Pay if Paid – Much Ado About Nothing?
Every few months I come across a scholarly-written legal article decrying the injustices of a "pay if paid" clause in subcontracts. Perhaps the time is right to revisit what effect this controversial provision actually has on subcontractors seeking payment.
1. "Pay if paid" versus "pay when paid" Clauses.
A pay if paid clause makes payment to the subcontractor expressly conditional on the general contractor obtaining payment from the project owner.
- Sample "pay if paid" clause:
It is agreed that as a condition precedent to any payment by Contractor to Subcontractor hereunder the Contractor must first receive payment from the Owner for the Work of Subcontractor for which payment is sought. Subcontractor specifically agrees that it is relying upon the Owner's credit (not the Contractor's) for payment, and Subcontractor specifically accepts the risk of non-payment by Owner. AGC of Washington Subcontract 2009 Edition.
By contrast, a "pay when paid" provision states that the subcontractor will be paid at a time certain regardless of whether the owner ever pays the general contractor.
- Sample "pay when paid" clause:
It is agreed that payment by Contractor to Subcontractor hereunder is not due until 10 days after payment has been received by Contractor from Owner, or until after the passage of a reasonable time from which payment from Owner is due, whichever is sooner. "Reasonable time" as used herein shall not exceed 90 days. AGC of Washington Subcontract 2009 Edition.
Thus, the subcontractor will be paid no later than 90 days after payment from the owner is due regardless of whether the general contractor is ever paid.
2. Rationale of the two clauses:
- Reason for the "pay when paid" provision: The general contractor is the party in the best position to directly investigate and determine the owner's ability to pay for construction work and to bargain for and secure protection against insolvency or non-payment. The general contractor is better able to assess the credit risk of the owner and adjust its contract price to reflect that risk than would be any of the subcontractors or suppliers.
- Reason for the "pay if paid" clause: The general contractor is not the financial guarantor of the subcontractor’s payment. The subcontractor can in its price take that risk into account. The risk of nonpayment should be shared by all participants in the construction process and ultimately paid by the owner—the entity that should be accountable for this risk.
Most subcontractors and suppliers acknowledge some shared risk in the eventuality of an owner insolvency and can take that into account in the pricing of the project.
3. Where's the beef?
The major opposition to a "pay if paid" provision seems to center on the circumstance in which the owner does not pay because the general contractor has somehow mismanaged the project or fails to pay due to another subcontractor’s breach (such as faulty workmanship). Under this circumstance, the innocent subcontractor seeking payment will never get paid unless the dispute with the owner is resolved in favor of the contractors. If the dispute is resolved against the general contractor (or other breaching subcontractor), the innocent subcontractor never gets paid.
Washington, Oregon and Alaska have not squarely dealt with this legal issue. There are a number of "pay when paid" cases in Washington and Oregon but no decisions taking on a "pay if paid" clause to determine whether, in the event that non-payment of the owner is solely due to the general contractor (or another subcontractor under its control), the innocent subcontractor will forfeit its payment right.
A. Legislative solutions in other states. A number of states have addressed and expressed their disfavor of conditional payment clauses in legislation.
- North Carolina: N.C. Gen. Stat. § 22C-2 (1991) "Payment by the owner to a contractor is not a condition precedent for payment to a subcontractor…"
- Wisconsin: Wis. Stat. § 779.035 (1992) "[P]ayment to a general contractor from a person who does not have a contractual agreement with the subcontractor or supplier is not a condition precedent to a general contractor’s payment to a subcontractor or a supplier."
- Maryland: Md. Real Prop. Code § 9-133 (1994) "A conditional payment clause is not a defense to a claim brought under the Lien Act."
- Illinois: Il. Stat. Ch. 77 § 60/21 (1994) "A conditional payment clause is not a defense to a claim under the Lien Act."
- Missouri: Mo. Stat. § 431.183 (1995) "A conditional payment clause is not a defense to a claim brought under the Lien Act."
B. Judicial treatment of the pay if paid provisions. Courts in some jurisdictions have held that conditional payment clauses that abrogate a subcontractor's lien rights are void and unenforceable as contrary to public policy.
- West-far Electric Contractors v. Aetna Casualty & Surety Company, 661 N.E.2d 967, 972 (NY 1995).
- WRM Clark Corp. v. Safeco Ins. Company of America, 938 P.2d 372, 374 (Cal. 1997).
- OBS Company v. Pace Construction Corp., 558 So.2d 404, 406 (Fla. 1990).
There are a number of other states in which courts have reached the same or similar conclusions where the "pay if paid" provision collides with the remedial nature of lien statutes.
C. Existing remedies. Generally the interpretation of construction payment terms should be such that forfeitures of payment rights (for reasons totally out of control of the entity seeking payment and more immediately within the control of the contracting party) are avoided. Until the Mike M. Johnson v. Spokane County, 150 Wn.2d 375, 78 P.3d 161 (2003) decision was issued, I would have predicted that since courts abhor forfeitures that a conditional payment clause would be void since the clause causes a forfeiture of the subcontractor's payment. However, with the aplomb with which the Supreme Court cast aside the whole notion of abhorring forfeiture, that outcome is now less certain.
- Lien conflict.
It is likely, were the "pay if paid" provision to come up against Washington's lien statute, that the lien statute may well trump the offending clause considering the fact that the lien statute in Washington is highly remedial in nature (protects the "public interest of encouraging participation of [contractors] in the construction industry and protecting their right for payment for furnishing necessary labor, material, equipment and services." RCW 60.04.021 (emphasis added)).
- Restatement Second of Contracts.
The Restatement (a compendium of case precedent used as guidance by courts in many states) provides a possible solution to the pay if paid issue when the subcontractor is not at fault for the non-payment. "Where a party's breach by non-performance contributes materially to the nonoccurrence of a condition of one of his duties, the non-occurrence is excused." Rest. 2nd Contr. § 45(1981). This simple statement is referred to as the "prevention doctrine."
Even those courts that broadly construe contingent payment clauses are unlikely to enforce those clauses when the reason for nonpayment is the breach by the general contractor of its contract with the owner. To excuse the prime contractor in such a situation would be tantamount to allowing it to benefit from its own wrongful acts contrary to the "prevention doctrine." The "prevention doctrine" has been adopted by Washington courts. See Puget Sound Service v. Bush, 45 Wash. App 312, 318, 324 P.2d 1127 (1986). A party may not rely on the failure of a condition where the party was at fault for such failure. See McDonald v. Wyant, 167 Wash. 49, 55, 8 P.2d 428 (1932). Thus, if the general contractor is solely at fault for the non-payment, the general contractor has caused the failure of payment to occur, the general contractor has triggered the condition upon which its liability depends to occur and therefore cannot take advantage of that failure. See Refrigeration Engineering Co. v. McKay, 4 Wn. App 963, 969-970, 486 P.2d 304 (1971).
As to what direction a court would take in Washington, Oregon or Alaska when confronted with a "pay if paid" provision is pure speculation. However, if the subcontractor seeking payment is not at fault for the non-payment, the remedial nature of the bond and lien statutes is one avenue the courts may use to nullify a "pay if paid" provision, the "prevention doctrine" is another. In today's environment, it is difficult to predict what course, if any, a court may take when confronted with a particular set of facts.
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