Battle Between Policy and Contract

It’s a fundamental tenant of American public policy that trade contractors and suppliers should be paid for their work, and should not be the parties required to bear the financial risk of construction projects. This belief that people should be paid what they are owed, and that the parties closest to the money should bear the ultimate financial risk, is deeply ingrained in the laws governing the American construction industry.

In fact, this is why the mechanics lien instrument was created. The concept that subs and suppliers, (people further down on the payment ladder), deserved to be protected from non-payment above them traces back all the way to the founding our this country.

The financial risk of non-payment shouldn’t fall on the lower-tiered parties. The offshoot of the belief that the financial risk of non-payment shouldn’t fall on the lower-tiered parties, and the corresponding result that GCs and property owners (those at the top end of the payment ladder) should be the ones to bear the burden of a project’s financial risk, is that property owners and GCs have looked for ways to change that equation. Nobody likes to be forced to shoulder a financial risk, so GCs and property owners have, throughout the years, attempted to shift the burden back to the parties below them on the chain via contractual risk-shifting clauses. This battle of contract vs. policy is ongoing.

After the creation of statutory protection for subs and suppliers vis-a-vis the allocation of the ultimate financial risk of a construction project on their property to the owners and GCs, an ongoing string of risk-shifting contractual clauses emerged.

Risk-Shifting Contract Provisions

In the 1940s, contracts began to include “no lien clauses” in an attempt to pass the financial risk to sub and suppliers. When cases involving these no-lien clauses made it to court, however, these clauses were routinely thrown out as impermissibly denying a statutory right, and as against public policy. Since “no lien clauses” were determined to be impermissible, GCs and property owners adapted and began to include a different risk-shifting clause in their contracts, the pay when paid clause. Again, however, courts came down on the side of the subs and suppliers by treating pay when paid provisions as a timing mechanism, rather than a means to avoid payment. This means they allowed the GCs to wait for a “reasonable period of time” to receive payment before they were obligated to pay the subs – BUT they were not absolved of that responsibility altogether.

When the effect of pay when paid clauses was lessened, GCs and owners responded by modifying pay when paid clauses into pay if paid clauses, and again inserted them into contracts in an attempt to shift the risk down the payment chain. These, again, have been the subject of much litigation, and the results have varied. Many courts have also held these provisions to be akin to no-lien clauses, and have declared them void as against public policy, but there are situations in which these provisions may still be effective.

While the required language varies from state to state, it is generally required that the clause specifically state that the it is meant to shift the risk of nonpayment to the sub or supplier, and that payment to the GC is a condition precedent to payment to the sub or supplier. Many states, either via court decision or through statutory law have decided that shifting financial risk through pay-if-paid clauses is disallowed, and have declared pay if paid clauses void as against public policy, at least as regards the claimant’s mechanics lien rights. This is not universal, however, or even necessarily the norm. Pay-if-paid clauses are still allowed and enforceable in many states, provided certain specific language is included in the clause itself.

While the required language varies from state to state, it is generally required that the clause specifically state that the it is meant to shift the risk of nonpayment to the sub or supplier, and that payment to the GC is a condition precedent to payment to the sub or supplier. Even in states where these types of clauses are allowed, they are generally not favored, however. Courts in most states view pay if paid clauses with disfavor, and do not need much incentive to find them unenforceable.

On one side of the scale, there are statutory laws protecting subs and suppliers that attempt to keep the financial risk of construction projects on the property owners and GCs: mechanics liens, bond requirements, criminal statutes, payment timing provisions, etc., and on the other side there are there are the contract provisions described above with which the GCs and property owners attempt to shift the project’s financial risk back down the ladder. Generally, judges tip the scales back in favor of the subs and suppliers when these issues come up in litigation, but by no means is that always the case.

A prudent construction credit manager is wise to keep these provisions in mind.