“Pay If Paid” vs. “Pay When Paid”

ALERT

“PAY WHEN PAID” vs. “PAY IF PAID” AND THE IMPACT OF PASS THROUGH LIQUIDATING CLAUSES

THIRD CIRCUIT CONCLUDES THAT SUBCONTRACTOR WAS ONLY ENTITLED TO PRO RATA SHARE OF CONTRACTOR’S RECOVERY AGAINST OWNER IN LIGHT OF OWNER’S FAILURE TO PAY ENTIRE CONTRACT AMOUNT

August, 2011

Matthew Chabal III, Esq.
James Smith Dietterick & Connelly, LLP
P.O. Box 650, Hershey, PA 17033
717.533.3280
[email protected]

On August 1, 2011, the United States Court of Appeals for the Third Circuit decided the case of Sloan v. Liberty Mutual Insurance Company, 653 F.3d 175 (3d Cir. 2011), which tackled the issue of a subcontractor’s right to receive payment when the owner failed to pay the entire amount owed to the contractor. In this case, the subcontract contained a provision that was either a “pay when paid” clause or a “pay if paid” clause, as well as a “pass-through” or “liquidating agreement.”

Isla of Capri Associates, LP (“IOC”), was the owner of a project for the development of waterfront condominiums in Philadelphia. IOC had a prime contract with Shoemaker Construction Company. Shoemaker, in turn, contracted with Sloan & Company for drywall and carpentry work. When the project was completed, IOC owed Shoemaker about $6.5 million. Shoemaker owed about $5 million to subcontractors, including $1,074,260 claimed by Sloan.

Shoemaker filed suit against IOC to recover the $5 million balance owed, but ultimately settled for $1 million. IOC then offered each subcontractor a pro rata share of the settlement as payment in full.

Sloan filed suit against Shoemaker’s payment bond for the claimed $1,074,260 subcontract balance. The surety, Liberty Mutual Insurance Company, denied Sloan’s claim citing a provision of Sloan’s subcontract that Liberty Mutual interpreted as a “pay if paid” clause, i.e., Shoemaker’s obligation to pay Sloan was conditioned on its receipt of payment from IOC. Put another way, Sloan was entitled to be paid only whatever amount Shoemaker received from IOC for Sloan’s work. Sloan responded that the contract provision at issue was a “pay when paid” clause. In contrast to a “pay if paid” clause, a “pay when paid” clause does not establish a condition precedent, but merely creates a timing mechanism for the contractor’s payment to the subcontractor.

In analyzing the question of whether the provision at issue was a “pay when paid” clause or a “pay if paid” clause, the Third Circuit noted that Pennsylvania cases recognize that express language of condition is sufficient to establish a “pay if paid” condition precedent. But when certainty is lacking in the contract language, Pennsylvania courts tend to interpret payment provisions as “pay when paid” clauses. Ultimately, the court concluded that the subcontract did contain a “pay if paid” clause. But, as the court wrote, “that is not the end of the story.”

The Third Circuit found that the parties intended to have a modified “pay if paid” clause. A modification of a “pay if paid” condition is not an uncommon practice in the construction industry, and there are several ways to modify such clauses. One obvious way is to convert it to a “pay when paid” clause by eliminating the condition precedent after a contractually stated period of time. That is precisely what the court found in this case: the “pay if paid” provision yielded after six months of IOC non-payment and was replaced with a timing mechanism that specified when and for how much Sloan could sue Shoemaker. It permitted Sloan to pursue a claim for final payment, but required Sloan to wait to pursue its claim for a defined time period in order to allow Shoemaker to try to recover what it could from IOC.

Having determined that Sloan was entitled to some money, the question became: How much did Shoemaker have to pay Sloan since Shoemaker only received $1 million on its $6.5 million claim against IOC? The answer to that question was found in another typical subcontract provision known as a “pass through” provision, also known as a “liquidating agreement,” which provided as follows:

In the event [Sloan] asserts a claim for payment of the Subcontract Sum or a portion thereof . . . 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 . . . .

The decision or determination of [IOC] or its representative making the first and/or original decision shall be final and conclusive on [Sloan] except to the extent that [Shoemaker] may in its sole, exclusive and arbitrary discretion . . . appeal to other representatives of [IOC] or commence a proceeding in Court or arbitration or other dispute resolution forum . . . .

Then, in such event, [Sloan] agrees to be bound to [Shoemaker] to the same extent [Shoemaker] is bound to [IOC] by any final decisions of said other representative of [IOC] or of a Court of competent jurisdiction or by any final or interim award issued in arbitration or by any final decisions issued in any other dispute resolution forum . . . .

A “pass through” provision is generally meant to provide a subcontractor with a legal remedy against the owner in situations where the subcontractor would have none because it lacks a contractual relationship with the owner. Such a provision can also serve to limit a subcontractor’s damages to the amount the contractor recovers from the owner for the subcontractor’s work. As a result, the Circuit Court concluded that Sloan was only entitled to Shoemaker’s initial offer of a pro rata share of the $1 million settlement.

This case teaches that the interpretation of contract provisions that seem to be straightforward when read individually, can be more complicated than might appear. Consequently, it is important for to review the entirety of a contract to determine how each provision interacts with the others. As was the case in Sloan v. Liberty Mutual Insurance Company, a seemingly favorable rights-granting provision can be limited by other contract language, the relevance of which may not be readily obvious.

For more information, please contact Matt Chabal, P.O. Box 650, Hershey, PA 17033 | 134 Sipe Ave., Hummelstown, PA 17036 | 717.533.3280 EXT 2070 | [email protected].

This Alert is provided for informational purposes only and does not constitute legal advice. Before taking any action related to the issues addressed above, you should consult with an attorney of your choice.