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Pay When Paid Pay If Paid - The Seventh Circuit Weighs In

Construction and Surety Alert | September 17, 2012
By: Robert T. Carlton, Jr.

Last year in Sloan v. Liberty Mutual Insurance Company, 653 F.3d 175 (3d Cir. 2011), the United States Court of Appeals for the Third Circuit ruled that a general contractor and its payment bond surety did not bear the risk of having to pay the general’s subcontractors if the project owner failed to pay the general contractor, because the general contractor’s subcontract contained a “pay-if-paid” clause.

This past July, the United States Court of Appeals for the Seventh Circuit in BMD Contractors, Inc. v. Fidelity and Deposit Company of Maryland, 679 F.3d 643 (7th Cir. 2012) reached a similar result and held that a contractor’s payment bond surety could rely on a pay-if-paid clause as a defense to liability in a subcontractor’s action.

This case arose out of the construction of a transmission manufacturing plant in Tipton, Indiana, during 2007 and 2008. The owner was Getrag Transmission Manufacturing, LLC (Getrag) and the plant was to manufacture automobile transmissions for Chrysler. Getrag hired Walbridge Aldinger Company (Walbridge), as general contractor and Walbridge entered into multiple subcontracts, including one with Industrial Power Systems, Inc. (Industrial) for mechanical piping work. Among other things, Industrial’s contract with Walbridge required Industrial to post a payment bond. Industrial complied and executed a payment bond with Fidelity and Deposit Company of Maryland (F&D) as surety.  Industrial then entered into a second level, or sub-subcontract, with BMD Contractors, Inc. (BMD) to perform the piping work required under the Walbridge/Industrial subcontract.

BMD started work on the project in November 2007. Over the next year, Walbridge paid Industrial from payments it received from Getrag, and Industrial paid BMD. In October 2008, Getrag filed for bankruptcy. All work on the project ceased, as did payments down the tiers of subcontractors. Walbridge failed to pay Industrial and Industrial failed to pay BMD. The financial fallout was that Getrag owed Walbridge $40 million, Walbridge owed Industrial $11 million and Industrial owed BMD $1.5 million. BMD demanded payment from F&D and F&D refused to pay. As a result, BMD sued F&D on the payment bond in the United States District Court for the Southern District of Indiana.

The subcontract between Industrial and BMD conditioned Industrial’s duty to pay on its own receipt of payment from Walbridge. The district court construed this condition as a “pay if paid” clause which required Industrial to pay BMD only if  it received payment under its own contract with Walbridge.  Because Walbridge did not pay Industrial, Industrial did not have to pay BMD. Because Industrial did not have to pay BMD, the district court ruled that F&D did not have to pay BMD. BMD Contractors, Inc. v. Fidelity and Deposit Company of Maryland, 828 F. Supp. 2d 978, 991 (S.D. Ind. 2011).

BMD appealed to the United States Court of Appeals for the Seventh Circuit.

At the beginning of its opinion, The Seventh Circuit stated the issue before it as follows:

This case requires us to decide an increasingly important question in complex multi-tiered construction contracts – if the property owner becomes insolvent or otherwise defaults in payment, preventing a contractor from paying a subcontractor, which contractor bears the risk of loss? There is an additional wrinkle here because the question arises in a suit on a payment bond.

679 F.3d at 645.

In deciding the appeal the Seventh Circuit focused on key provisions in the Industrial/BMD contract, the Walbridge/Industrial Contract and F&D’s payment bond. The court first considered the payment bond which by its terms obligated F&D to pay claimants of Industrial under the Walbridge/Industrial contract in the event Industrial did not pay what was owed. The bond provided: “[I]f the Principal shall promptly make payments to all claimants … for all labor and material used or reasonably required for use in the performance of the subcontract then this obligation shall be void; otherwise it shall remain in full force and effect ... .” Id. at 646-47. The payment bond defined a “claimant” as “ ‘one having a direct contract with the Principal for labor, material or both, used or reasonably required for use in the performance of the contract.’ ” Id. at 647. The payment bond described a claimant’s right to sue as follows:

[E]very claimant … who has not been paid in full before the expiration of a period of ninety (90) days after the date on which the last of the claimant’s work or labor was done or performed, or materials were furnished by such claimant,  may sue on this bond … [and] prosecute the suit to final judgment for such sum or sums as may be justly due claimant, … .

Id. (emphasis in the original).

The Industrial/BMD subcontract contained the following clause: “IT IS EXPRESSLY AGREED THAT OWNER’S ACCEPTANCE OF SUBCONTRACTOR’S WORK AND PAYMENT TO THE SUBCONTRACTOR FOR THE SUBCONTRACTOR’S WORK ARE CONDITIONS PRECEDENT TO THE SUBCONTRACTOR’S RIGHT TO PAYMENT BY THE CONTRACTOR.” Id. (emphasis in original).

The Walbridge/Industrial contract contained a similar provision stating that Industrial would be paid only if Walbridge itself is paid. This provision stated:

[Industrial] acknowledges that it has considered [Getrag’s] solvency and [Getrag’s] ability to perform the terms of its contract with [Walbridge] before entering into the Subcontract. [Industrial] acknowledges that it relies on the credit and ability to pay of [Getrag] and not [Walbridge], for payment for work performed hereunder. [Industrial] is entering into this Subcontract with the full understanding that [Industrial] is accepting the risk that [Getrag] may be unable to perform the terms of its contract with [Walbridge]. [Industrial] agrees that as a condition precedent to [Walbridge’s] obligation to make any payment to [Industrial], [Walbridge] must receive payment from [Getrag].

Id.

BMD argued that the conditional language in its subcontract with Industrial was only a “pay-when-paid” clause and that Industrial remained liable even though it did not receive full payment from Walbridge. F&D argued that the conditional provision in the Industrial/BMD contract was a “pay-if-paid” clause, and because Industrial did not receive payment it had no duty to pay BMD.

The Seventh Circuit agreed and held:

This language is plain. Industrial Power’s receipt of payment is a condition precedent to its obligation to pay BMD. True, the clause does not say in so many words that BMD assumes the risk of up-stream nonpayment. The question here is whether express “transfer of risk” language is necessary to create a pay-if-paid clause or whether condition-precedent language is enough. We conclude that the condition-precedent language is clear and sufficient on its face to unambiguously demonstrate the parties’ intent that BMD would not be paid unless Industrial Power itself was paid. 

The Indiana courts have not squarely addressed pay-if-paid clauses, but most jurisdictions that have done so have interpreted condition-precedent language as sufficient to create a pay-if-paid clause.

Id. at 649. (citations omitted).

BMD argued in the alternative that pay-if–paid clauses are void under Indiana public policy. The Circuit Court rejected this argument stating:

Indiana has a strong background presumption favoring freedom of contract. Indiana courts will not enforce contracts that violate state statues, but they will not find a violation “ ‘unless the language is clear and unambiguous that the legislature untended that the courts not be available for either party to enforce a bargain made in violation thereof.’ “

Id. at 652 (citations omitted).

BMD cited two Indiana statutes to support its position but the Seventh Circuit ruled that neither statute was on point. The first statute, Section 32-28-3-16(b) of the Indiana Code provided the “A provision in a contract for the improvement of real estate… is void if the provision requires a person … who furnishes labor, materials, or machinery to waive a right to: … (2) a claim against a payment bond; before the person is paid for the labor or material is furnished.”   The Seventh Circuit held that while the statute invalidates, “[A]ny contract provision that requires a party to waive its claims under a bond, it does not cast doubt on the validity of  pay-if-paid clauses. Nothing in the Industrial/BMD subcontract required BMD to waive its right to recover under the payment bond.”  Id. at 652.

The second statute BMD cited was section 32-38-3-18(c) of the Indiana Code which prohibits contract provisions that limit a contractor’s mechanic’s lien rights. The Seventh Circuit also held that “This statute does not affect the validity of pay-if-paid clauses.” Id. at 653.

Finally, BMD  argued that because the payment bond did not incorporate the terms of the Industrial/BMD subcontract, F&D could still be liable under the bond even though Industrial is not liable under the subcontract.  The Seventh Circuit rejected this argument and held:

This argument contradicts basic principles of surety law. In Indiana, as elsewhere, a surety must answer only for the debts of the principal and cannot be liable where the principal is not.

BMD emphasizes that the payment bond does not expressly incorporate the terms of the Industrial Power/BMD subcontract, but this is legally insignificant…[S]urety contracts create tripartite  relationships – the very existence of a surety implies an underlying obligation between the principal and the obligee. Accordingly, Indiana courts have recognized that where a contract and a surety bond are executed together, they must also be construed together. This principle of joint construction is just a restatement of the more general rule that a surety will not be liable where the principal is not.

Id. at 654 (emphasis in original).

The court concluded its opinion as follows: “The clear trend of recent case law bolsters the basic principle of Indiana law that a surety may assert all of the defenses of its principal. Fidelity, no less than Industrial Power, may rely on the pay-if-paid clause in the Industrial Power/BMD subcontract to defend against this suit on the payment bond.” Id.

The lesson from Sloan v. Liberty Mutual Insurance Company and BMD Contractors, Inc. v. Fidelity and Deposit Company of Maryland is that a clearly articulated condition precedent in a subcontract precludes the subcontractor from proceeding against the contractor and its payment bond surety, when the condition precedent, the contractor’s receipt of payment, has not occurred.  

For more information regarding this alert, please contact Robert Carlton (215.764.6275; carltonr@whiteandwilliams.com).

This correspondence should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult a lawyer concerning your own situation and legal questions.
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