to a lack of funding.
• The owner did not pay Brown, and Brown did not pay the Subcontractors, for work done under the subcontracts.
• The Subcontractors sought to recover the amounts they were owed from F & D, and the surety asserted the “pay-if-paid” clause as a defense.
The sole issue for the Court to decide was “whether or not F & D’s legal defense based on the conditional payment provisions in the subcontracts . . . is valid under Kansas law.”
Drawing from the case of MidAmerica Construction Management, Inc. v. MasTec North America, Inc., 436 F.3d 1257 (10th Cir. 2006), the Court began its analysis with a discussion of the difference between a “pay-when-paid” clause and a “pay-if-paid” clause.
A “pay-when-paid” clause is one common form of a conditional payment provision, and will often read as follows: “Contractor shall pay subcontractors within seven days of contractor’s receipt of payment from the owner.” While the general contractor’s obligation to pay the subcontractor is triggered by receipt of payment from the owner, this is a timing mechanism only, and the obligation is only suspended for a reasonable length of time. This does not create a “condition precedent” to the general contractor’s duty to ever pay the subcontractor.
Another form of a conditional payment provision is called a “pay-if-paid” clause, which may read like this:
Contractor’s receipt of payment from the owner is a condition precedent to contractor’s obligation to make payment to the subcontractor. The subcontractor expressly assumes the risk of the owner’s nonpayment and the subcontract price includes this risk.
A “condition precedent,” as used in this provision, is an act or event that must occur first, before a party to a contract is obligated to perform a duty under the contract, and before there can be a breach of that duty. An enforceable “pay-if-paid” clause must contain clear language, and must express an unambiguous intent to shift the risk of owner nonpayment to the subcontractor.
In the Faith Technologies case, the Court found there was a clear and enforceable “pay-if-paid” clause in Brown’s agreements with the Subcontractors. This stood as a valid defense to the Subcontractors’ claims directly against Brown. However, there remained the issue of the payment bond. Could the surety, F & G, also rely upon the “pay-if-paid” clause as a defense to the claims against that bond?
Kansas law generally provides that a surety is only liable to the extent the principal on the bond is liable. In 2005, the Kansas legislature enacted the Kansas Fairness in Private Construction Contract Act, found at K.S.A. 16-1801, et seq. This law, which generally applies to non-public construction projects other than small residential ones, provides several tools to ensure payment to contractors and subcontractors. Among the subsections of the Act is one aimed at conditional payment provisions:
(c) Any provision in a contract for private construction providing that a payment from a contractor or subcontractor to a subcontractor is contingent or conditioned upon receipt of a payment from any other private party, including a private owner, is no defense to a claim to enforce a mechanic’s lien or bond to secure payment of claims pursuant to the provisions of article 11 of chapter 60 of the Kansas Statutes Annotated, and amendments thereto.
K.S.A. 16-1803 (c).
The Kansas District Court noted there are three general types of bonds that may be provided on a construction project:
• Public works bonds. These are bonds required, under K.S.A. 60-1111, on public improvement projects. They stand in place of the contractor’s or subcontractor’s normal ability to file a mechanic’s lien against the project when not paid.
• Release of lien bonds. These are statutory bonds, which may be filed with the clerk of the district court in the county in which the project is located under K.S.A. 60-1110. These bonds serve to prevent a lien from being filed against the project, or to discharge any lien that has been filed.
• Private bonds. These are non-statutory bonds (payment or performance) often required by the terms of a contract between the owner and general contractor, or between the general contractor and a subcontractor.
The Court determined that the prohibitory language of the Kansas Fairness in Private Construction Contract Act applies to public works bonds and release of lien bonds, but not to private bonds. The result of this finding was that F & G, the surety on a private payment bond, is entitled to assert as a defense the “pay-if-paid” condition precedent found in the subcontracts, to the same extent as can Brown, the principal on the bond.
There are a couple lessons to be learned from this case for those in the construction industry:
• What type of conditional payment provision exists in the subcontract? Both general contractors and subcontractors should carefully analyze any conditional payment provisions in the subcontract, to determine whether they create a “pay-when-paid” term (in which case the general contractor may eventually be required to pay the subcontractor, even if the owner fails to pay), or a valid “pay-if-paid” term, in which case the subcontractor has assumed the ultimate risk of non-payment by the owner.
• Will the payment bond destroy the benefit of the conditional payment provision? General contractors and subcontractors should recognize that the utility of an otherwise valid “pay-if-paid” clause can be short-lived in situations involving the use of a public works bond or a lien release bond. In these situations, an unpaid subcontractor can proceed against the bond, and the surety cannot assert the “pay-if-paid” clause as a defense. If the surety is forced to pay, it will seek to recover its payment from the principal on the bond (the general contractor or subcontractor who posted it) under its indemnity agreement,