eneral contractors and sureties will have to be much more diligent about reviewing the capitalization of the owners with whom they work now that "pay-if-paid" clauses in construction subcontracts have been declared void by the California Supreme Court.  

The case that invalidated the clause was WM. R. Clarke Corp. v. Safeco Ins. Co. of America. I argued this case last spring and it was decided by the California Supreme Court on June 27, 1997 as follows:  

"A general contractor's liability to a sub-contractor for work performed may not he made contingent on the owner's payment to the general contractor... 

"We... conclude that a pay if paid provision is void because it violates public policy that underlies the anti-waiver provisions of the mechanic's lien laws." 

Frequently by general con-tractors in recent years. The use of this clause arose from Yamanishi v. Bleily & Collishaw, Inc. which was argued 25 years ago. In Yamanishi the California Court of Appeals indicated that a condition precedent ("pay-if-paid") clause might have barred the sub-contractor from receiving payment unless the general contractor was paid by the owner.  

Following Yamanishi general contractors began using "pay-if-paid" clauses in their contracts. After the Clarke Corp. case, however, the "pay-if-paid" clause is not enforceable and subcontractors are to be paid "within a reasonable period of time."  

In the Clarke Corp. case, as construction began it became apparent to the general contractor that the owners did not have sufficient financing to complete the project. The general contractor discovered that the building was encumbered for twice its value and that the owners had insufficient capitalization to fund the project themselves. The partnership consisted of two recently formed corporations. Accordingly, it was obvious to the general contractor that this was a very risky project.  

The general contractor's internal memorandums regarding the project stated that because of the risk of insufficient financing, it was necessary to shift the risk of nonpayment to the subcontractors. This was not revealed to the subcontractors. In order to shift the risk, in addition to the "pay-if-paid" clause the general contractor drafted an addendum to the sub- contracts that stated that the subcontractors acknowledged that they had no rights against the general contractor unless the general contractor was paid for the project. The addendum also stated that this was without waiving any rights the subcontractors had to Mechanics' Lien.  

The general contractor's fears were realized and it was not paid for a substantial portion of the subcontractors' work. When the subcontractors contacted the general contractor for payment the general contractor responded that it had no obligation to pay any subcontractors because it had not been paid by the owner.  

The general contractor sub-subsequently pursued an action against the owner and received some compensation. The general contractor then offered pro-rata payment of what it received to the subcontractors but the sub-contractor parties to the action rejected less than full payment for the work performed and they filed suit to collect on the payment bond for the project, which was written by Safeco, the surety.  

At the trial, Safeco argued that it had no obligation to pay on the payment bond since the general contractor had not been paid. In response, the subcontractors stated that Civil Code Section 3226 specifically set forth that non-payment by the owner does not relieve the surety of its obligation on a surety payment bond.  

The trial court agreed with the subcontractors and ruled that pursuant to Civil Code Section 3226 payment by the owner to the general contractor was not an excuse for the surety bond insurer to refuse payment to the subcontractors who made claims on the payment bond.  

Of course, Safeco was unhappy with the results of the trial. The general contractor was as well, since in all likelihood the general contractor would be required to indemnify Safeco for approximately $2 million in claims. As a result, both Safeco and the general contractor appealed to the California Court of Appeals.  

The Court of Appeals affirmed the trial court's judgement, stating that since the surety bond arises from the same bundle of rights included in the right to a Mechanic's Lien, and the contract acknowledges the right to a Mechanics' Lien, the contract also acknowledged the right to recover on the surety bond. Again, Safeco and the general contractor were not happy with the court's decision so they petitioned the California Supreme Court to review the Court of Appeals decision.  

The California Supreme Court invalidated "pay-if-paid" clauses in construction subcontracts in their entirety. This removed Safeco's argument that its obligation for payment had not yet arisen and made Safeco liable on the payment bond.  

Now that the "pay-if-paid" clause has been invalidated, general contractors and sureties will have to be much more diligent when reviewing the capitalization of the owner on their projects. Sureties and general contractors have argued that invalidating the "pay-if-paid" clause would have adverse impact on small general contractors and their ability to bond projects. The reality is that bonding is most common on public projects where solvency of the owner is not an issue and the bonding requirements were already in place that exclude small general contractors. From now on, all payments to subcontractors will be due in a reasonable time. In the end, everyone should benefit because this heightened scrutiny will help assure adequate financing for work that is performed o all construction projects.  

While settling the "pay-if-paid" issue, the Clarke Corp case may increase confusion surrounding "pay-if-paid" and "pay-when-paid" contract clauses. It is imperative for all construction credit professionals to understand the difference between these two provisions and their relationship to construction contracts. The "pay-when-paid" clause is alive and well. Therefore, contracts may call for payment when the general contractor gets paid or within a "reasonable time," but they may not eliminate the general contractor's obligation to make payment to subcontractors even if the general contractor is not paid by the owner.  

A final note: On September 8, 1997 the petition by Safeco for a rehearing of the case was denied.