“Pay If Paid” and “Pay When Paid” clauses are contingent payment provisions commonly used in the construction industry. Over the past two decades the provisions have grown in complexity and sophistication as property developers and general contractors attempt to shift the financial risk of a project down the contracting chain.
The effect of pay-if-paid and pay-when-paid clauses differ from state to state, but it is prudent to always look for this language and know what you are getting into, as these type of clauses are generally present in construction subcontracts. Unfortunately these clauses are often misunderstood. Pay-if-paid and pay-when-paid clauses both concern the responsibility of each party with respect to payment of their subcontractor – but their effects can differ in significant ways.
Pay When Paid Clauses are Timing Mechanisms
Generally speaking, pay-when-paid clauses are interpreted as a mere timing mechanism for payment, i.e. the contractor will pay the subcontractor within a certain amount of days after receiving payment from the owner. That is, the language that a contractor will pay his sub when he receives payment from the property owner is not interpreted to string that time out indefinitely. If the contractor is not paid by the owner, the pay-when-paid clause does not absolve the contractor from his obligation to pay his subs.
The clause works merely to define the time period by which the subcontractor must be paid.
This almost seems counter-intuitive when reading the plain language. If I personally make a promise to give somebody money when I get money from somebody else, I would expect that, until I receive that money, I would not be obligated to pay the person I promised to pay.
Courts have rejected this approach, however.
For the most part, if there is any other way to interpret a contract, courts will shy away from enforcing a harsh condition precedent. Most courts feel that a pay-when-paid clause can be interpreted as a timing condition that is not clear enough to absolve the general of the responsibility to pay if he does not receive payment first. The risk is not transferred, and is still borne by the general contractor – the clause merely suspends the obligation for some reasonable time.
Pay If Paid Clauses Are Risk-Shifting Mechanisms
Pay-if-paid clauses, on the other hand, are specifically designed to shift the risk of non-payment to the party lower on the ladder.
The pay-if-paid clause is formulated to be specific enough that it allows the courts into enforcing the condition precedent to payment – the contractor must pay the subcontractor if and only if he first receives payment. This shifts the burden of non-payment to the subcontractor in that it excuses the obligation of the prime contractor to pay if the prime does not receive payment.
These types of clauses are generally viewed unfavorably by courts.
In order for a pay-if-paid clause to have a chance of being enforceable, the wording must be clear and precisely worded as to leave no room for interpretation about what it is trying to accomplish. To do this, pay-if-paid clauses generally employ language like “the contractor’s receipt of payment from the property owner is specifically agreed to be a condition precedent to the contractor’s obligation to pay the subcontractor, and the subcontractor specifically and expressly assumes the risk of the property owner’s nonpayment.” Specific wording is required because the risk-shifting nature of the clause may not be inferred.
Therefore, specific contractual language is mandatory to state that it is understood by both parties that the risk should be shifted. The basis for allowing this type of clause is the generic catch-all of contractual freedom. Absent certain factors, parties are free to contract between themselves however they see fit.
Some States Consider Pay If Paid Clauses Against Public Policy
Courts in some states, New York and California for example, disallow pay-if-paid clauses and hold them to be void and unenforceable as against public policy.
The courts in these states consider the risk-shifting nature of the pay-if-paid clause to violate the mechanics lien rights of the subcontractor. The ability to perfect and enforce a mechanics lien is protected, and an important part of the statutory law. A pay-if-paid clause effectively results in the subcontractor giving up the ability to enforce a mechanics lien in the event the property owner is insolvent. In that situation, neither the owner nor the prime contractor may be recovered against.
This is considered unacceptable by some states, such that the pay-if-paid clause is considered against public policy.
Some States Have Legislated Against Pay If Paid Clauses
Finally, some states have taken their opposition to pay-if-paid clauses further. Instead of relying on court precedent and leaving the determination that the clauses are against public policy to the courts, some states’ legislatures have imposed bans on pay-if-paid clauses directly in statutory language.In fact, several states have adopted this approach through some version of a “prompt payment” statute. This approach seems to be gaining favor.
These prompt payment statutes mandate payment to a subcontractor by the party with whom he contracted, provided the work was performed. This short circuits any potential pay-if-paid clause by specifically stating that payment to the prime contractor may not be a condition precedent to the payment of that contractor’s subs.
Despite the trend towards disfavoring pay-if-paid clauses, there are some situations in which one may still be valid. It is important, as a subcontractor or supplier, to tread cautiously when a contract includes this language. Part of good credit management is making sure there are as few obstacles as possible standing in the way of getting paid.
Payment Clauses Between the Subcontractor and General Contractor Do Not Affect Contracts with Suppliers
One of the reasons why many courts and legislatures consider “pay-if-paid” clauses to be unfair is that the clauses’ effectiveness is limited to the contracting parties. In other words, just because a contractor is prohibited from getting paid due to a pay-if-paid clause doesn’t mean that the subcontractor is free to stiff their supplier. The supplier must still be paid.
Although subcontractors frequently cite payment provisions as a reason for not paying a supplier’s invoice, there is really no legal connection. It’s only a practical excuse as to why the subcontractor doesn’t have the necessary funds.