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Sloan v. Liberty Mutual Insurance Company: “Pay if Paid” or “Pay When Paid" – The Third Circuit Weighs In

White and Williams Construction and Surety Alert | January 13, 2012
by: Robert Carlton, Jr.

In Sloan v. Liberty Mutual Insurance Company, 653 F.3d 175 (3d Cir. 2011) the United States Court of Appeals for the Third Circuit addressed the issue of whether a construction subcontract contained pay-if-paid or pay-when-paid terms, as this distinction governed whether the general contractor bore the entire risk of the project owner’s failure to pay. This was a diversity case and Pennsylvania law applied.

This case arose when Shoemaker Construction Company (Shoemaker) failed to pay a subcontractor, Sloan & Company (Sloan), the balance of its subcontract for drywall work on a waterfront condominium project in Philadelphia owned by Isle of Capri Associates LP (IOC). At the project’s completion, IOC refused to pay Shoemaker nearly $6.5 million owed under the general contract. Of that amount $5 million was due to the subcontractors. IOC claimed it was withholding money for several reasons, one of which was that some of the subcontractors’ work was untimely and deficient. Shoemaker then refused to pay Sloan the full amount of the remaining balance that Sloan claimed was due under its subcontract - $1,074,260. 

In May 2007, Shoemaker sued IOC to recover the balance on the general contract. Sloan then made a claim on Shoemaker’s payment bond. Five weeks later, the payment bond surety Liberty Mutual Insurance Company (Liberty Mutual) denied the claim in its entirety, reserving all rights and defenses. One of the grounds Liberty Mutual asserted for denying payment was one of the subcontract’s terms, found in Paragraph 6.f, that conditioned Sloan’s right to payment on Shoemaker’s receipt of payment from IOC.

In December 2007, Sloan sued Liberty Mutual in the United States District Court for the Eastern District of Pennsylvania. Sloan moved for summary judgment in the amount of $1,074,260. Liberty Mutual cross-moved for summary judgment arguing that even if Sloan were entitled to payment, the amount was $785,067 because of various offsets.

At the same time, Shoemaker settled with IOC for $1 million. This was because Shoemaker learned that IOC could not satisfy a judgment for Shoemaker’s entire claim, even if Shoemaker prevailed. Shoemaker offered Sloan and the other subcontractors their pro rata share of amounts owed from the $1 million in exchange for a release of claims. Sloan would not agree and continued to press its suit against Liberty Mutual.  In August 2009, the District Court granted partial summary judgment in favor of Sloan for $785,067 and rejected Liberty Mutual’s interpretation of the subcontract as conditioning Sloan’s right to payment on IOC’s payment to Shoemaker.

On appeal, Liberty Mutual challenged the District Court’s interpretation of the subcontract. Liberty Mutual argued that Sloan was entitled to be paid only whatever amount Shoemaker received from IOC for Sloan’s work.

The issue of “pay-if-paid” or “pay-when-paid” involved the interpretation of Paragraph 6.f of the subcontract which dealt with final payment. Paragraph 6.f contained two sub-paragraphs. The first provided: “Final payment shall be made within thirty (30) days after the last of the following to occur, the occurrence of which shall be conditions precedent to such final payment…” 653 F.3d at 179. The sub-paragraph then listed the seven conditions precedent. The third was that “[IOC] shall have accepted the work and made final payment to [Shoemaker].” Id. Another condition was that “[Shoemaker] shall have received final payment from [IOC] for [Sloan’s] Work.” Id.

Liberty Mutual argued that these conditions constituted a “pay-if-paid” clause. Sloan argued that the first sub-paragraph of 6.f did not establish a condition precedent to Sloan’s payment, but was a “pay-when-paid” clause. The court agreed with Liberty Mutual and further held that in the second sub-paragraph of 6.f, Shoemaker and Sloan agreed to share the risk of IOC’s nonpayment. Shoemaker would bear its share of the loss by distributing all of the settlement proceeds pro rata to its subcontractors and keep nothing for itself. The second sub-paragraph of paragraph 6.f contemplated litigation in the event of the owner’s nonpayment and provided in part:

[I]f within six months of the date that final payment is due to [Shoemaker by IOC], [Sloan] has not received final payment for its Work, [Sloan] may pursue its claim against [Shoemaker] and its surety for final payment as follows:

If within six months of the date that final payment is due and payable to [Shoemaker], [Shoemaker] commences legal proceedings against [IOC] … (the Contractor Dispute Resolution) to resolve its own claim for final payment, [Sloan] agrees not to pursue its claim against [Shoemaker] or Surety until the Contractor Dispute Resolution and all appeals are completed and become final …

Upon completion of the Contract Dispute Resolution…[Sloan] may pursue any remaining claim for final payment it may have against [Shoemaker] or its Surety.

Id. at 181.

The second sub-paragraph concluded by saying, “[n]othing in Paragraph 6.f is intended to modify the provisions of Paragraph 20 [,which deals with dispute resolution,] under the Subcontract.” Id.  Paragraph 20 was a liquidating agreement which provided, “In the event [Sloan] asserts a claim for payment of the Subcontract Sum … and in the event {Shoemaker] in its sole…discretion… submits said Claim to [IOC] …then all decisions or determinations made by [IOC] ... shall be binding upon [Sloan] even though [Sloan] may not be a party thereto.” Id. at 182.   

The Third Circuit held that these provisions meant that Sloan was limited to a pro rata share of the $1 million settlement that Shoemaker obtained from IOC. When Shoemaker sued IOC, it was acting pursuant to Paragraph 20. $5 million of its $6.5 million claim was for subcontract work. Paragraph 20 stated that all decisions and determinations made by IOC in connection with the pass-through claim would be binding on Sloan. 

We thus conclude that Paragraphs 20 and 6.f create a mechanism for passing through Sloan’s remaining claims for final payment and peg Sloan’s recovery to the amount that Shoemaker receives from IOC for Sloan’s work.

As such, Sloan must bear its share of IOC’s failure to pay by accepting only a pro rata share of the recovery by Shoemaker rather than the full balance of its subcontract. 

Id. at 184.

Sloan illustrates how a carefully drafted subcontract will protect the general contractor from liability to its subcontractors if the owner fails to pay. Under the Sloan subcontract Shoemaker and its payment bond surety, Liberty Mutual, were shielded from liability to Shoemaker’s subcontractors if Shoemaker was not paid in full by IOC. The subcontract also gave Shoemaker the option to bring a claim against IOC both for itself and as a sponsor of the subcontractors’ claims. If Shoemaker elected to bring such sponsored claims against IOC, the subcontractors would receive their pro rata share of any recovery by Shoemaker, but would not receive any additional recovery against Shoemaker’s payment bond surety.  

For more information, please contact Bob Carlton at 215.864.6275 or 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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