Over the last four years we’ve all had to deal with the funding crashes that followed the 2008 financial crisis. In those four years, many have also learned the difference between pay-if-paid clauses and pay-when-paid clauses. But what is the difference between the two, when should each one be used, and why should it matter to you?
If you’re a contractor, subcontractor, or sub-subcontractor, you should take the time to find out how and if a pay-when-paid and pay-if-paid clause will effect you. As a contractor, how you word your contract could mean financing a project for an insolvent owner that never pays you. As a subcontractor, if the owner goes out of business you may never get paid for work you do if the contractor never gets paid. In many states, all this depends on some simple wording.
We’ll explain what a pay-if-paid and what a pay-when-paid clause is one at a time so you can compare the differences:
Pay When Paid Clauses
The phrase “pay-when-paid” is deceiving: most people believe pay when paid means that if the contractor does not receive payment from the owner, then he has no obligation to pay his subcontractor. However, most courts have interpreted “pay-when-paid” as timing provisions. In New York, for instance, the court has defined pay-when-paid clauses as permitting a delay in payment for a reasonable period of time. In short, courts refuse to permit the risk of non-payment to be shifted to the subcontractor based on pay when paid provisions. According to an article titled “Pay-If-Paid Clauses: Freedom of Contract or Protecting the Subcontractor from Itself?“,written by William M. Hill and Mary-Beth McCormack in the Construction Lawyer, Winter 2011 edition, when interpreting pay-when-paid clauses, Courts usually point to the “harsh effects of ‘conditions precedent’, and a general policy of avoiding them if other reasonable readings of a contract is possible.”
Courts have not uniformly construed “pay-when-paid” clauses. One of the premiere cases “that squarely addresses the issue is Seal Tite Corp v. Ehret, Inc., 589 F.Supp. 701 (D.N.J. 1984). In Seal Tite, the court, following the reasoning expounded in the Sixth Circuit case, Thos. J. Dyer Co. v. Bishop Int’l Engineering Co., 303 F.2d 606 (6th Cir. 1962), construed a subcontract “pay-when-paid” provision as postponing payment for a reasonable period of time rather than a conditional promise to pay by the general contractor. The court explained that because the payment clause did not make reference to the possibility of the owner’s insolvency, but did refer to the amount, a time and method of payment, the clause was merely a provision affording the general contractor a reasonable time to procure from the owner the funds necessary to pay the subcontractor. Seal Tite, 589 F.Supp. at 704 (quotations omitted). Ultimately, the court’s determination turned on whether there is any indication in the payment clause that the subcontractor would undertake any risk in the event the owner of the project would become insolvent. Id. Simply put, there must be express language clearly showing the intention of the parties to shift the risk. Id. The Dyer approach has been recognized as the leading decision in this area. Lafayette Steel Erectors, Inc. v. Roy Anderson Corp., 71 F. Supp. 2d 582, 587 (S.D. Miss. 1997) (“Dyer has been cited and relied upon repeatedly . . . .”); Mrozik Constr., Inc. v. Lovering Associates., Inc., 461 N.W.2d 49, 51 (Minn. Ct. App. 1990) (describing Dyer as “a leading case on which the Restatement [(Second) of Contracts] illustration was based”); Watson Constr. Co. v. Reppel Steel & Supply Co., 598 P.2d 116, 119 (Ariz. Ct. App. 1979) (terming Dyer “a leading decision in this area”).” See Fixture Specialists, Inc. v. Global Construction, LLC
Pay-If-Paid Clause – Majority Rule
Pay-if-paid clauses are generally enforced by courts. Two big exceptions to the enforcement of pay-if-paid clauses are New York and California, which have held that pay-if-paid clauses are unenforceable and against public policy. Let’s deal with the majority rule first though.
Enforcing pay-if-paid clauses is more palatable to courts because there is no “condition precedent” to payment. The contract’s pay-if-paid generally clearly states that payment to the subcontractor is to be directly contingent upon the receipt by the general contractor of payment from the owner. In MidAmerica Const. Management Co., Inc. v. Mastec North America, Inc., 436 F.3d 1257 (10th Cir. 2006), the Federal Court for the Tenth Circuit first noted the distinction between “pay-when-paid” and “pay-if-paid” clauses:
A typical “pay-when-paid” clause might read: “Contractor shall pay subcontractor within seven days of contractor’s receipt of payment from the owner.” Under such a provision in a construction subcontract, a contractor’s obligation to pay the subcontractor is triggered upon receipt of payment from the owner. Most courts hold that this type of clause at least means that the contractor’s obligation to make payment is suspended for a reasonable amount of time for the contractor to receive payment from the owner. The theory is that a “pay-when-paid” clause creates a timing mechanism only. Such a clause does not create a condition precedent to the obligation to ever make payment, and it does not expressly shift the risk of the owner’s nonpayment to the subcontractor. . . .
A typical “pay-if-paid” clause might read: “Contractor’s receipt of payment from the owner is a condition precedent to contractor’s obligation to make payment to the subcontractor; the subcontractor expressly assumes the risk of the owner’s nonpayment and the subcontract price includes this risk.” Under a “pay-if-paid” provision in a construction contract, receipt of payment by the contractor from the owner is an express condition precedent to the contractor’s obligation to pay the subcontractor. A “pay-if-paid” provision in a construction subcontract is meant to shift the risk of the owner’s nonpayment under the subcontract from the contractor to the subcontractor. In many jurisdictions, courts will enforce a “pay-if-paid” provision only if that
language is clear and unequivocal. Judges generally will find that a “pay-if-paid” provision does not create a condition precedent, but rather a reasonable timing provision, where the “pay-if-paid” provision is ambiguous.
Pay-If-Paid Minority Rule
Regardless of the language used in the pay-if-paid clauses, courts in New York and California will not enforce such clauses, holding the clauses to be void and unenforceable as contrary to public policy.” Interestingly, the courts based their decisions on New York’s mechanics lien law and California’s mechanics lien law. In so finding, the courts held that conditional payment provisions effect an indirect waiver of a subcontractor’s protected mechanics’ lien rights.
In yet some other states, pay-if-paid clauses have been outlawed by statute: generally in the “prompt payment” acts that have been enacted throughout the country. Over 32 states have some type of prompt payment act, which requires timely payment of amounts due from contractors to subcontractors. Massachusetts is one of these states, voiding any pay-if-paid clauses for projects worth over three million dollars, unless the project involves residential construction consisting of 4 or fewer dwelling units. Illinois, Maryland, Missouri, Wisconsin, North Carolina and South Carolina have banned pay-if-paid clauses for all private projects.
An age old story in construction is as follows: the owner doesn’t pay the contractor, and a subcontractor, who has performed its work diligently and according to its contract, doesn’t get paid either.
Most of these situations arise because the subcontract contains “pay when paid” or “pay-if-paid” clauses. These clauses shift the risk of nonpayment from a general contractor to its subcontractors.
What Is a “Pay-If-Paid” Provision?
When used, “pay-if-paid” provisions are typically found in contracts prepared by contractors between themselves and subcontractors. A pay-if-paid provision makes a general contractor’s payment to a subcontractor conditional-dependent on whether the owner first pays the general contractor. Some examples of these provisions are as follows:
“Receipt of funds by contractor from owner is a condition precedent to the contractor’s obligation to pay subcontractor, regardless of the reason for owner’s nonpayment. Contractor shall have no obligation, legal, equitable or otherwise, to pay subcontractor for work performed by subcontractor unless and until contractor is paid by the owner for the work performed by the subcontractor. Furthermore, in the event contractor is never paid by owner for subcontractor’s work, then subcontractor shall forever be barred from making, and hereby waives, in perpetuity, any claim against contractor therefor.”
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“Subcontractor agrees and acknowledges that payment of the subcontract sum shall be made only from funds which are due from owner that contractor has actually received in hand from owner and designated by owner for disbursement to subcontractor. Subcontractor agrees to look solely to such funds for payment. Subcontractor agrees that contractor shall have no liability or responsibility for any reason whatsoever for any amounts due or claimed to be due to subcontractor except to the extent that contractor has actually received funds from owner that are due from owner specifically designated for disbursement to subcontractor. “
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“Subcontractor agrees that contractor shall never be obligated to pay subcontractor under any circumstances, unless and until funds are in hand received by contractor in full, less any applicable retainage, covering the work or material for which subcontractor has submitted an application for payment. This is a condition precedent to any obligation of contractor, and shall not be construed as a time-of-payment clause.”
These provisions are popular among contractors because they shift the risk of an owner’s nonpayment down the chain to subcontractors. While subcontractors try to avoid these provisions, the provisions have become standard in the construction industry and subcontractors usually have the choice of agreeing to “pay when paid” or not taking the job.
The question is whether these clauses are even enforceable, and the answer depends on what state you are in, and how the clause is written.
Courts are generally split on whether pay-if-paid provisions are enforceable. New York, Nevada and California have found pay if paid provisions unenforceable because they constitute waivers of mechanics’ lien rights. The reasoning used by the California court was that pay-if-paid provisions have the practical effect of acting as an express waiver of statutory lien rights-rights that could not be waived, except in limited circumstances, according to the state’s statute.
In addition to ruling by courts declaring pay if paid provisions unenforceable, the following states have enacted statutes have declared paid if paid contract clauses void: Nevada, Illinois, Maryland, Missouri, North Carolina, and Wisconsin.
The states that have taken the opposite approach, explicitly allowing pay if paid provisions in subcontractors, have done so on the theory that commercial enterprises should have the liberty to contract, a freedom with which the State should not interfere. Among these states are Connecticut, West Virginia, New Mexico, Texas, and New Jersey.
As always, there are states that are on the fence. Florida, Louisiana, Indiana, Iowa, Kentucky, Massachusetts, Minnesota, Nebraska and South Carolina, Ohio, and Tennessee have found that pay-if-paid provisions set a fixed time for payment to the subcontractor, but that the subcontractor does have unconditional right to payment within a reasonable time.
For more information on this topic, take a look at the following articles, which discuss “pay if paid” and “pay when paid” clauses in more detail.