Most dealers have been asked to enter into a subcontract with a general contractor (GC). In these situations, the GC has entered into an agreement with the owner of a project to undertake the entire job. Many times, the GC will subcontract portions of the job to specialists such as a floor covering contractor.

This is generally referred to as a subcontract, and the flooring contractor is the subcontractor. Under this arrangement the subcontractor has no direct contract with the project owner. The sub, therefore, has to rely on payments from the GC. The GC, likewise, is relying upon the owner to first pay him for the job.

The owner in these situations wants to be assured the money finds its way to the subcontractors. His concerns are if the subs are not paid they may file mechanic’s liens against the property, and he may be forced to pay for the subcontract work twice—once to the GC and then to the sub who can show he was never paid.

To avoid these problems, the owner will require the GC to post a “labor and material bond.” This bond is a guarantee by the insurance company to pay the subcontractor in the event the GC does not pay him for completed work. These bonds are not easy to obtain and generally require either a very strong financial statement and history from the GC or some sort of collateral.

The GC often will insert into his subcontractor agreement something generally referred to as a “pay if paid” clause, which conditions the GC’s obligation to pay the subcontractor upon the owner’s payment to the GC. If the GC does not get paid then neither does the subcontractor.

In a recent federal case, the agreement between the GC and the owner provided the GC post a labor and material bond, which he did. This bond, as interpreted by the judge, contained an unequivocal promise by the insurance company to pay all the subcontractors and suppliers if they did not receive payment.

The case came about after the owner filed a bankruptcy petition just before the project’s completion. So, when the GC stopped receiving payments he likewise stopped paying the subcontractors. This caused the subcontractors to bring a lawsuit against both the GC and insurance company.

In its defense, the GC pointed to the pay-if-paid language in its subcontract and contended since it had not been paid by the owner it had no liability to the subcontractors. The insurance company, likewise, relied on the clause and contended it could not be responsible since the payments it guaranteed in the bond were not required to be made under this subcontract.

The judge agreed with the subcontractors. First, he determined the “plain language” of the bond established absolute liability on the insurance company to pay the subcontractors for work completed no matter the cause of non-payment.

Even more importantly, however, the judge held the pay-if-paid language was in face contrary to public policy and was unenforceable in any event. “Permitting a contractor to avoid its obligation to pay a subcontractor by means of an exculpatory provision limiting liability to payments to the prime contractor by a project owner would be tantamount to defeating the objectives of (the lien law) and is an indirect way to enforce what is in effect a forbidden waiver.”

We should note here that although this case was decided by a federal judge, he referred to New York law in his decision which has since been appealed. Take note, the law may vary from state to state as we’ll see next time when we look at a very recent decision from a similar type of case.