Pay When Paid or Pay if Paid Provisions

posted by Michael Fortney  |  Dec 15, 2009 10:02 PM in Construction Law

One of the greatest concerns and risks on a construction project is payment by the owner.  Once the contract work has been fully performed, everyone wants to be, and should be, fully paid.  One of the risks of nonpayment is the owner's potential inability to pay.  Contractors need to agree on who bears the risk of nonpayment – the general contractor or the subcontractor.  

Contractors routinely try to shift the burden of nonpayment to subcontractors.  "Pay when paid" and "pay if paid" provisions are popular. Most pay when paid clauses only serve to delay the time for payment to the subcontractor, whereas a properly worded pay if paid clause may actually shift the burden of nonpayment to the subcontractor.

Typical pay when paid clauses provide something like:

"The total price paid to [subcontractor] shall be [contract price], no part of which shall be paid until 5 days after payment is received from owner."

or

". . . the Contractor shall pay the Subcontractor each progress payment and final payment . . . within three working days after he receives payment from the Owner . . . ."

In Thos. J. Dyer v. Bishop International Engineering Co., the Sixth Circuit U.S. Court of Appeals refused to enforce a pay when paid clause.  In Dyer, a general contractor was not paid on a project after the owner declared bankruptcy.  The general contractor, in turn, did not pay its subcontractor for the work it performed.

The Sixth Circuit held that conditions on payment are enforceable, so long as such conditions are clearly expressed.  In construing the clause that "no part [of payment] shall be due until five days after the owner shall have paid the contractor", the court decided that the clause was sufficiently ambiguous to require examination of the parties' intent.

In examining the parties' intent, the court noted that general contractors normally bear the risk of nonpayment due to insolvency.  The court held that this normal relationship could be varied only with clear and unequivocal language.

Accordingly, the court held that the pay when paid clause was only effective to delay payment "for a reasonable period of time after the work was completed, during which the general contractor would be afforded the opportunity of procuring from the owner the funds necessary to pay the subcontractor."

Ohio courts have followed the Dyer rule.  In Power & Pollution Services, Inc. v. Suburban Power Piping Corp., the Cuyahoga County Court of Appeals reversed the trial court's dismissal of a subcontractor's claim against a general contractor after the owner, LTV Steel, declared bankruptcy.  The subcontract contained the language that the general contractor "shall not be required to pay such monthly billing of the subcontractor prior to the date Company receives payment of its corresponding monthly billing from the Owner."

How do contractors shift the burden of nonpayment by the owner?  Say it clearly in a contract provision.  

What should be said?  The contract should state that

  1. the subcontractor is paid only if the general contractor is paid, (or the subcontractor will not be paid unless the general contractor receives payment from the owner); and 
  2. the subcontractor assumes the risk of nonpayment by the owner due to insolvency or other inability to pay.

Such contract language has been held by many courts to sufficiently shift the burden of nonpayment to the subcontractor.

Some states, however, have held that such risk shifting violates public policy.  The California Supreme Court has ruled "pay if paid" clauses are unenforceable as a violation of California’s public policy.  Wm. R. Clarke Corp. v. Safeco Ins. Co. of Amer., 938 P.2d 372 (Cal. 1997).  The court noted that a "pay if paid" clause is an indirect forfeiture of a subcontractor’s constitutionally protected lien rights.  The New York high court has likewise concluded that "pay if paid" clauses are void as against public policy.