A recent 7th Circuit opinion suggests that Indiana will allow a surety to assert a contractor’s pay-if-paid defense and likely, by extension pay-when-paid defenses. These defenses have not been addressed directly by the Indiana Supreme Court.
A pay-if-paid clause provides that a subcontractor will be paid only if the contractor is paid. This clause ensures that each contracting party bears the risk of loss only for its own work. A typical clause of this type might say: “Contractor’s receipt of payment from the owner is a condition precedent to contractor’s obligation to make payment to the subcontractor; the subcontractor expressly assumes the risk of the owner’s nonpayment and the subcontract price includes the risk.” BMD Contractors, Inc. v. Fid. & Deposit Co. of Maryland, 679 F.3d 643, 645 (7th Cir. 2012) as amended (July 13, 2012).
A pay-when-paid clause governs the timing of a contractor’s payment obligation to the subcontractor. Usually the clause indicates that the subcontractor will be paid within some fixed time period after the contractor itself has been paid. A typical clause might state “Contractor shall pay subcontractor within seven days of contractor’s receipt of payment from the owner.” Id.
The 7th Circuit Court of Appeals in BMD Contractors, Inc. v. Fid. & Deposit Co. of Maryland, held that a surety may assert the principal’s pay-if-paid defense which eliminated the surety’s liability under the payment bond. BMD Contractors, Inc. (“BMD”), who was a subcontractor for Industrial Power Systems, Inc. (“Industrial Power”), who was a subcontractor for Walbridge Aldinger Company (“Walbridge”), the general contractor executed a payment bond with Fidelity and Deposit Company of Maryland (“Fidelity”), making Fidelity a surety for Industrial Power’s payment obligations to BMD. Ultimately, the manufacturer declared bankruptcy, causing a series of payment defaults to flow down the levels of contractors and subcontractors. Walbridge failed to pay Industrial Power, Industrial Power failed to pay BMD, and Fidelity refused to pay BMD. BMD sued Fidelity on the bond. The Court held, “the Industrial Power/BMD subcontract expressly provides that Industrial Power’s receipt of payment is a condition precedent to its obligation to pay BMD. This language is clear and properly construed as a pay-if-paid clause.” Id.
The Court pointed out that Indiana surety law is clear on two points: (1) sureties are generally liable only where the principal itself is liable and (2) concurrently executed bonds and the contracts they secure are construed together.
Until this case, it was generally believed in Indiana that a surety was barred from asserting pay-when-paid and pay-if-paid defenses under Midland Eng’g Co. v. John A. Hall Constr. Co., 398 F.Supp. 981, 993–94 (N.D.Ind.1975) (discussing Dyer ); Oberle & Assocs., Inc. v. Richmond Hotel, Ltd., No. 33C01–8706–CP–130, 1998 WL 35297806, at *5–7 (Ind.Cir.Ct. July 2, 1998). The BMD case distinguished this case. It agreed that
to transfer the risk of upstream insolvency or default, the contracting parties must expressly demonstrate their intent to do so; that is the rule from Dyer. But by clearly stating that the contractor’s receipt of payment from the owner is a condition precedent to the subcontractor’s right to payment, the parties have expressly demonstrated exactly that intent. Adding specific assumption-of-risk language would reinforce that intent but is not strictly necessary to create an enforceable pay-if-paid clause. BMD Contractors, Inc. v. Fid. & Deposit Co. of Maryland, 679 F.3d at 650.
The Court went on to state that “the Industrial Power/BMD contract unambiguously states that Industrial Power’s receipt of payment is a condition precedent to BMD’s right to payment.” Id. Finally the Court noted that “the subcontracts at issue in Dyer, Midland, and Oberle did not use condition-precedent language.” Id.
Therefore, if a subcontract contains clear “condition precedent” language in either a pay-if-paid or pay-when-paid clause, it is likely that the Indiana courts will allow a surety to assert these defenses if its principal can also assert the defenses.