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Young Electrical Contractors, Inc. v. Dustin Construction, Inc.

Court of Appeals of Maryland

May 24, 2018

Young Electrical Contractors, Inc.
v.
Dustin Construction, Inc.

          Argument: October 6, 2017

          Circuit Court for Montgomery County Case No. 381002V

          Barbera, C.J., Greene, Adkins, McDonald, Watts, Hotten, Getty, JJ.

          OPINION

          McDonald, J.

         In a typical scenario in the construction industry, the owner of a construction project enters into a prime contract with a general contractor to erect or renovate a building. The general contractor then enters into subcontracts with suppliers and trade contractors, such as plumbers and electricians, to provide materials or to perform portions of the work. For various reasons, the owner of the project may later be unable or unwilling to pay the general contractor under the prime contract. What this means for the subcontractor depends on the terms of its subcontract with the general contractor.

         A subcontract may contain a provision that relates payment of the subcontractor by the general contractor to the payment of the general contractor by the project owner. Some provisions, sometimes called pay-when-paid clauses, concern the timing of payment by the general contractor, but do not relieve the general contractor of its liability to the subcontractor under the subcontract. Other provisions, sometimes called pay-if-paid clauses, make the project owner's payment of the general contractor a condition precedent of the general contractor's obligation to pay the subcontractor and thus can relieve the general contractor of liability to the subcontractor, even though the subcontractor has fully performed its part of the subcontract.

         This case concerns the propriety of an award of summary judgment in favor of a general contractor against a subcontractor based on a pay-if-paid clause. The subcontractor, Petitioner Young Electrical Contractors, Inc., sued the general contractor, Respondent Dustin Construction, Inc., in the Circuit Court for Montgomery County for breach of contract relating to a construction project in Virginia. Applying Virginia law, the Circuit Court held that a pay-if-paid provision in the subcontract applied to the damages sought in the action, determined that there was no dispute that the owner of the project had not paid the general contractor with respect to the matters in issue, and awarded summary judgment in favor of the general contractor. The Court of Special Appeals affirmed that decision, although for slightly different reasons.

         We hold that the pay-if-paid clause relied upon by the Circuit Court, which was cited by neither party in motion papers or argument concerning summary judgment, does not necessarily apply to the issues in this case. Moreover, consistent with Maryland law concerning review of awards of summary judgment, we decline to seek other reasons to affirm the Circuit Court's decision. Accordingly, we vacate the judgment of the Court of Special Appeals and remand the matter to the Circuit Court for further factual development.

         I

         Background

         A. "Pay - When - Paid" and "Pay - If - Paid" Clauses

         In a typical construction project, the owner of the project contracts with a general contractor to carry out the project. The general contractor then enters into contracts with various suppliers and trades - the subcontractors - to provide the materials and carry out the actual construction. There is no necessary linkage between a subcontractor's or supplier's entitlement to compensation for performing a subcontract and the owner's performance of its obligations - primarily payment of the general contractor - under the prime contract. Thus, in the absence of an agreement to the contrary, a subcontractor that has completed its work is entitled to be paid regardless of whether the general contractor has been paid by the project owner. See J. Acret & A.D. Perrochet, Construction Litigation Handbook 3rd, §4.4.

         During the latter half of the twentieth century, general contractors began to include contingent payment provisions in their subcontracts. Although there apparently was no standard language, such a clause would typically provide that the general contractor was not obligated to pay the subcontractor until some specified number of days after the general contractor received payment under the prime contract from the owner of the project. Thus, for example, a window distributor that entered into a subcontract to supply windows for a project would not necessarily receive payment upon delivery of the windows, but would be required to await payment of the general contractor by the owner of the project.

         Such clauses could be viewed as creating two different types of conditions. One interpretation of such a clause would view it simply as a timing provision - i.e., it permits the general contractor to delay payment of the subcontractor until after it receives payment from the owner or (if that does not occur) some other period deemed reasonable, but does not relieve the general contractor of its obligation to compensate the subcontractor for its work. This interpretation might be viewed as a subcontractor-friendly version of the clause, as it considers the provision to govern when, but not whether, the subcontractor is to be paid by the general contractor.

         Another interpretation of such a clause would view it as a condition precedent for payment of the subcontractor - i.e., if the general contractor is not paid by the project owner under the prime contract, then the general contractor is not obligated to pay the subcontractor under the subcontract. In such a view, the subcontractor has not only agreed to provide materials or to perform work on the project, but is also providing the general contractor with a sort of insurance against the risk of non-payment by the owner - a risk usually associated with insolvency or bankruptcy of the owner. This might be viewed as a general contractor-friendly version of the clause.

         Although the nomenclature used in the case law and legal literature has not been consistent, for purposes of this opinion we shall distinguish between these two types of clauses by adopting the terminology used in a number of recent cases.[1] We shall refer to a provision that creates a timing condition as a "pay-when-paid" clause. We shall refer to a provision that creates a condition precedent for the obligation to pay as a "pay-if-paid" clause." As is often the case, when there is a dispute as to whether a particular contract provision falls into one category or the other, the devil is in the details.

         This case will require us to apply the law of Virginia to construe a subcontract and prime contract. To put that law in perspective, we review briefly the evolution of judicial treatment of such clauses.

         The Majority Approach

         Under what has frequently been described as the majority approach, [2] a court will construe such a clause narrowly and interpret it to be a payment timing provision - i.e., a pay-when-paid clause - unless the language of the provision clearly and necessarily creates a risk-shifting provision - i.e., a pay-if-paid clause.

         The leading case is Thos. J. Dyer Co. v. Bishop International Engineering Co., 303 F.2d 655 (6th Cir. 1962). In that case, a general contractor entered into a subcontract with a plumbing subcontractor to install plumbing for a construction project at a race track. The plumbing subcontractor provided the services required by the subcontract, but there were cost overruns due to additional work requested by the owner and general contractor, some of which was outside the scope of the prime contract. When the plumbing subcontractor sought payment for the additional work, the general contractor declined because it had not been paid by the owner, which had become insolvent and filed for bankruptcy. The general contractor relied on language in the subcontract stating "no part of [payment] shall be due until five (5) days after Owner shall have paid Contractor[.]"

         The Sixth Circuit observed that the "crucial issue" in the case was "whether … [the contract provision] … is to be construed as a conditional promise to pay, enforceable only when and if the condition precedent has taken place [i.e., a pay-if-paid provision] … or … is to be construed as an unconditional promise to pay with the time of payment being postponed until the happening of a certain event, or for a reasonable period of time if it develops that such an event does not take place [i.e., a pay-when-paid provision]." 303 F.2d at 659.

         While the Dyer court conceded that the expressed intention of the parties ultimately governed the interpretation of a particular provision, it observed that courts had generally viewed such clauses as timing, rather than risk-shifting, provisions unless the contract language clearly indicated otherwise. After reviewing case law in Ohio and Kentucky concerning conditional payment clauses, the court concluded that "[t]he tendency of the courts is to hold that, unless the contract shows clearly that such an action is an express condition, the provision with reference to such act is inserted in order to fix the time of performance, but not to make the doing of such act or the happening of such event a condition precedent. If this is the intention of the parties, the fact that such act is not performed or that such event does not happen, does not discharge the contract, and the act which the parties agree to do upon the performance of such act or upon the happening of such event, is to be performed in at least a reasonable time." 303 F.2d at 660 (internal citations and quotations omitted).

         The Dyer court rooted its analysis in its understanding of risk-sharing in the construction industry. The court considered it "basic in the construction business" for the general contractor to expect to be paid in full because it is "a fundamental concept of doing business[.]" 303 F.2d at 660. Although the "solvency of the owner is a credit risk necessarily incurred by the general contractor, " various mechanisms such as installment payments and liens are designed to keep those risks to a minimum. The court went on to explain that these issues are "even more pronounced in the case of a subcontractor, whose contract is with the general contractor, not with the owner." Id. The court observed that, while a subcontractor might be dependent on the solvency of the general contractor, normally the insolvency of the owner would not defeat the subcontractor's claim against the general contractor. Thus, "in order to transfer this normal credit risk [related to the owner] ... from the general contractor to the subcontractor, the [subcontract] should contain an express condition clearly showing that to be the intention of the parties." Id. at 660-61.

         In the case before it, the Sixth Circuit ultimately concluded that the language of the subcontract did not indicate that the plumbing subcontractor intended to bear the burden of the owner's insolvency and, accordingly, the appellate court affirmed the trial court's judgment in favor of the plumbing subcontractor. Id. at 661. ("To construe [the provision] as requiring the subcontractor to wait to be paid for an indefinite period of time until the general contractor has been paid by the owner, which may never occur, is to give to it an unreasonable construction which the parties did not intend at the time the subcontract was entered into.").

         The majority approach appears to be based, at least in part, on a general principle that disfavors construing a contract provision to effect a forfeiture, particularly when the condition precedent is outside the control of the party at risk of forfeiture. See Restatement (Second) of Contracts, §227(1) (March 2018 update) ("In resolving doubts as to whether an event is made a condition of an obligor's duty … an interpretation is preferred that will reduce the obligee's risk of forfeiture, unless the event is within the obligee's control or the circumstances indicate that he has assumed the risk"). In the context of a subcontract for a construction project, this principle favors construing a conditional payment provision as a timing provision rather than a risk-shifting provision. Id., illustration 1 (describing example apparently based on Dyer case).

         Pay-if-Paid Clause as against Public Policy

         In some jurisdictions there is more than a preference for construing conditional payment clauses as timing provisions. In those jurisdictions, there is a view that the transfer of risk effected by a pay-if-paid clause in a construction subcontract is contrary to public policy. At least two state courts have held that such a clause, even if explicitly set out in a subcontract, is void as against public policy. See West-Fair Elec. Contractors v. Aetna Cas. & Sur. Co., 661 N.E.2d 967, 970 (N.Y. 1995) (holding that pay-if-paid clause was inconsistent with state legislature's enactment of mechanic's lien statute to protect "those who furnish work, labor and services or provide materials for the improvement of real property"); William R. Clarke v. Safeco Ins. Co., 938 P.2d 372, 373-74 (Cal. 1997) (citing West-Fair and stating similar rationale); but see Superior Steel, Inc. v. Ascent at Roebling's Bridge, LLC, 540 S.W.3d 770, 785-87 (Ky. 2018) (declining to adopt public policy rationale in light of state's long tradition of freedom of contract). In addition, the legislatures in several states have enacted statutes declaring such clauses to be void. See R.F. Carney & A. Cizek, Payment Provisions in Construction Contracts and Construction Trust Fund Statutes: A Fifty-State Survey, 24 Construc. Law. 5 (Fall 2004); M. Alsbrook, Contracting Away an Honest Day's Pay: An Examination of Conditional Payment Clauses in Construction Contracts, 58 Ark. L.Rev. 353, 379-83 (2005).

         Maryland Case Law

         Although the contract in this case is not governed by Maryland law, the Virginia Supreme Court has referenced Maryland law in its own analysis of conditional payment clauses. In order to fully understand Virginia law, it is useful to review the Maryland decisions on which it is partly based.

         This Court has relied upon, and quoted at length from, the Dyer decision in resolving a payment dispute between general contractor and a subcontractor when a project owner has not fully paid the general contractor. See Atl. States Const. Co. v. Drummond & Co., 251 Md. 77, 81-84 (1968); Fishman Constr. Co. v. Hansen, 238 Md. 418, 422-23 (1965). Consistent with Dyer, this Court has stated that such provisions are to be construed as timing provisions - pay-when-paid clauses - unless the contract language clearly indicates that the parties intended otherwise.

         In a decision later relied upon by the Virginia Supreme Court, the Court of Special Appeals considered what language would suffice to shift the risk of owner insolvency from the general contractor to the subcontractor. Gilbane Bldg. Co. v. Brisk Waterproofing Co., 86 Md.App. 21 (1991). In that case, a masonry subcontractor had completed all of the work required under its subcontract on a residential condominium project. The general contractor refused to make the final payment that was due to the subcontractor because the general contractor had not received a payment from the project owner. After the masonry subcontractor's mechanic's lien on the property had been extinguished as a result of the project owner's bankruptcy, the masonry subcontractor sued the general contractor for payment.

         In declining to pay the masonry subcontractor, the general contractor had relied on a subcontract provision which stated, in pertinent part, that "[i]t is specifically understood and agreed that the payment to the trade contractor is dependent, as a condition precedent, upon the construction manager receiving contract payments, including retainer from the owner." 86 Md.App. at 25 (emphasis added in original). The Court of Special Appeals concluded that the reference in the subcontract to owner payment as a "condition precedent" was sufficient to shift the risk of owner insolvency to the masonry subcontractor as a matter of objective contract interpretation, regardless of whether the parties had actually discussed the risk of owner insolvency during their negotiations. Id. at 28.

         Virginia Case Law

         In 1995, the Virginia Supreme Court addressed for the first time the distinction between pay-when-paid and pay-if-paid clauses and whether a particular subcontract provision shifted the risk of owner default from the general contractor to the subcontractors. Galloway Corp. v. S.B. Ballard Const. Co., 464 S.E.2d 349 (Va. 1995). That case arose from the construction of a commercial office complex in downtown Norfolk, Virginia. The general contractor had entered into various subcontracts with suppliers of labor and materials, all of which contained a provision stating that "[t]he Contractor shall pay the Subcontractor each progress payment within three working days after the Contractor receives payment from the Owner." 464 S.E.2d at 352 (emphasis added in original). Each subcontract contained similar language with respect to the final payment due to each subcontractor. Id.

         Work had progressed on the project for nearly two years, when the project owner encountered financial difficulties in the midst of construction. After the owner failed to make three progress payments to the general contractor, construction stopped and lawsuits began. 464 S.E.2d at 352. The subcontractors recovered some of the compensation due them through the satisfaction of mechanic's liens on the project, and sought to recover the remainder through a breach of contract action against the general contractor. The general contractor relied on the payment clause to defend itself from the subcontractors, arguing that it was not liable to the subcontractors because it had not been paid by the owner. Id. at 353. The trial court ruled in favor of the subcontractors, concluding that the payment clause in the subcontracts concerned the timing of payment and did not relieve the general contractor of its liability to the subcontractors.

         On appeal, the Virginia Supreme Court came to a more nuanced conclusion. It discussed the Dyer case at some length and opined that the Sixth Circuit decision was "sound and in concert with traditional notions of the freedom to contract." 464 S.E.2d at 354. It regarded the Dyer case as dealing with contract language that, on its face, reasonably contemplated eventual payment of the subcontractor. The Virginia court contrasted the contract language in Dyer with that in Court of Special Appeals' Gilbane decision, which it regarded as an equally clear example of an instance in which the parties intended to establish a condition precedent to the general contractor's liability. Id.

         In the case before it, however, the Virginia Supreme Court concluded that the contract language was not as clear as in either Dyer or Gilbane. The Court said "there is no additional language here which would permit us to find that the parties contemplated payment 'within a reasonable time[, ]'" as it understood the provision in Dyer. Unlike Gilbane, "nothing in the contracts would permit us to find ... that the parties clearly understood these terms to assert a condition precedent on payment." 464 S.E.2d at 355. As a result, the Virginia Supreme Court concluded that "the phrases 'after the Contractor receives payment from the Owner' and 'has received payment from the Owner' constitute latent ambiguities in the contracts." Id. Because the clauses were latently ambiguous, the court relied on parol evidence to determine the intent and understanding of the parties. It concluded that the general contractor had intended to create a pay-if-paid clause and then assessed the testimony of the various subcontractors at trial as to whether each had the same understanding. The court ultimately concluded that four of the five subcontractors shared the general contractor's understanding of the clause and that the clause was a basis for the general contractor's defense as to the claims of those subcontractors. It therefore reversed the trial court's ruling as to those subcontractors and upheld the judgment in favor of the fifth subcontractor. Id. at 356.

         Summary

         While a minority of jurisdictions regard pay-if-paid clauses as void as against public policy, the majority approach is to recognize both "pay-when-paid" and "pay-if-paid" clauses, with some preference given to construing such a clause as a timing rather than a risk-shifting provision. To distinguish one from the other under Virginia law, a court is to look first to the language of the provision. If the language appears to contemplate that the subcontractor will ultimately be paid, the provision will be construed as a pay-when-paid clause. If the contractual language clearly sets forth owner payment as a condition precedent to the general contractor's liability to the subcontractor, as in Gilbane, it will be construed as a pay-if-paid clause. If the language contains a latent ambiguity, the court looks to parol evidence to determine the intent of the parties.

         B. Facts and Proceedings

         The record in this case discloses the following facts, which are in many respects undisputed, and the resulting legal proceedings that have led to this appeal.

         The Prime Contract

         This case arose out of a construction project undertaken by George Mason University ("George Mason" or "Owner"), a Virginia state university located in Fairfax, Virginia, to renovate a student union building (the "Project"). On July 20, 2010, George Mason contracted with Dustin Construction Inc. ("Dustin" or "Contractor"), a general contractor based in Ijamsville, Maryland, to conduct the renovation ("the Prime Contract"). The Prime Contract consisted of a three-page document setting out the particulars of the Project that was signed by representatives of George Mason and Dustin. That document incorporated various other documents, including a 49-page form attachment setting forth, in 50 multi-part sections, standard general contract terms approved by the Virginia Department of General Services for state government construction contracts.[3]

         A few days later, on July 30, 2010, George Mason issued a "Notice to Proceed" with the Project to Dustin. Although the Prime Contract stated a "Substantial Completion" date of November 15, 2010, [4] the Notice to Proceed set forth a substantial completion date of ...


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