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Use With Caution: Contingent Payment Clauses
"Pay when paid" versus "pay if paid"
One of a contractor's greatest concerns on a
construction project is making sure he is
paid for his work. When the contract has
been fully performed, everyone wants to be,
and should be, fully paid.
It is not uncommon for a general contractor
to try to shift to subcontractors the risk
of nonpayment by the owner. Consequently,
“pay when paid” and “pay if paid” provisions
are popular with general contractors;
however, they are not so popular with the
courts.
Public policy, both state and federal,
favors protecting a subcontractor’s or
materialman’s right to be fairly compensated
for labor and materials he puts into a
construction project. Mechanic’s lien laws
protect parties that do work on private
projects; payment bonds protect those who
work on federal, state or municipal
projects. The amount due the subcontractor
and the time when it becomes due, however,
are usually determined by the terms of the
contract.
Typical pay-when-paid clauses go something
like this:
“The total price paid to [subcontractor]
shall be [contract price], no part of
which shall be paid until five 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 form the Owner …”
Majority view. 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 that case, Dyer installed plumbing at a
race track owned by the Kentucky Jockey
Club. Bishop was the general contractor on
the job. Their subcontract read:
“The total price to be paid to
Subcontractor shall be $119,000 lawful
money of the United States, no part of
which shall be due until five (5) days
after Owner shall have paid Contractor
therefore …”
Unfortunately, the Jockey Club filed
bankruptcy without paying Bishop for Dyer’s
work. Bishop argued that it was obligated to
pay Dyer only if it was paid by the Jockey
Club. The court disagreed.
In deciding what the subcontract language
“meant,” the court reasoned that general
contractors ordinarily bear the risk that
the owner may become insolvent and thus
unable to pay for the work. It interpreted
the pay-when-paid clause to be a “reasonable
provision” designed to postpone payment for
a “reasonable period of time,” during which
the general contractor would have an
opportunity to collect payment from the
owner. It would be “unreasonable” to require
the subcontractor to wait an indefinite
period of time for payment — i.e., until the
general contractor had been paid by the
owner — which may never occur.
The Arizona view. Arizona has adopted
the Dyer court’s interpretation of
pay-when-paid clauses. Arizona courts look
unfavorably upon a “pay when paid” or “pay
if paid” clause, which must be written very
carefully to be enforceable. The contract
language must plainly state that the
subcontractor agrees to be paid only out of
a specific fund, and, if that fund is
insufficient or never created, he will
forfeit payment for some or all of his work.
For example, in L. Harvey Concrete, Inc.
v. Agro Construction & Supply Co., the
Arizona Court of Appeals held that the
following clause was plain enough to shift
the credit risk to the subcontractor:
[S]ubcontractor
agrees as a condition precedent to payment
… that the owner shall have first paid the
payment … to the contractor, and that
payment for either progress payments or
final payment is not due and owing to the
subcontractor as provided for herein until
the owner has made such payment to the
contractor.
The court held that this language states
plainly that payments from the owner to the
general contractor were the sole source of
funding for the subcontract, and, until the
owner paid the general, no payment to the
subcontractor became due.
Subcontractors should understand that, as a
practical matter, a pay-when-paid or
pay-if-paid clause always creates confusion
about when and if payment becomes due. You
can bet that the general contractor thinks
the clause is binding, and time and money
will be required to prove otherwise.
General contractors should understand that,
at the present time, a pay-when-paid or
pay-if-paid provision can be valid in
Arizona, provided it is properly written and
plainly shifts the risk of nonpayment to
subcontractors. However, courts do not like
these provisions and will try very hard to
find a reason to invalidate them.
“Pay if paid.” How do contractors
satisfy the Dyer ruling in shifting
the burden of owner nonpayment by the owner?
Say it clearly in a contract provision, for
example:
“…
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) …”;
or
“…
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.
No guarantees. Even with that
apparently safe language, though, a
pay-if-paid clause can encounter rough
sledding if judges are of the opinion that
“risk shifting” violates public policy.
The California Supreme Court ruled, in
Wm. R. Clarke Corp. v. Safeco Ins. Co. of
Amer., that pay-if-paid clauses are
unenforceable as a violation of California’s
public policy. 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.
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