A growing trend nationwide is to give little (or no) effect to pay if paid clauses, particularly when they’re ambiguous. Many jurisdictions limit the effectiveness of pay if paid clauses by merely treating them as time shifting devices, too. But twice now, Kentucky has bucked this trend. As you may recall, last year we wrote about a Kentucky Court of Appeals case: Pay If Paid Contracts Strengthened In Kentucky.
We ended that post with this line: “Hopefully the Supreme Court of Kentucky will weigh in.” Well…they did. In a discouraging (though perhaps unsurprising) opinion, the Kentucky Supreme Court also found that the pay if paid provision should be enforced. However, the claimants were successful in having their unjust enrichment claim revived.
Pay If Paid Clauses Still Going Strong In Kentucky
We discuss pay if paid clauses regularly, but here’s a quick definition: A pay if paid clause purports to shift the risk of nonpayment down the chain. Where a pay if paid clause is present, generally, a contractor will have no duty to pay its subcontractors until the contractor itself has been paid. If a contractor is never paid, that means the subs are never entitled to payment. Because this is such a harsh result, many states merely treat a pay if paid clause as a time shifting device rather than a risk shifting device.
Providing some context should be helpful to showing why this result is pretty brutal for the subcontractors.
D&M (“the Contractor”) was hired by Corporex to build a luxury condominium. The Contractor, in turn, hired Superior and Ben Hur (“the Subcontractors”) to fabricate, erect, and install steel on the project. After the contracts between the Contractor and The Subcontractors had been signed, Corporex and the Contractor altered the plans for the project. When notified of the changes, the Subcontractors expressed concern – the changes would require extra work to be performed that was not originally contemplated in the contract.
One of the Subs met with representatives of Corporex and the Contractor to express these concerns and that they were worried about the possibility of nonpayment. Rather than put anything in writing, Corporex and the Contractor verbally assured that payment would be made to the Subs. They told the Subs to keep track of the time and costs as the Subs performed the extra work. The day after this meeting, a representative from the Contractor drafted a letter that acknowledged the additional work and putting, for the first time, the request for extra work to writing. However, Corporex directed the Contractor not to send that letter.
Ultimately, the Subcontractors performed extra work on the project. They submitted their work orders to the Contractor, and the Contractor sent them to Corporex. Corporex paid for some of the work, but left large sums unpaid. Later, Corporex refused to make those payments, along with the standard retainage payments under the base contract. Several months later, the Subs filed mechanics liens on the project.
The Kentucky Supreme Court
The Kentucky Supreme Court found that the language of the contract between the Contractor and the Subs was an unambiguous pay if paid provision. First, the court noted that the language of the contract prevented additional payment not contemplated in the contract unless (1) the owner had made additional payment to the contractor, or (2) unless written agreement had been made between the Contractor and the Subcontractors. As you’ll recall, Corporex prevented the Contractor from putting the additional work in writing.
Anyway, the court found that the pay if paid provision was very clear in that it was creating a condition precedent for payment to the Subcontractors (read: “If the Contractor wasn’t paid, then the Subs wouldn’t get paid“). Thus, payment was technically not due to the Subcontractors since the Contractor had not been paid. Because of this, the mechanics liens were invalidated and the breach claims did not stand. However, Corporex did benefit from the work and did fail to pay for that work, so the Kentucky Supreme Court found that the Subcontractors’ unjust enrichment claims should be revived.
Admittedly, the pay if paid clause at issue in this case was very clear. But the existence of such a clause hardly arises from a freedom to contract – these clauses arise from a one-sided industry. Parties down the chain have the fewest bargaining chips, and as a result, risk shifting pushes an inordinate amount of liability to the end of the chain. The Facts section above is pretty much a 101 course on how not to collaborate on a construction project. As always, Levelset wants to encourage a better way – through transparency, communication, and collaboration, financial risk can be minimized.
It’s worth noting that, as they relate to mechanics liens, pay if paid clauses may very well be unenforceable by the letter of the law in Kentucky. As pointed out by the American Subcontractors Association in their amicus brief for this case, Section 371.405(2)(b) of the Kentucky Fairness in Construction Act prohibits “A provision that purports to waive, release, or extinguish rights provided by KRS Chapter 376, with the exception of partial waivers of lien rights provided by the contractor or subcontractor for progress payments” as void and unenforceable and contrary to public policy (KRS Chapter 376 is the mechanics lien statute of Kentucky).