“Show Me the Money”: Who Bears the Risk of Owner Nonpayment? The Contractor or the Subcontractor? . . . Or the Surety?
One frequent dilemma in construction contracting is who bears the financial risk of nonpayment if the owner becomes insolvent or otherwise fails to pay for work performed—the general contractor or the subcontractor? Many general contractors believe that this financial risk should be shifted to the subcontractor and insert such risk-shifting clauses into their subcontracts. On the other hand, and not surprisingly, many subcontractors take the position that their credit risk is with the general contractor (and not the owner) and, therefore, the general should assume the full risk of owner nonpayment. In short, if the owner does not pay the general contractor for work performed by the subcontractor, should the contractor be obligated nonetheless to pay the subcontractor?
This risk is controlled by and dependent on: (1) the subcontract language, in a contingent payment clause; and (2) the law of the governing jurisdiction. A contingent payment clause is a contractual provision that makes payment contingent on the happening of some event. There are two commonly used types of contingent payment clauses:
- The “pay-when-paid” clause is construed as a timing provision, which allows the general contractor to delay payment to the subcontractor until it receives payment from the owner or, if the owner does not pay, within a reasonable period of time. The pay-when-paid provision requires the general ultimately to pay the subcontractor.
- The “pay-if-paid” clause is viewed as creating a condition precedent for payment of the subcontractor: if the owner fails to pay the general contractor, the general is not obligated to pay its subcontractor. This means that the subcontractor assumes the risk of owner nonpayment to the general.
The difference between these two types of contingent payment clauses is significant and impacts both the contractor’s and subcontractor’s financial risk. Ultimately, contingent payment clauses may impact a surety’s risk as well. It is, therefore, crucial that surety professionals and their contractors and subcontractors understand what these terms mean, how they differ from each other, and how they impact contractors’ and subcontractors’ rights and liabilities in the jurisdiction(s) in which they perform work.
This is a complex issue, as not only does the wording of these clauses vary from contract to contract, but also the enforceability and validity of the clauses vary from jurisdiction to jurisdiction.
Courts are reluctant to construe a contingent payment clause as making the owner’s payment a condition precedent to the contractor’s duty to pay the subcontractor because pay-if-paid clauses have serious consequences for subcontractors. Therefore, the approach adopted by a majority of courts has been to construe a contingent payment clause narrowly and, when possible, as a timing provision (that is, a pay-when-paid clause), unless the language of the clause expressly and unambiguously shifts the risk of non-payment to the subcontractor with clear language that payment from the owner is a condition precedent to the general’s duty to pay the subcontractor and/or that the subcontractor is assuming the risk of owner non-payment. If there is any ambiguity in the clause, courts will read it as merely permitting the general contractor to postpone paying the subcontractor for a reasonable time so that that the general can try to procure the funds from the owner. If the clause is construed as a timing provision, then the question becomes how long is the “reasonable period of time” before payment is due. What a reasonable time is for a general to withhold payment to its subcontractor varies from case to case.
Although there are many variations of pay-when-paid clauses, typical such language follows: “The Subcontractor shall be paid within seven (7) days after receipt by the General Contractor of payment from the Owner for Subcontract work.” The main effect of pay-when-paid clauses is to suspend the payment obligation for some reasonable period of time.
Under the minority approach, courts hold that contingent payment clauses that attempt to transfer the risk of owner non-payment to subcontractors are against public policy and are, therefore, unenforceable. The past few years this minority approach has gained some momentum in courts and legislatures. Courts in at least two states, California and New York, have held that pay-if-paid clauses are void as against public policy. Other states have enacted statutes that, to some extent, void such provisions.
In some recent decisions, courts have put a higher standard on contractors seeking to use the pay-if-paid defense. Some of these courts have strained hard to find that the subcontract contained a pay-when-paid clause, asserting, perhaps disingenuously, that the relevant clause/subcontract was ambiguous and did not show a clear intent to shift the risk of the owner’s non-payment to the subcontractor.
A number of courts have found phrases such as “condition precedent,” “if and only if,” and “unless and until” to be sufficient to establish that the contract shifted the risk of non-payment to the subcontractor, providing a pay-if-paid defense for the general. One court that disfavors pay-if-paid clauses found the following language to be a good illustration of a valid pay-if-paid clause:
|Subcontractor agrees that Contractor shall never be obligated to pay Subcontractor under any circumstances, unless and until funds are in hand received by Contractor . . . [t]his is a condition precedent to any obligation of Contractor, and shall not be construed as a time of payment clause.
This example of a valid pay-if-paid clause wisely includes belts and suspenders language. Such language would almost certainly protect a general contractor seeking to shift the risk of owner nonpayment to the subcontractor (except in those jurisdictions where such clauses are void as against public policy).
Then there is the important question of whether the surety could still be liable under the payment bond, if the general was not liable under the pay-if-paid clause in the subcontract. In the past most courts have recognized that, if a general can assert the pay-if-paid defense, then the surety could take advantage of the same pay-if-paid defense to avoid payment. The argument goes as follows: because a payment bond surety stands in the shoes of its bonded principal, it should be able to assert all the defenses of that principal, including the pay-if-paid defense. And, the argument continues, if the general has not defaulted on its obligations to the subcontractor, the surety’s obligation has not been triggered.
Recently, however, some courts have refused to enforce the pay-if-paid clause in favor of the surety because, they claim, it defeats the very purpose of the payment bond, the payment of subcontractors for sums justly due. The tension between two precepts of suretyship creates different outcomes in different courts: (1) a surety’s liability is coextensive with that of its principal; and (2) the remedial purpose of payment bonds is to ensure that certain subcontractors (and suppliers) are paid for work performed (and materials supplied). Therefore, some courts have determined that a surety is liable to a subcontractor on a payment bond even if the bonded principal owes nothing to the subcontractor pursuant to a pay-if-paid defense.
Contractors and sureties should have their subcontracts carefully drafted by knowledgeable construction attorneys licensed in the applicable jurisdiction(s) to determine if they can rely on the contingent payment provisions to avoid bearing the full risk of owner non-payment. On the other hand, subcontractors should have their subcontracts carefully reviewed by knowledgeable construction attorneys licensed in the applicable jurisdiction(s) to determine if the contingent payment clause voids the subcontractor’s right to recover from the contractor and/or the surety.