“Industry Insight” articles like this one below are submitted to NASBP by those knowledgeable of important industry topics who are providing their insight for the benefit of NASBP members, affiliates, and associates.

Pay If Paid Provisions in Subcontracts—Who Bears the Risk of Owner Nonpayment: the General Contractor or the Subcontractor?Pay If Paid and Pay When Paid clauses in subcontract agreements are not new developments, but the scrutiny they have recently received may make them seem so. The prolonged economic slowdown continues to produce failed real estate developments, and the contractors and subcontractors who worked on these projects all line up to file their mechanics liens to secure their unpaid work. Bonded general contractors also face claims against their payment bonds from unpaid subcontractors. The attempts by unpaid subcontractors to collect for the work they have performed has brought renewed attention to two provisions that are frequently buried in the general conditions of a subcontract agreement: the “Pay When Paid” and “Pay If Paid” clauses. The impact of a failed development and the application of a Pay If Paid clause can be financially devastating to both general and subcontractors.

What Are Pay If Paid and Pay When Paid Clauses?

Pay When and Pay If Paid language is found in subcontract agreements and is a tool used by the general contractor to determine when monthly progress payments are due to the subcontractor; to manage the credit risk presented by the project owner; or to control exposure to its subcontractor’s claims for compensation for additional work. The two clauses appear similar but they are quite different.

The Pay When Paid provision establishes when a subcontractor’s progress payment is due from the general contractor. A typical clause will state that “payment to the subcontractor is due within 7 days of the receipt by the general contractor of its payment from the owner.” This language is considered by the courts to be a timing provision and the language does not shift the risk of owner nonpayment—as when the owner/developer goes bankrupt—from the general contractor to the subcontractor. That means that the subcontractor can hold the general contractor ultimately responsible for payment. This has clear implications to the general contractor’s payment bond surety. If the owner goes bankrupt and is unable to pay the general contractor, the Pay When Paid language will not protect the payment bond surety and the surety can find itself liable for the credit risk presented by the owner as well as the risk posed by its bond principal. To address this issue, Pay If Paid language was developed.

A Pay If Paid clause provides that payment to the subcontractor is due only if the general contractor receives payment from the owner. The Pay If Paid clause almost always includes language declaring the intent of the parties to the subcontract to shift the burden of nonpayment by the owner to the subcontractor. This language mostly comes into play in cases of a subcontractor’s request for payment for extra work. In that case, the language means that general contractor owes the subcontractor only if the request for additional compensation is approved by the project owner. The general contractor is not separately liable for the cost of the work. However, the language can also apply when the project owner files for bankruptcy and fails to pay the general contractor. Now, the subcontractor may find that it is unable to collect for its base contract work even though there is no dispute.

Is Pay If Paid Enforceable?

In reviewing a claim involving a Pay If Paid, a surety will rely on the time-honored rule that a defense of the principal is a defense to the surety. A subcontractor making a claim against a payment bond may find that a Pay If Paid clause is a defense to a claim because, the surety will argue, the general contractor’s liability has not ripened and, therefore, the surety has no obligation either.

Some courts have been hostile to the Pay If Paid clauses while other courts have enforced it. Courts deciding claims under the federal Miller Act, which involve federal projects, have generally not enforced the clause when there is a surety involved. The general contractor will be subject to this ruling by virtue of its indemnity obligations to the surety. State Courts hearing claims under state public works statutes as well as private projects are split. Some state courts have enforced the contract as written—even though it appears harsh to the subcontractor. Other state courts have ruled that it is against public policy, which refuses to enforce contracts that result in forfeiture, especially in cases where the clause contains a waiver of the subcontractor’s mechanics lien rights. Finally, several state legislatures have passed statutes that prohibit the enforcement of these clauses. Others are reportedly considering similar statutes. In summary, the defense may not be available to the surety depending upon where the project is located and who is the owner.

Implications for General Contractors

A Pay If Paid clause can be an effective tool during difficult economic times for a general contractor seeking to reduce its risk to a financially shaky owner. By inserting this clause into its subcontracts, the general contractor can obtain some protection from the claims of downstream subcontractors in the event of an owner bankruptcy. This can also protect the general contractor against claims for compensation for extra work that the owner denies. In these cases, the clause will afford some protection against the dispute. General contractors should be aware of the limitations.

Implications for Subcontractors

Subcontractors, on the other hand, should be wary of accepting a subcontract with such language. Subcontractors should try to have these deleted from the contract, especially as it applies to owner defaults. Subcontractors are rarely in a position to negotiate financial terms with the project owner and are, therefore, simply not in a position to make a sound judgment regarding the risk they are taking regarding an owner default. As applied to a subcontractor’s claims for extra work, this provision is fairly standard and does not represent any additional risk than is traditional. It is the credit posed by the owner that is the issue. Whether or not the general contractor is willing to negotiate a modification of the clause is a major issue. The success a subcontractor has with a modification will be a combination of factors: the existing relationship with the general contractor and, of course, the competitiveness of the market.

Implications for Sureties

Depending on the type of project and its location, the most significant result to a surety is that the traditional right of the surety to assert any defense that its principal has may not apply. In these jurisdictions, the application of the indemnity may effectively void the general contractor’s ability to rely on the defense because of the obligations contained in the indemnity agreement.

What Should Agents Tell Their Customers?

Most important, the bond principal needs to understand that the clause may not be enforceable and that they still may be liable to a subcontractor—or to the surety under the indemnity agreement. The earlier this message is provided to the principal, the more time the bond principal will have to analyze its implications. And of course, the bond principal should always cooperate with its surety during the investigation of a claim. If the clause appears in connection with the application for a subcontract bond, the subcontractor should be advised of the potential results and explore the possibility of negotiating some modification of the clause. In all instances, the advice of counsel experienced in construction matters should be sought so that the client can determine how the clause will apply to its project.

To learn more about Pay If Paid and Pay When Paid clauses, purchase the audio recording of the NASBP Virtual Seminar on this topic by clicking here. The NASBP Virtual Seminar was presented November 29 by James E. Rudnik, Esq., of Cashin Spinelli & Ferretti, (the author of this article) and John Morris, Esq., of McElroy Deutsch Mulvaney and Carpenter.

The opinions expressed in this article are those of the authors and do not necessarily represent those of NASBP.

The author of this article is James E. Rudnik, Esq. who is the Regional Manager of Cashin Spinelli & Ferretti, LLC and an officer of NASBP member Rudnik Surety, Inc. Rudnik’s career in the surety industry has spanned over 30 years. Rudnik can be reached at JRudnik@csfllc.com or (215) 392-4450. Cashin Spinelli & Ferretti, LLC, http://www.csfllc.com/ is a multi-disciplinary consulting firm to the surety and construction industries.