November 2006

New York Courts Split on Enforceability of “Imported” Pay-If-Paid Clauses

Holland & Knight Newsletter
Timothy B. Froessel

In the case of West-Fair Contractors v. Aetna Casualty and Surety Co., 87 N.Y.2d 148 (1995), the New York State Court of Appeals (New York’s highest court) held that “pay when paid” clauses in construction contracts violate public policy, and will not be enforced, when the clause is drafted in such a manner as to create a condition precedent to payment “which forces the subcontractor to assume the risk that the owner will fail to pay the general contractor.” In many jurisdictions, a contract clause of this type is commonly referred to as a “pay-if-paid” clause. Conversely, the Court of Appeals held that a “pay-when-paid” clause, which merely fixes a time for payment and does not “indefinitely suspend a contractor’s right to payment”, will not violate public policy and will be enforced. Underlying the Court’s decision in West-Fair was its observation that a “pay-if-paid” clause deprives a subcontractor of its right to file a mechanic’s lien under New York law, because under the New York statute “mechanic’s liens may not be enforced until a debt becomes due and payable.”

In the 10 years following West-Fair, there were relatively few reported cases concerning the enforceability of “pay-if-paid” or “pay-when-paid” clauses in New York. In 2005, however, a new issue arose concerning the enforceability of a “pay-if-paid” provision contained in a contract with a governing law clause that makes the law of a state that fully enforces “pay-if-paid” provisions applicable to the parties’ relationship. In two separate cases involving the same general contractor, two of New York’s Appellate Divisions (New York’s intermediate appellate courts) considered this issue and came to opposite conclusions.

On June 2, 2005, the Appellate Division, First Department (which has jurisdiction over appeals taken in Manhattan and the Bronx), decided this issue in favor of the general contractor defendant in Hugh O’Kane Electric Co., LLC v. MasTec North America, Inc., 19 A.D.3d 126 (1st Dept. 2005). In that case, the contract between the Florida-based general contractor and its subcontractor contained a Florida choice of law clause, and provided that the general contractor’s obligation to pay the subcontractor was “expressly contingent upon and subject to” its receipt of payment from the owner. In the trial court, the general contractor moved for summary judgment based upon the “pay-if-paid” clause in the subcontract, and the subcontractor in turn cross-moved to dismiss the general contractor’s affirmative defense that the “pay-if-paid” clause precluded the subcontractor’s lawsuit. The trial court had denied the motion for summary judgment and granted the cross-motion, holding that under West-Fair, the “pay-if-paid” clause was unenforceable. On appeal, the Appellate Division, First Department, observed that “pay-if-paid” clauses are enforceable under Florida law, and stated that the general contractor’s Florida domicile justified the choice of Florida law. The Court held that the “pay-if-paid” provision in the parties’ contract “should be enforced,” because such contract clauses were not clearly prohibited in New York until the decision in West-Fair in 1995, and thus were not so “deeply-rooted” in New York state as to preclude the application of another state’s law. The Appellate Division, First Department, thus modified the decision below to reinstate the general contractor’s affirmative defense based upon the “pay-if-paid” clause (the denial of the general contractor’s summary judgment motion was affirmed on other grounds).

Less than six months after the First Department decided O’Kane, the Appellate Division, Second Department (which has jurisdiction over appeals taken in Brooklyn, Queens, Staten Island and several suburban counties), decided a case with identical facts and reached the opposite result. On November 28, 2005, the Second Department held in Welsbach Electric Corp. v. MasTec North America, Inc., 2005 N.Y. App. Div. LEXIS 13487 (2d Dept. 2005), that the “pay-if-paid” provision contained in the parties’ subcontract, although governed by Florida law, was “inconsistent with this State’s long-standing public policy to ‘advance building and construction by assuring subcontractors of payment in the event of the insolvency of the owner or general contractor,’” and therefore ruled that the clause in the parties’ subcontract was unenforceable. The Second Department specifically stated that it did not “find the reasoning and conclusion of the Appellate Division, First Department, in O’Kane to be persuasive.”

The Welsbach decision created a split of authority among two of New York’s appellate divisions with respect to the enforceability of a “pay-if-paid” clause that is “imported” from another state (New York’s other two appellate divisions, the Third and Fourth Departments covering the northern and western portions of the state, have not addressed this issue). The split of authority makes this issue ripe for an appeal to the Court of Appeals, but as of this writing no motion for leave to appeal to the Court of Appeals has been filed in Welsbach matter.

We will be monitoring the court dockets for any indication that the New York Court of Appeals will resolve this important issue. In the meantime, out-of-state construction managers and general contractors that will be doing business in New York are best forewarned that the enforceability of their imported “pay-if-paid” clauses will ultimately depend upon the county in which the project is located.

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