What is a “Pay if Paid” Contract Clause and Can it Apply to a Construction Subcontractor?

What constitutes a “pay-if-paid” construction contract clause? The United States Court of Appeals for the Third Circuit recently addressed this question in Sloan v. Liberty Mutual Insurance Company, 653 F.3d 175 (3d Cir. 2011).

That case involved a waterfront condominium in Philadelphia.  Isla of Capri Associates LP, the developer of the condominiums (“IOC”), contracted with Shoemaker Construction Co. (“Shoemaker”) to be the contractor for the project (“Contractor Contract”).  Subsequently, Shoemaker hired subcontractor Sloan & Co. (“Sloan”) to perform construction involving drywall and carpentry (“Subcontract”).  Liberty Mutual Insurance Co. (“Liberty”) issued a surety bond guaranteeing payment for the subcontractors work.  After the work was completed, IOC refused to pay Shoemaker for monies owed under the contractor contract because IOC was unhappy with some of the subcontractors’ work.  As a result, Shoemaker withheld the remaining balance due to Sloan.

Sloan filed a claim against Liberty for payment pursuant to the surety bond. Id. at 177.  Liberty denied any payment obligation under the premise that Paragraph 6.f of the subcontract contained a provision that conditioned Sloan’s right to payment on IOC’s payment to Shoemaker (a pay-if-paid clause). See id.  Therefore, Sloan was not entitled to payment since Shoemaker never received payment from IOC. Id.  The United States District Court for the Eastern District of Pennsylvania entered partial summary judgment for Sloan, rejecting Liberty’s view of the contract. Id. at 178.

The dispute here centered on the interpretation of Paragraph 6.f of the subcontract, which dealt with final payment.  The first subparagraph provided: ‘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 . . .’ Id. at 179.  There were seven (7) conditions precedent, one of which was that ‘[IOC] shall have accepted the Work and made final payment thereunder to [Shoemaker].’ Id.  Another provided that Shoemaker “shall have received final payment from [IOC] for [Sloan’s] work.’ Id.

Paragraph 20’s liquidating provision in the subcontract further clarified the extent of Shoemaker’s responsibility for payment to Sloan:

“In the event [Sloan] asserts a claim for payment of the Subcontract Sum or a portion therof . . . and in the event that [Shoemaker] in its sole, exclusive and arbitrary discretion submits said . . . Claim to [IOC] . . . for a decision or determination, then all decisions and determinations made by [IOC] or its representative shall be binding upon [Sloan] even though [Sloan] may not be a party thereto.”

Id. at 182.

When Liberty appealed the United States District Court for the Eastern District of Pennsylvania’s judgment, the Third Circuit was satisfied that the contract stipulated a pay-if-paid compensation policy for Sloan. See id. at 184.  The Third Circuit concluded 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.” Id.   Sloan, therefore, received a proportional/pro rata share of the recovery Shoemaker gained from its separate lawsuit against IOC rather than receiving the full balance it was owed under the contract. See id.

The lesson here for subcontractors is to be aware of the pay-if-paid issue when drafting the subcontractor agreement.

Comments/Questions: gdn@gdnlaw.com

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