IT IS A truism that construction is a risky business. Construction contracting is an exercise in dealing with these inherent risks. One common way involves allocating these risks among the various project delivery team members. Many contract clauses will allocate risk by shifting it from one party to another on the pretense that the party being assigned the risk is better able to absorb or control it; more likely, it is that the party shifting the risk does not want to have to deal with it. Examples of typical risk-shifting clauses found in construction contracts include: no-damages-for-delay clauses; indemnification clauses; special dispute resolution procedures; performance guarantees; and pay-if-paid clauses. For projects requiring performance and payment bonds, sureties likely will be held to these clauses in carrying out their obligations. Likewise, sureties may be able to rely on such clauses to the same extent their principals can when faced with bond claims.
One example of a risk-shifting clause with potential risks and benefits to the surety is the pay-if-paid clause. This provision, commonly found is contracts between the general contractor and its trade subcontractors, shifts the risk of owner non-payment from the general to the subcontractor. Simply put, the general contractor’s payment obligation to its subcontractor only arises if the owner pays the general contractor for the corresponding work. Such a clause can be extremely powerful tool for the general contractor and an extremely risky proposition for the subcontractor.
At its extreme, if the owner never pays the general contractor, then the general contractor might avoid altogether its payment obligation to the subcontractor. As a result, most states have scrutinized these clauses very carefully and found them to be enforceable only in instances where the applicable language clearly and unequivocally states that payment by the owner to the general contractor is an express condition precedent to the general contractor’s obligation to pay the subcontractor and that the parties mutually intend for this condition to be in place. Further, many states have refused to enforce such provisions if the general contractor has taken some action to prevent the condition (owner payment) from occurring.
With the existence of such a risk-shifting clause, the payment bond surety for the general contractor might want to assert this as a defense to a claim on non-payment by a subcontractor. Here, the underlying premise would be that, while the payment bond obligates the surety to answer for the debt, default, or miscarriage of its principal, such obligation does not arise until the payment becomes due. Whether the surety can rely upon this defense will depend on several factors. Three important factors are discussed below.
First, is the bond at issue one for a private construction project or for a public construction project? For construction projects in which a local or state government agency or the federal government is the procuring entity, bond requirements are established by statute. At the federal level, this statutory scheme is known as the Miller Act. Most states have comparable statutory bonding requirements, commonly referred to as “Little Miller Acts.” Payment bonds issued for publicly owned construction projects would be subject to these statutes. As a general rule, sureties cannot rely upon any pay-if-paid provision in a subcontract covering public works construction projects as a defense to their obligations to the unpaid subcontractor. Two recent cases illustrate this.
In the 2011 case of Glencoe Education Found., Inc. v. Clerk of Court & Recorder of Mortgages for Parish of St. Mary, the Court of Appeal of Louisiana was asked to determine “whether a surety, which has issued a statutory bond governed by