“Pay-if-paid” clauses, if worded properly, are generally enforceable in the United States and permit general contractors not to pay subcontractors where the general has not been paid by the owner.  Nonetheless, on a project with a payment bond, a majority of states will not permit the surety also to take advantage of the “pay-if-paid” clause to avoid payment under the same circumstances.

In a recent decision refusing to apply the majority view, the United States District Court for the Southern District of Indiana has held that a surety properly refused to make payment under a bond to a subcontractor and one of its suppliers based on a “pay-if-paid” clause contained in the subcontract.  In BMD Contractors, Inc. v. Fidelity and Deposit Company of Maryland, 2010 WL 326041, S.D.Ind., January 20, 2010, the bankrupt owner of a construction project failed to pay the general contractor, which in turn refused to pay the subcontractor based on the following clause in the subcontract:

IT IS EXPRESSLY AGREED THAT OWNER’S ACCEPTANCE OF SUBCONTRACTOR’S WORK AND PAYMENT TO THE CONTRACTOR FOR THE SUBCONTRACTOR’S WORK ARE CONDITIONS PRECEDENT TO THE SUBCONTRACTOR’S RIGHT TO PAYMENTS BY THE CONTRACTOR.

The subcontractor and supplier then sued the surety to recover on a payment bond securing the payment of “such sum or sums as may be justly due” by the general contractor. 

The court noted the vast difference between a “pay-if-paid” clause and a “pay-when-paid” clause, the former obligating the contractor to pay the subcontractor only if the contractor receives payment from the owner, whereas the latter merely postpones the time for payment, making payment to the subcontractor “a matter of when, not a matter of if.”  Based on the “pay-if-paid” clause, the court concluded that the general contractor was not liable under the subcontract.  

The court then considered the more controversial question of whether the surety nevertheless could still be liable under the bond.  The court held that, in Indiana, a surety’s liability is limited to that of its principal, and the subcontract and the bond must be construed as a single instrument.  Thus, because the general contractor had not defaulted on its obligations to the subcontractor, the court concluded that the surety’s obligation under the bond was not triggered. 

Finally, the court considered the subcontractor’s and supplier’s argument that a ruling in favor of the surety would nullify the whole purpose of a payment bond, a position the court noted was backed by considerable support, including the decision of the Seventh Circuit Court of Appeals in Culligan Corp. v. Transamerica Ins. Co., 580 F.2d 251 (7th Cir. 1978).  In Culligan, the Seventh Circuit had held that a surety’s liability on a bond was not affected by a dispute between the prime contractor and the owner because the conditions of the bond were met, a decision in line with the majority view.  The district court in the BMD case, however, found that Culligan was distinguishable since the bond in the Culligan case did not provide that a bond claimant was only entitled to sums that were “justly due,” which the court reasoned could only mean justly due from the general contractor.  Since the bond in the BMD case provided that the surety was only liable for sums “justly due” and the general contractor owed nothing to the subcontractor, the district court held that the surety was not liable on the bond.

Although the case currently is on appeal to the Seventh Circuit Court of Appeals, unless it is reversed, it may provide some basis in Indiana to bar payment to a subcontractor on a payment bond under circumstances where the general contractor has invoked a pay-if-paid clause and has not paid the subcontractor because the owner did not pay the general.