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Due to the relationship between owners, contractors, and subs, industry members often operate in a cover-your-rear fashion and look to pass liability for nonpayment around like a hot potato. Two of the most prevalent ways contractors and subs do this is through pay when paid and pay if paid contracts. Under a pay when paid contract, only the timing of payments is shifted. A higher tier is not liable for payment until they have been paid- but the obligation to pay still exists. Under pay if paid contracts, a higher tier has no obligation to pay a lower tier if payment hasn’t been received by the higher tier. Pay if paid contracts are so disfavored that they have actually been outlawed in many states. Here’s an infographic depicting which states have disallowed pay if paid provisions.
In a recent case, Beal Bank Nevada v. Northshore Center THC, the appellate court interpreted a contract between the prime contractor and sub, finding that a pay when paid provision was at hand rather than a pay if paid provision. Because the agreement established a pay when paid relationship rather than a pay if paid relationship, payment from the property owner to the subcontractor was not a condition precedent to the agreement between the prime contractor and the sub.
Because the crux of this case relies on the language of the subcontract agreement, let’s keep the factual background brief. An owner hired FCL Investors (FCL) to perform work on their property. FCL then hired Lake County Grading (Lake County) to perform grading work on the site. While the contract did quite clearly shift liability, the language of the subcontract agreement did not explicitly describe whether it was creating a pay when paid or a pay if paid situation.
After both the contractor and the sub had completed a substantial amount of work, the owner stopped making payments. As a result, Lake County and FCL both filed mechanics liens on the property for $775K and $943K, respectively, as well as other actions including a breach of contract action from Lake County against FCL. Soon after, the mortgage holder stopped receiving payments from the owner as well and filed for foreclosure on the house. In exchange for Lake County releasing its lien, the subcontractor was paid $475K. Meanwhile, the contractor secured a judgment against the owner. Unfortunately for FCL, it obtained a $943K judgment against a company that had been dissolved.
With over $300K still at issue, FCL and Lake County returned to court for the breach of contract claim. FCL contended that the under the terms of the contract, it had no duty to pay Lake County unless FCL had been paid. The trial court agreed, stating that this was a pay if paid contract, and that since the condition precedent (payment) had not been met, FCL had no duty to pay Lake County. The subcontractor appealed.
On appeal, the court sided with the sub. After a closer look at the subcontract, the court found that while the contract did purport to shift liability for payment, the agreement in no way contemplated nonpayment by the owner. Rather, the agreement merely shifted the time frame for payment. This is important because in Illinois, public policy dictates that courts disfavor condition precedents, unless they have been unambiguously established by contract. Because the obligation to pay was not based on the condition of payment (a condition precedent) from the owner, FCL was still obligated to pay the subcontractor for its work.
Pay when paid and pay if paid provisions create all sorts of issues for contractors, subcontractors, and the courts. The lower a party stands on the construction payment chain, the riskier these provisions become. While both pay when paid and pay if paid provisions can destroy on a laborer’s right to payment, it is clear that pay if paid provisions pose a bigger threat to subcontractors and suppliers. Regardless, the industry should ditch both in pursuit of a construction payment utopia. Only when industry members collaborate on a basis of transparency, trust, and communication will the issues of the construction payment chain disappear.