Business and Legal Insights

The law of contract formation allows parties “freedom to contract” in most aspects of transactions, services and/or liabilities. In the area of construction law, general contractors have largely negotiated a shift in the distribution of risk away from the general contractor and to the subcontractor with the inclusion of “pay-if-paid” contractual clauses that make the general contractor’s receipt of payment from the owner a condition precedent to the general contractor’s ultimate payment to the subcontractors. Absent such a provision, general contractors bear the risk of an owner’s potential insolvency.

Due to the rise of such provisions in construction contracts in recent years, subcontractors have sought to circumvent contractual “pay-if-paid” provisions by bringing claims against both the general contractors and their sureties who may guarantee payment. While the “pay-if-paid” clause may be cited by the general contractor as an affirmative defense where there has been no payment made by the owner, the effectiveness of such a defense by the general contractor’s surety is still an open question. One issue is whether such a defense would be available to a surety not in privity-of-contract with the parties during the negotiation and formation of the subcontract. Courts are split on this question. In OBS Co. v. Pace Constr. Corp., 558 So. 2d 404, 408 (Fla. 1990), the Florida Supreme Court explained that “[t]he payment bond is a separate agreement, and any liability to proceed against the general contractor does not necessarily prevent recovery against the sureties under the bond”. In OBS, recovery under the payment bond was not conditioned on the owner making final payment to the subcontractor and the bond did not incorporate the subcontract’s payment terms. Id. The Florida Supreme Court went on to note that “it would be inequitable to nullify the bonding company’s liability because the owner has not paid the contractor” and “[w]hen a surety on a private construction project issues a bond that purports to protect against mechanic’s liens, the bond must be construed and applied in accordance with the conditions of section 713.23, Florida Statutes”. Id.

Contrarily, other courts have ruled that the surety stands in the shoes of the general contractor and thus is afforded all the contractual defenses of the general contractor. In Great Am. Ins. Co. v. Sch. Bd. of Broward County, 2010 U.S. Dist. LEXIS 120030, *45, 2010 WL 4366865 (S.D. Fla. July 30, 2010), the United States District Court for the Southern District of Florida stated that once a surety has fulfilled its obligations under the bond, “the surety confers a benefit upon the obligee . . . . That benefit relieves the obligee of the burden of completing the construction". Id.; see also International Fid. Ins. Co. v. Cty. of Rockland, 98 F. Supp. 2d 400, 429, 2000 U.S. Dist. LEXIS 7454, *87 (S.D.N.Y. 2000). In short, these courts have interpreted the principal’s rights as shifting to the surety.

While it is unclear whether, absent clear and unequivocal language supplementing the subcontract to include this additional condition precedent, credence will be given to the surety’s affirmative defense under the general contractor's “pay-if-paid” contractual terms, we can be certain of more litigation in the near future pertaining to the applicability and extension of “pay-if-paid” clauses. In the interim, due diligence during contract formation is crucial in avoiding certain pitfalls.