Crosno v. Travelers – Payment Bond Claim Voids Surety’s “Pay-When-Paid” Defense

Author: Robert Bernstein

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May 11, 2020 9:00am

The purpose behind a public works payment bond is to provide subcontractors with “a quick, reliable and sufficient means of payment.”  (Cooley v. Freeman (1928) 204 Cal. 59, 62.)

“An owner, direct contractor, or subcontractor may not, by contract or otherwise, waive, affect, or impair any other claimant’s rights under this part, whether with or without notice, and any term of a contract that purports to do so is void and unenforceable unless and until the claimant executes and delivers a waiver and release under this article.”
California Civil Code §8122.

In a decision published on April 17, 2020, amid courthouse closures and stay home orders related to the coronavirus, the California’s Fourth District Court of Appeal, Division One, issued an opinion which affirms that a “pay-when-paid” clause in a subcontract cannot not be raised by the surety issuing a public works payment bond to delay prompt payment of a covered claim to the bond’s beneficiary. (Crosno Construction, Inc. v. Travelers Casualty and Surety Company of America (2020) D075561, D075562). The decision extended the holdings in prior cases, which found that attempts to defeat mechanic’s lien and payment bond claims based on pay-IF-paid provisions in subcontracts were improper as against public policy in the private construction and the public works arenas.

The Set Up

The North Edwards Water District (“District”) chose Clark Bros., Inc. (“Clark”) as general/direct contractor for a public works project to build an arsenic removal water treatment plant. Clark then subcontracted with Crosno Construction (“Crosno”) for the latter to build and coat two steel reservoir tanks. The subcontract included a “pay-when-paid” provision under which Clark agreed to pay subcontractor Crosno for its work within a reasonable time of receiving payment from the District. “Reasonable time” was further defined as, “in no event less than the time Contractor (Clark) and Subcontractor (Crosno) require to pursue to conclusion their legal remedies against Owner (District) or other responsible party to obtain payment  .  .  .  .”

As required by its general contract with the District, Clark obtained a payment bond from Travelers Casualty and Surety Company of America (“Travelers”), to secure the payment of subcontractors and material suppliers at the project upon its failure to make payments. The payment bond obligated Travelers to make payments in the event of default by Clark, and included the recovery of attorney’s fees by the unpaid subcontractors. Crosno was listed by Clark as a subcontractor on the project.

When most of its scope was finished, Crosno was directed by Clark to stop work, due to a dispute between Clark and the District. Crosno then filed a stop payment notice with the District. Two weeks later, Clark advised Crosno that the District terminated the prime contract and that Clark could not pay in excess of $500,000.00 owed for Crosno’s completed work. Crosno submitted a claim to Travelers under the payment bond. Travelers rejected the claim as premature. Travelers cited the pay-when-paid provision in Crosno’s subcontract and asserted that payment was not owed until Clark’s then ongoing lawsuit against the District was resolved.

Crosno then filed suit in Kern County against Clark, the District and Travelers. As to Travelers, Crosno alleged the right to recover on the payment bond.

The Trial Court Decision

At the trial court, Crosno filed a motion for summary judgment against Travelers.  It asserted that the pay-when-paid provision in the subcontract was void and unenforceable because Crosno never impaired its rights under the payment bond by executing a waiver and release, which is the exclusive means to extinguish such rights under California Civil Code §8122. It also argued that Travelers could not assert the pay-when-paid provision in the subcontract as a defense to payment because the payment bond acts as a remedy separate and independent of the subcontract. In response, Travelers argued that §8122 was inapplicable to the facts, because the pay-when-paid provision did not constitute a waiver of Crosno’s payment bond rights (as would be the case with a pay-if-paid provision), but only delayed their exercise. Travelers also argued that, in its role as a surety, the underlying subcontract defined its rights and obligations as to the payment bond.

In granting Crosno’s summary judgment motion, the trial court found that the pay-when-paid provision impermissibly impaired Crosno’s rights under the payment bond, because it violated the policies supporting §8122. It awarded $562,435.00 to Crosno, but stayed enforcement of the ruling for 60 days to allow for settlement negotiations. Crosno moved the trial court for an award of prejudgment interested from the date of submission of its payment bond clam to Travelers, which motion was also granted. Crosno later moved for award of attorneys fees under the bond, and received an award of $22,500.00. Travelers appealed.

Meanwhile, settlement negotiations continued in Clark’s action against the District.  Eventually, the District interplead funds with the trial court sufficient to resolve Crosno’s claim for payment, essentially conceding that the funds were owed, giving them to the trial court to hold in escrow and asking the court to determine the appropriate disposition of them. Although Crosno’s claim for the funds owed for its work was essentially resolved, Travelers pursued its appeal, asking the Court of Appeal to review both the trial court’s prejudgment interest and the attorney fee awards to Crosno.

The Court Of Appeal’s Analysis

The Appellate Court summarized the issue before it as follows:

“ .  .  .  [M]ay a payment bond surety turn to a “pay-when-paid”
provision in a subcontract to delay its bond obligation to a subcontractor until some unspecified point at which litigation between the direct contractor and project owner concludes?”

The Appellate Court reviewed the basis of mechanics liens, which is found in the California Constitution (Cal. Const., art. XIV, §3) and which protects parties who provide value to a property through their labor and/or materials by allowing them to place a lien on the property’s title to insure payment. The Court then noted the statutory framework which supports the recording and enforcement of mechanic’s liens, the need for a similar structure for public works projects which involves stop payment notices and payment bonds (due to sovereign immunity) and referenced prior decisions which held that the parallel frameworks concern the same subject and are construed together.  It then referenced authorities which specify that a payment bond surety’s obligation, “is measured by the terms of the bond and the statutes referenced in the bond,” (Wm. R. Clarke Corp. v. Safeco Ins. Co. (1997) 15 Cal.4th 882, 893), that the terms of such a bond are construed against the issuing surety and in favor of the bond’s beneficiaries (Civil Code §8154(c)), and that Crosno was among those entities who were authorized by statute to pursue recovery under such a bond (Civil Code §9100(a)(1)).

Having established the constitutional and statutory basis for payment bonds, the court then reviewed prior cases which construed the application of pay-if-paid provisions to mechanics liens and to publics works payment bonds.  In the 1997 Clarke v. Safeco decision, the California Supreme Court determined that a surety could not employ a pay-if-paid provision to defeat a subcontractor’s mechanic’s lien claim, because to do so would be in violation of the California Constitution and the statutory mechanic’s lien framework and, thus, against public policy. A Court of Appeal thereafter extended the ruling in Clarke to apply to a surety’s attempt to defeat a subcontractor’s payment bond claim arising out of a public works project when the subcontract included a pay-if-paid provision.  (Capitol Steel Fabricators, Inc. v. Mega Const. Co. (1997) 58 Cal.App.4th 1049, 1061.)

In extending a similar reasoning to the interpretation of a pay-when-paid clause, the Court of Appeal complimented what it termed the trial judge’s “thoughtful analysis” of the issues and authorities. It agreed with the trial judge’s finding that the pay-when-paid provision, by establishing a potentially lengthy and uncertain period during which a subcontractor would not be permitted to enforce its statutory right to recover the value of its work and materials, was void as a violation of the public policy underlying Civil Code §8122. This is because, while explicitly providing for payment to be delayed for a reasonable period after completion of the work, it did not compel payment within a reasonable period, which is the intent of the payment bond framework.

Takeaway

Courts view skeptically any efforts to interfere with longstanding rights, particularly those guaranteed by the California Constitution. Because public works bonds are statutory in nature, special protections apply.  Although parties are entitled to contract in many respects as they see fit, to the extent the provisions of a private contract are applied in such a way that they interfere with rights deemed significant and superior, such contract provisions are void, because they violate public policy. In this instance, Travelers’ attempt to leverage the pay-when-paid clause in a subcontract to defeat Crosno’s payment bond claim failed because it ran afoul of the statutory payment bond structure and protections afforded to subcontractors under the California Constitution.  The Crosno decision reinforces the importance for subcontractors and material suppliers to understand and protect their rights to secure payment, and for sureties to fully evaluate the likelihood and scope of potential exposure when setting bond premiums.

Robert G. Bernstein is Senior Counsel in the San Diego office of Tyson & Mendes. He has practiced law in California for 30 years and is a member of the firm’s Construction Defect and Property Team.  He has wide-ranging litigation experience representing a diverse group of individuals and businesses in California, with a focus on construction and property-related matters.

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