Construction Law

This article appeared in the October 2003 issue of "The Construction Advisor" published by Lang Baker & Klain, PLC. Free Subscription to the Construction Advisor View the Construction Advisor index

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. Mechanics' 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.