Clarkelectric v. Safeco

 – On April 9, 1997, the California Supreme Court heard arguments on an issue near and dear to every subcontractor, the validity of “pay if paid” clauses in subcontracts. Bill Crawford, of Crawford & Bangs, General Counsel to the American Subcontractors Association, California and the Los Angeles-Orange County Chapter argued on behalf of the subcontractors’ position that the “pay if paid” clause is in violation of California Law. Bill Crawford was able to tell the court of his own problems with the “pay when paid” clause from his days as an air-conditioning subcontractor, and the impact the newer “pay if paid” clause has on subcontractors.

The case arises out of the remodel of the MGM-Pathe Headquarters downtown Los Angeles in 1990. The owner of the project was “6420 Wilshire Partners Ltd.” “6420 Wilshire Partners Ltd.” entered into a general contract for construction with Keller Construction. The owner then requested Keller to obtain a payment bond, which Keller obtained from Safeco.

Keller’s contract with the subcontractors contained language that payment to Keller, by the owner, was a condition precedent to Keller’s obligations to make any payments to a subcontractor (“pay if paid” clause). During early construction it became apparent to Keller that the owner had insufficient financing to complete the project. Keller’s internal memorandums stated that because of the risk of insufficient financing it was necessary to shift the risk of non-payment to the subcontractors (none of this was revealed to the subcontractors).

In an effort to shift the risk to subcontractors, Keller drafted an addendum to the subcontracts that stated the subcontractors were acknowledging that they had no rights against Keller unless Keller was paid. The addendum to subcontract went on to say that this was without waiving any rights the subcontractor had to a mechanic’s lien.

Unfortunately for the subcontractors, Keller’s fears were realized and Keller was not paid for a substantial portion of its work and walked off the job. When contacted for payment, of course Keller responded that it had no obligation to pay any subcontractors because it had not been paid. Keller did pursue an action against the owner and received partial compensation of its claim and offered pro-rata payments of what it received. The subcontractor parties to the appeal rejected less than full payment for work performed and made claims on the surety bond on the project written by Safeco.

Safeco responded that it’s obligation for payment had not yet arisen to the subcontractors since Keller had not yet been paid for the amounts sought. The subcontractors responded by pointing to Civil Code Section 3226 that specifically sets forth that non-payment by the owner does not relieve a surety of its obligations on a surety payment bond.

At the trial court level the court agreed with the subcontractors, ruling non-payment by the owner to the general contractor was not an excuse for the surety bond to refuse payment to the subcontractor making claims on the payment bond. Safeco was obviously not happy with this result, nor was Keller since Keller in all likelihood is required to indemnify Safeco for the approximately two million dollars in claims. As a result, Safeco and Keller appealed to the California Court of Appeals.

The California Court of Appeals affirmed this judgment on the ground that since the surety bond is from the same bundle of rights included in the right to a mechanic’s lien, and the contract acknowledged the right to a mechanic’s lien, the contract also acknowledged the right to recover on the surety bond. Following this decision, the California Supreme Court granted certiorari (review) requested by Safeco and Keller.

At the hearing on April 9, 1997, attorneys for each of the four subcontractors in the case spoke in support of subcontractors rights, arguing that the “pay if paid” clause in operation prevented the right to recover against a surety bond. As a result, the “pay if paid” clause was an invalid waiver prohibited by Civil Code Section 3262. In addition to counsel for the surety, general contractor, and subcontractors, there was representation on behalf of the Surety Association and AGC; supporting Safeco’s position and numerous trade and specialty subcontractor associations in support of the subcontractors’ position. During the argument, counsel for the surety and general contractor were questioned by the court regarding whether the “pay if paid” clause operated as a void waiver of the rights to surety bond guaranteed in Civil Code Section 3262.

At this point the court has concluded all arguments, and consistent with the pace of this case, will in all likelihood rule sometime in late 1997 or even in 1998 on this issue of upmost importance to all subcontractors.