When negotiating a construction subcontract between the contractor and a subcontractor, one of the most important provisions is the payment provision. The date when payment is due from the contractor to the subcontractor, and the question of who bears the risk of loss if the owner fails to render payment even if the subcontracted work has been completed, are important concerns for both parties.
As a matter of public policy, in many states, if a subcontractor performs work, they are entitled to payment – and the contractor’s obligation to pay its subcontractors is not generally contingent upon whether the contractor has first received payment from the owner. Because the contractor has negotiated with, and is presumed to be familiar with, the owner and his or her financial wherewithal, the contractor is seen to be in the better position than the subcontractor to assess the risk of the owner’s non-payment.
Many contractors do try to condition their obligation to pay their subcontractors on the receipt of payment from the owner. The contractor’s success in shifting the risk of non-payment by the owner will depend on how well the payment terms are drafted as well as the state law that will apply to the interpretation of the contract.
‘When’ vs. ‘If’
There are two different types of payment provisions in the construction industry that are often confused with one another: “pay when paid” vs. “pay if paid.” Generally, courts construe “pay when paid” as a provision of timing of payment, requiring contractors to render payment to subcontractors within a “reasonable” time frame, even if the contractor has not yet received payment from the owner. Payment from the contractor is not excused, or conditioned upon, the owner’s payment or lack thereof. In some cases, “pay when paid” clauses specifically state a timing concept. However, even without a specific reference to timing, courts will generally construe such clauses as “pay when paid” timing provisions, meaning the contractor must render payment to the subcontractor within a reasonable time regardless of whether the contractor has previously been paid by the owner. What is a “reasonable” time frame will depend on the facts at hand and case law in the applicable jurisdiction, as well as prompt payment laws that may dictate the time by which contractors – and subcontractors – must be paid.
In order for a contractor to shift to its subcontractors the risk of the owner’s non-payment, the subcontract must be clear and unequivocal in the subject payment terms. By way of example, some courts have enforced “pay if paid” clauses that state, in effect, “it is expressly understood and agreed that the payment to the subcontractor is dependent on the contractor receiving payment from the owner, and the owner’s payment to the contractor is a condition precedent to contractor’s obligation to pay the subcontractor.” Given the public policy against this shifting of risk to subcontractors, some courts have gone further in what is required, such that an enforceable “pay if paid” clause must state in so many words that the “subcontractor is assuming and accepting the shifting of the risk of owner’s non-payment to subcontractor.”
If the attempted “pay if paid” clause is not clear and unambiguous, then courts have interpreted such clauses as “pay when paid” provisions, with the contractors remaining responsible for payment to its subcontractors and retaining the risk of the owner’s non-payment.
In some jurisdictions, even the most carefully crafted “pay if paid” clauses will not be enforced, whether by contrary legislation or by court ruling. In many of these jurisdictions, “pay if paid” clauses are seen as eliminating or impairing the subcontractor’s lien rights. If the subcontractor cannot file a lien against a project until payment is due, and by the terms of the subcontract payment is only due if and when the contractor has been paid by the owner, courts and legislatures fear that a subcontractor may never have a “ripe” lien claim. Others that will enforce a properly drafted “pay if paid” clause overcome this hurdle by construing the relevant construction lien law to interpret “when payment is due” to mean when the work is completed. Such jurisdictions generally view the lien claim as a right against the owner and the project that is independent of the contractual obligation of the contractor to pay the subcontractor.
Some state legislatures and courts, however, have taken the view that even the most clearly stated “pay if paid” provisions are so contrary to public policy that such provisions have been, by statute or by judicial decision, deemed unenforceable.
Accordingly, it is critical for any contractor seeking to shift to its subcontractors the risk of a project owner’s non-payment to understand and know the laws of the state by which the subcontract will be governed. Even with subcontractors who unwittingly or willingly accepted even a clearly crafted “pay if paid” clause, there is the possibility of recovering payment from a contractor “within a reasonable time frame” even if the owner has failed to render payment. Subcontractors can press to limit when such clauses will apply. Considering these factors while negotiating the payment provision in your contract, can go a long way to protect yourself and your project against an owner’s non-payment.