Pennsylvania State Court Enforces Pay-If-Paid Clause

Last summer, the United States Court of Appeals for the Third Circuit issued a precedential opinion in Sloan Co. v. Liberty Mutual Ins. Co., 653 F.3d 175 (3d Cir. 2011), that had broad implications for the construction community, because it affirmed an important industry-standard practice. More specifically, the Third Circuit held that a “pay-if-paid” provision in a subcontract, which provided that the general contractor’s receipt of full payment from the owner is an express condition precedent to the subcontractor’s right to full payment from the general contractor, was valid and enforceable by the general contractor and/or its payment bond surety.

Although “pay-if-paid” provisions are common in the construction industry, the enforceability of such provisions has been called into question by several courts around the country. In Sloan, however, the Third Circuit unequivocally recognized that: (1) few general contractors could absorb a significant owner default on a large construction project and that without risk-sharing the ultimate result would be an insolvent general contractor; and (2) a “pay-if-paid” provision was an appropriate and enforceable method for sharing risk among the general contractor and its subcontractors.

Specifically, the payment provision in Sloan stated, in relevant part, that:

Final payment shall be made within thirty (30) days after the last of the following to occur, the occurrence of all of which shall be conditions precedent to such final payment: . . . (3) Owner shall have accepted the Work and made final payment thereunder to Contractor . . . (6) Contractor shall have received final payment from Owner for Subcontractor’s Work.

The Third Circuit interpreted this provision, in conjunction with several other provisions in the subcontract, and found that words “shall be conditions precedent” were sufficient by themselves to establish an overall “pay-if-paid” structure, under which the subcontractor is entitled to receive only those payments that the general contractor receives from the owner for the subcontractor’s work.

Furthermore, the Third Circuit found that a related provision in the subcontract constituted a “liquidating agreement” which permitted the general contractor to assert claims against the owner on behalf of its subcontractors on a pass-through basis. Because the “liquidating agreement” provision bound the subcontractor to the owner’s decision on the pass-through claim, the Third Circuit found that this provision taken together with the “pay-if-paid” provision established a payment scheme that shifted risk of the owner’s non-payment to the subcontractor. Based on this payment structure, the Third Circuit reversed the lower court’s decision and held that the general contractor and its payment bond surety were insulated from the risk of an owner’s default.

Since the Third Circuit’s ruling in Sloan, the legal and construction community have speculated on whether a Pennsylvania state court would follow the Third Circuit’s legal analysis and ruling. Now, a recent decision by the Philadelphia Court of Common Pleas suggests that Pennsylvania state courts will follow the Third Circuit, and enforce “pay-if-paid” clauses.

In Pencoyd Iron Works v. Axis Constr. Servs., LLC, Case No. 000814, 2012 Phila. Ct. Com. Pl. LEXIS 23 (Phila C.C.P. January 18, 2012), a subcontractor filed suit against a general contractor and asserted claims for breach of contract, unjust enrichment, and violations of the Pennsylvania Contractor and Subcontractor Payment Act (“CSPA”).

In Pencoyd, the contract between the contractor and subcontractor included a “pay-if-paid” clause that stated “payment from Owner to Contractor is a condition precedent to payment from the Contractor to the Subcontractor.” The contract also stated that “Subcontractor acknowledges that in the event that payment is not made to the Contractor from the Owner for any reason … Subcontractor shall look exclusively to the Owner for payment of any and all funds under this Subcontract.”

After reviewing these provisions, the court concluded that the conditional language of these payment provisions constituted an unambiguous pay-if-paid clause. As a result, the court found that the subcontractor could only maintain a claim for breach of contract against the general contractor, if the subcontractor could show that the general contractor received full payment from the owner specifically for the work performed by the subcontractor. Because there was no dispute that the owner failed to pay the general contractor, the court granted the general contractor’s motion for summary judgment, enforced the pay-if-paid clause, and dismissed the subcontractor’s breach of contract claim.

Similarly, because the general contractor never received payment from the owner, the court also found that the subcontractor’s unjust enrichment claim and CSPA claim also failed, because the general contractor was not unjustly enriched, and that no obligation to tender payment was triggered by CSPA.

In light of the recent decisions in Sloan and Pencoyd, both federal and state courts are demonstrating an inclination to apply Pennsylvania law in a manner which enforces carefully crafted pay-if-paid clauses. As a result of these decisions, contractors, subcontractors, and sub-subcontractors should take the time to review their payment provisions to ensure they are protected in the case of non-payment.