Twist in Pay-if-Paid Contracts

by Robert C. Angelillo

A pair of conflicting decisions at the state appellate court level in New York has one standard applying to the Bronx and Manhattan and another to Brooklyn, Queens, Long Island, and Westchester County.

Last year, a state appellate court in Manhattan slightly cracked a ban on the use of "pay-if-paid" subcontracts in New York that had been established under a 1995 state court decision. Now, another state appellate court in Brooklyn has entered the fray, issuing a decision that conflicts with its Manhattan counterpart - potentially setting up a showdown that will once again try to settle this thorny area of contractual law.

In 1995, the state's highest court had found that "pay-if-paid" contracts - which permit general contractors awaiting payment from a project owner to withhold payment from their subcontractors until the owner pays out - to be against the public policy of New York and unenforceable. That decision, West-Fair Electric Contractors v. Aetna Casualty and Surety Co., had clarified this area of law for the last decade.

But in a surprising decision, the Appellate Division First Department in Manhattan ruled early last year in Hugh O'Kane Electric Co., LLC v. Mastec North America, Inc., that the public policy "shield" established in the West-Fair case had limits.

In that case, Mastec, a Florida-based general contractor, had not received payment from the owner of a construction project involving telecommunications installation in New York City, and had not paid Hugh O'Kane, its subcontractor. Mastec relied on a "pay-if-paid" provision in its contract with Hugh O'Kane to withhold payment from the subcontractor because it had not received payment from the owner. Hugh O'Kane sued, arguing that the "pay-if-paid" provision was unenforceable under West-Fair.

But the contract stated that Florida law applied, and in Florida, "pay-if-paid" subcontracts are allowed. The Manhattan court found that the public policy referred to in West-Fair was not "fundamental" enough to prevent application of the Florida law. As a result, Hugh O'Kane was out of luck and the "pay-if-paid" clause in the contract was enforced, meaning it could not collect its payment from Mastec.

Now, however, an appellate court in Brooklyn has joined the fray in a case entitled Welsbach Electric Corp. v. Mastec North America, Inc. Faced with the same issue of a contract governed by Florida law - and, in fact, the same general contractor, Mastec - the Appellate Division Second Department in Brooklyn ruled that the public policy "shield" West-Fair established is strong enough to prevent Mastec from enforcing the "pay-if-paid" clause to avoid paying its subcontractor, Welsbach. This conclusion is directly opposite to the Hugh O'Kane decision.

What does this mean for contractors and subcontractors? In one sense, it means that contractors and subcontractors arguing this issue must take into account the jurisdiction in which their legal action has been filed, or if they have not yet sued or been sued, the jurisdiction that they would want to handle it. The reason is that the Hugh O'Kane decision applies to all court cases filed in Manhattan or the Bronx, while the Welsbach ruling applies to cases filed in Brooklyn, Queens, Long Island, and Westchester, among other places.

If the case is in the Brooklyn appellate section, even if the contract is governed under another state's law that permits "pay-if-paid" clauses, the provision will not be enforced. However, if you are in court in Manhattan or the Bronx under the same circumstances, the "pay-if-paid" contract will be enforced. Therefore, the location of the court is critically important.

Beware that plaintiffs cannot simply pick the court to sue in to make sure that they get the result they want. First, many contracts specify the court that would hear any lawsuits related to the transaction. Second, the location of the project itself may very well determine where a case has to be brought.

Even if the contract or project location does not determine the proper court, parties are not free to go into court wherever they want. A number of factors are involved, including where each party's offices are located. If a plaintiff chooses the wrong court for any reason, the court can transfer the case to the correct forum.

Down the road, the Welsbach case seems to have set the stage for a showdown between the Manhattan appellate decision and the Brooklyn appellate decision in the Court of Appeals, the state's highest court, which has the power to render a statewide ruling on the issue. Any such decision would hopefully clarify the status of "pay-if-paid" subcontracts that are controlled by another state's law. At the moment, however, it is not clear if and when this will happen.

As a final point, the Welsbach decision does not affect a recently enacted New York statute that makes it illegal to have another state's law apply to most construction contracts. This law affects contracts that were effective on or after January 14, 2003 for work on projects that started after that date.

In cases where the statute applies, the "pay-if-paid" issue is moot because the court will not apply another other state's law at all, meaning any "pay-if-paid" clause would not be enforced. However, with older contracts, from before January 14, 2003, the other state's law will be considered in jurisdictions where Hugh O'Kane applies.

For now, until the state's highest court settles the matter, knowing how these decisions would affect a particular case ultimately hinges on when the project took place and what court in New York is hearing the case.

Robert Angelillo is an attorney practicing construction law and litigation at Meyer, Suozzi, English & Klein, a law firm based in Mineola, N.Y.