Paid when Paid Clauses on Bonded Projects

Scenario:  You have a “paid when paid” clause in your contract with your subcontractors/vendors. A Payment Bond claim is presented to your bonding company by a third tier subcontractor or vendor for failure to be paid by your subcontractor. The bonding company wants to know your position regarding the matter before formally responding to the claim. You send them a copy of your subcontract with your subcontractor, highlight the section where it indicates your subcontractor will be paid when you’re paid and that should allow the Surety to deny the claim, right? Not always.

The fact is this situation is a summary of an actual bond claim presented to a Surety by a vendor of a subcontractor. The general contractor (the bond was written on behalf of) cited the “paid when paid” clause in their subcontract with the sub that had this contract with the vendor. However, the subcontractor didn’t have paid when paid language in their contract with the vendor, so the Surety indicated to their bonded general contractor they couldn’t use this defense to deny the claim. They would have no choice but to pay the claim if the general contractor was not willing to until payment was received from the owner. The next thing you know, the vendor notifies the owner they have filed a bond claim for failure to be paid. The owner then freezes all pending payments to anyone associated with the project.

To complicate matters further (and to light a fire under the general contractor and their Surety) the vendor threatens to file suit by a specific date if payment is not received prior to this drop dead date. The general contractor decides, at the urging of the Surety, to settle the matter promptly. However, the general contractor has to protect their interests by asking the vendor for a claim release and final waiver before releasing the claimed funds to the vendor. The vendor views this as a stall tactic and refuses.  This is when things start getting ugly. The Surety wants to avoid the lawsuit at all cost and is willing to pay the vendor if their general contractor doesn’t by the due date. Do you see where this is going? The general contractor felt all along that the “paid when paid” clause in the subcontract should have been a valid defense and this matter should have gone away immediately.

All this could have been avoided if the general contractor incorporated the paid when paid language in the subcontract so it also applied to the subcontractor’s contract with the vendor. By adding language similar to the following, the Surety would have been able to deny the claim and the general contractor’s leverage would not have been compromised.

Subcontractor agrees that it will bind all of its subcontractors hired to work on this job to all of the terms, obligations and conditions that Subcontractor is bound to by Contractor in this contract.  Subcontractor agrees all future contracts in furtherance of this contract between Subcontractor and any of its subcontractors will designate Contractor as an intended third party beneficiary of that contract.  Subcontractor hereby agrees to specifically label Contractor as an “intended third party beneficiary” in all contracts entered in furtherance of this contract.   Subcontractor agrees to indemnify and hold harmless Contractor for any damages, claims, losses or expenses arising out of or in connection with Subcontractor’s failure to bind any of its Subcontractors to the terms and conditions Subcontractor has agreed to in this contract. 

By incorporating this simple clause in your subcontracts, a situation similar to the above can be easily avoided and your leverage will not be compromised.