A while back this blog gave our readers a wonderful introduction to the complex world of pay if paid and pay when paid clauses.  As a quick refresher, construction subcontracts sometimes condition payment from the general contractor to the subcontractor on payment from the owner to the general contractor.  General contractors don’t want to have to pay their subs if the owner doesn’t first pay them first.  Yet the choice between “if” and “when” has serious consequences; generally speaking, a paid when paid clause only gives the general a reasonable amount of time to pay the subs but a pay if paid allows the general to withhold payment to subs entirely if the owner never pays (in states that don’t forbid such clauses as against public policy).

Why Virginia’s Interpretation is Unique

As the earlier post discussed, states have wildly different interpretations of these clauses.  Some states, such as New York, hold them completely unenforceable as a matter of public policy.  Other states, such as West Virginia, hold that, so long as the clause clearly and unambiguously shifts the risk of owner nonpayment from the general contractor to the subcontractor, both pay when paid and pay if paid clauses are always enforceable.  Another interpretation amongst states is that a pay when paid clause merely delays payment while a pay if paid clause permits indefinite withholding of payment to the sub.

Virginia’s interpretation, however, belongs in its own category entirely.  Specifically, courts in Virginia only consider the parties’ intent behind pay if paid and pay when paid clauses.  In Virginia’s landmark case on the issue, the Supreme Court of Virginia held that even if a general contractor uses the exact same language in all of its subcontracts, a pay when paid clause is sometimes enforceable if the sub intended the nonpayment risk to be transferred to the sub but unenforceable if the sub did not intend such a transfer.  [quote style=”boxed”]the Supreme Court of Virginia held that even if a general contractor uses the exact same language in all of its subcontracts, a pay when paid clause is sometimes enforceable but sometimes unenforceable, depending on the parties’ intents[/quote]

Intent Matters in Virginia

Virginia’s landmark pay when paid case, Galloway Corp. v. S.B. Ballard Construction Co. is really an exercise in applying the parties’ intents to contract language.  Some states only look to the words on the page in deciding how to interpret a contract; other states, such as Virginia, look beyond the page in an attempt to determine what rights and obligations the parties thought they were getting when they signed a contract.

In the context of pay when paid clauses, Virginia’s test for enforceability evaluates whether or not both parties intended to shift the risk of owner nonpayment from the general contractor to the subcontractor. Virginia’s test for enforceability evaluates whether or not both parties intended to shift the risk of owner nonpayment from the general contractor to the subcontractor. The Supreme Court of Virginia apparently placed greater weight on flexibility in contract interpretation than it did on predictability and uniformity.  While it’s inappropriate, and frankly very difficult, to evaluate if this flexible approach is better, the court’s method led to some very interesting results.

Same Contract Language, Different Intent

In 1998, Galloway Corp. was hired to build a 14-story building in Norfolk, Virginia.  The developer agreed to pay Galloway $10.6 million for the entire project.  Work proceeded smoothly for the next year and a half – in which Galloway hired five subcontractors to help complete the building – until the developer’s funding dried up.  At that point, the developer had only paid Galloway $3 million and, in turn, Galloway had not completely paid off all of its subcontractors.

Every single subcontract Galloway signed with each sub had the exact same language:

Final payment, constituting the entire unpaid balance of the Subcontract Sum, shall be made by the Contractor to the Subcontractor when the Subcontractor’s Work is fully performed . . . and the Contractor has received payment from the Owner.

After having their invoices unpaid, the five subcontractors filed mechanics liens on the property and sued the developer and Galloway to foreclose on those liens.  Although Galloway asserted that the clause quoted above clearly stated that it did not have to pay the subcontractors if the owner never paid, the trial court disagreed.  Instead, the lower court held that the clause only delayed payment to the subcontractors and could not “be construed to say that each sub must bear its own loss if Galloway never got paid.”

On appeal to the Supreme Court of Virginia, the court affirmed in part and reversed in part the lower court’s decision.  Instead of holding that the “pay when paid” clause could never transfer nonpayment risk to the subcontractor, the court found that the clause sometimes did and sometimes did not.  It all depended on the parties’ intent: Did each subcontractor understand that by signing the contract they would be bearing the risk of not getting paid if the owner didn’t pay the general contractor? Did each subcontractor understand that by signing the contract they would be bearing the risk of not getting paid if the owner didn’t pay the general contractor?

In a brief analysis of each subcontractor, the court concluded that four subcontractors understood that they were assuming the risk of nonpayment but that one, Ballard, did not understand that the pay when paid clause would do so.

What the Court’s Holding Means Moving Forward

Law surrounding pay when paid clauses in Virginia changed forever the day the Supreme Court of Virginia issued its holding in Galloway.  Yet since there’s no clear law, how can general contractors ensure that the subcontract will actually transfer the risk of nonpayment to the subcontractor, or, the other way around, how can subcontractors ensure that the risk will not be transferred?

The court does provide us with some guidance.  Instead of complex legalese, parties should make the contract language as crystal clear as possible.  Parties should make the contract language as crystal clear as possible. Parties could also document their discussions surrounding a pay when paid clause.  Finally, and perhaps most obviously, subcontractors and contractors could take steps that the developer really does have enough money to fund the entire project and could even have that money placed in escrow so it wouldn’t be spent elsewhere.

Whatever route parties to a pay when paid clause choose to take, one takeaway emerges: The clearer the pay when paid clause is, the easier it will be for the court to interpret it.