The million-dollar (or more) question

Aug. 2, 2018

On the veracity of contingent payment options for subcontracts

On heavy-highway projects, subcontractors typically perform about half, and even up to 70%, of the work required.

That percentage is even greater within the building construction industry as many prime contractors focus solely on project management and do not self-perform work. The mere presence of a middleman between the owner and subcontractors can get complicated at times—especially when it comes to getting paid.

No necessary linkage exists between an owner’s duty under the prime contract to pay the prime contractor and a subcontractor’s entitlement to payment for work it performs. In the absence of an agreement to the contrary, a subcontractor that has completed its work is entitled to be paid regardless of whether or not the prime has been paid by the project owner.

Over the last 50 years, prime contractors began to include contingent payment provisions in their subcontracts. Those provisions would typically state that the prime is not obligated to pay the subcontractor until some specified number of days after the prime receives payment from the owner. Thus, for example, a storm drainage subcontractor would not necessarily receive payment from the prime upon completion of a run of pipe but would be required to await the prime’s receipt of payment from the owner for that work. The million-dollar (or more) question arose when, for whatever reason, the project owner never paid the prime for the subcontractor’s work. Could the prime escape liability to the subcontractor, or must the prime nevertheless pay the sub?

Such clauses can be viewed in one of two ways. First, they could be construed as simply a timing provision—i.e., allowing the prime to delay payment to the subcontractor until after it receives payment from the owner or, if that does not occur, some other period deemed reasonable. However, it does not relieve the prime of its obligation to ultimately pay the subcontractor for its work. Although courts are inconsistent in their nomenclature, I will refer to this as the Pay-When-Paid approach.

The second possible interpretation would view the clause as creating a condition precedent for payment of the subcontractor—i.e., if the owner fails to pay, then the prime is not obligated to pay the subcontractor. Under the latter approach, the subcontractor is viewed as assuming the risk of owner non-payment to the prime. This is a Pay-If-Paid clause.

As litigation ensued over such clauses, court interpretations fell into two categories. Under what has frequently been described as the majority approach, a court will construe such a clause narrowly and interpret it to be a payment-timing provision (i.e., a Pay-When-Paid), unless the language of the clause expressly shifts the risk of non-payment by using clear and unambiguous language stating, for example, that payment from the owner is a condition precedent to the prime’s duty to pay the subcontractor and/or that the subcontractor is assuming the risk of owner non-payment. The majority approach appears to be based, at least in part, on a general principle that disfavors construing a contract provision to result in a forfeiture, particularly when the condition precedent is outside the control of the party at risk of forfeiture.

Under the minority approach, courts are concerned less with the language used and hold that clauses purporting to transfer the risk of owner non-payment to subcontractors, who they reason are in the poorest position to control that risk, are against public policy and, therefore, unenforceable.

At least two state courts (New York and California) have held that Pay-If-Paid clauses, even if unambiguously stated, are void as against public policy. Seven other states’ legislatures (Massachusetts, North Carolina, South Carolina, Maryland, Illinois, Missouri and Wisconsin) have passed statutes which, to varying degrees, make such provisions null and void.

Historically, sureties defending subcontractor payment bond claims have “stood in the shoes” of their prime contractor principals and thus have been able to avail themselves of all prime contract defenses, including Pay-If-Paid. However, a more recent trend has some state and federal courts rejecting the Pay-If-Paid defense for sureties because they view it as defeating the very purpose of the payment bond.

In order to fully understand the risks being taken with respect to payments, both contractors and subcontractors must closely scrutinize the language of their payment clauses and familiarize themselves with the law regarding Pay-When-Paid and Pay-If-Paid clauses in states in which they work.

About The Author: Caudle is a principal in Kraftson Caudle LLC, a law firm in McLean, Va., specializing in heavy-highway and transportation construction. Caudle can be contacted via e-mail at [email protected].

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