The Ohio Supreme Court chimed in on “pay if paid” clauses last week, and it’s not good for subcontractors.
In Transtar Elec., Inc. v. A.E.M. Elec. Servs. Corp., the court decided that a pay if paid clause within a construction contract was enforceable, and thus, a subcontractor was without any claim for payment against a prime contractor for work performed (read decision full text). A great recap and analysis of the court’s decision can be found on the Legally Speaking Ohio blog, authored by retired Ohio state appeals court judge Marianna Brown Bettman: Merit Decision: Condition Precedent Language in a Contract Means Pay-if-Paid. Transtar Elec., Inc. v. A.E.M. Elec. Servs. Corp.
The court got this decision all wrong and only creates more confusion for subcontractors and suppliers about their rights when doing business in Ohio. This article explores the problem with interpreting pay if paid clauses and the intersection of these clauses with mechanics lien rights.
Ohio Statutes Prohibit Pay If Paid Provisions To Protect Subcontractors
Public policy is a slippery subject, and can typically be manipulated at will to achieve the ends of a judge or lawyer. Nevertheless, it is surprising that public policy interests were not even mentioned in the Ohio Supreme Court’s Transtar Electric decision. This is noted in Hon. Bettman’s blog post about the case in her concluding observations: “While there was some discussion at argument and in the briefs about the public policy implications of pay-if-paid contracts, the majority simply did not go there.”
Not only did the majority ignore the public policy topic, but so did the dissent. This is especially surprising because Ohio’s public policy interests against contingent payment clauses (i.e. pay if paid clauses) is actually written into the state’s statutes. Ohio Rev. Code § 4113.62(E) provides as follows:
No construction contract, agreement, or understanding that makes payment from a contractor to a subcontractor or materials supplier, or from a subcontractor to a materials supplier, lower tier subcontractor, or lower tier materials supplier contingent or conditioned upon receipt of payment from any other person shall prohibit a person from filing a [mechanics lien].
A few months ago we wrote about this particular statute in the article “What Happens When Pay If Paid Clauses Are Disallowed, But Not Entirely?”
That article acknowledged that this prohibition is not as comprehensive as subcontractors may like because the statute only prohibits contingent payment clauses from compromising a subcontractor’s mechanics lien right. Nevertheless, the clause is a clear indication by the Ohio legislature that it places subcontractor payment rights above the right for owners and general contractors to shift a contract’s financial risk off their shoulders.
As the next section explores, the battle between who bears the financial risk on a project is an ongoing battle between construction participants that puts subcontractors in a compromising and abused position.
Financial Risk Shifting Efforts Evolve, But Courts Make Mistakes When They Enable Owners and General Contractors To Circumvent A State’s Long-Standing Policy Interests
Financial risk shifting is a recurring topic in this publication, and that’s because it’s a recurring topic in the construction industry. Financial risk is a zero-sum game on construction projects, and all of the participants are in a 200+-year-old battle to make sure the financial risk hot potato is not in their hands when something goes wrong.
Contingent payment provisions are an invention by the top of the chain to circumvent the judicial and legislative protections afforded to bottom-of-chain parties. This is not a topic we’ve conjured up here. It was the subject of the ENR Risk Summit last fall (Too Expensive To Ignore Payment Flow Abuse), and the CFMA/AGC risk summit at the same time (Owners Shifting More Financial Risk).
The history of financial risk shifting is especially interesting, as it is clear that top-of-the-chain parties (i.e. developers, lenders, general contractors) have been engaging in risk-shifting techniques for decades. Through all of this time, the obstacle to the top of chain parties has been strong legislative and juridical protection for the bottom of the chain parties. Consider prompt payment laws, mechanics lien rights, bond claim rights, misappropriation of funds crimes, etc.
Contingent payment provisions are an invention by the top of the chain to circumvent the judicial and legislative protections afforded to bottom-of-chain parties.
The first circumvention attempt was “no lien clauses,” which asked subcontractors to waive their mechanics lien rights before work ever began. These were quickly invalidated by courts and legislatures across the nation as against public policy that favored payment to sub-tiered parties. Financial risk, in other words, belonged at the top of the chain.
Developers and general contractors then invented the pay when paid provision, which was quickly reduced to a “timing” mechanism and not a risk-shifting mechanism. Developers and general contractors then turned to more restrictive pay if paid language, containing terms like “condition precedent” and “risk shifting.” Such is the provision before the Ohio court. You can trace the history of pay when paid and pay if paid provisions through Google’s nGram tool, with a graphic from a search on this tool, reproduced on the right.
The Ohio Supreme Court’s decision to allow the Transtar Electric pay if paid clause fails subcontractors in the state fails the construction industry and fails the 200 years of history in protecting that class of construction participants. Nevertheless, the decision doesn’t appear to touch Ohio R.C. § 4113.62(E), which means that pay if paid provisions will not impact or limit mechanics lien rights in Ohio.
The Ohio Court Mechanics Lien Rights, Which Arise From Contract, Remain A Subcontractor’s Best Friend And Only Reliable Protection
Go ahead and give Transtar Electric a call and ask them what they think about all of these excuses. They just lost $44,088.90 in payments, and a heap of attorney fees. You can find their number and contact information here.
Last year, we published an article inquiring “Can Owners Disguise No Lien Clauses?” No lien clauses are ancient attempts to have subcontractors waive their lien rights before a project begins by owners and general contractors. In nearly every jurisdiction, including Ohio, these laws have been rendered invalid. The question of the article, however, was whether other clever contract provisions could have the same effect, and therefore, act as a no lien clause in disguise.
Certainly, after the Transtar Electric decision, a subcontractor somewhere with a pay if paid provision is going to also have a filed lien, and the tension between the right to file a lien and the pay if paid contractual agreement will rise to the surface. Such tension was not present in this case because Transtar Electric failed to file a mechanics lien (big mistake!). Nevertheless, when these circumstances do exist, the general contractor is going to argue that the mechanics lien is invalid because the subcontractor is without any contractual rights to recover payment on the project. How will the court resolve this?
It appears clear that Ohio R.C. § 4113.62(E) will compel the courts to invalidate the pay if paid provision in these circumstances. The statute clearly invalidates pay if paid provisions if they interfere with a mechanics lien rights. It seems silly, however, that the statute invalidating these provisions as against public policy would only apply circumstantially. At least for now, such appears to be the case in Ohio.
In our discussion earlier this year of Ohio R.C. § 4113.62(E), we explained the predicted policy ambiguity meant that it was extra important for subcontractors and suppliers to protect and perfect their mechanics lien rights:
The best protection in these [ambiguous] states is to make sure you comply with all necessary preliminary, and lien, requirements such that you can file a valid mechanics lien. The failure to do so may put you at the mercy of the pay if paid clause. While the pay if paid clause will not be effective in the face of a properly filed and valid mechanics lien claim, it can be effective as a defense to a breach of contract claim. And, since if your lien is invalid – whether for missing a deadline, non-compliance with preliminary notice requirements, or any other reason – your fallback option is a breach of contract claim, the pay if paid clause could ruin your chances to recover the money you are owed.
Subcontractors and suppliers may grimace at such a conclusion. Why can’t business be done on a handshake anymore, they’ll cry. We don’t need to file liens because we have great relationships with our general contractors, they’ll explain. Or GCs will try to discourage preliminary notice deliveries or lien filings by promoting how they “always pay their subcontractors on time,” and therefore, “don’t have a lien problem.”
Conclusion: Ohio Supreme Court Is Unfair To Subcontractors
Owners, developers, general contractors, and other top-of-the-chain parties can contort contract language to say whatever they want. If the courts and legislatures knock down one provision, they can come right back with another provision.
Such is the obvious evolution of the pay if paid provision that appeared before the Ohio Supreme Court.
The question the court must necessarily ask is whether the provision is allowed from a public policy standpoint and whether such a provision can topple over 200 years of protections given to subcontractors and sub-tiered parties on a construction project. Unfortunately, the Ohio Supreme Court simply ignored this question and thereby made a terrible decision that not only harms the state’s construction industry but injects a new level of confusion about the state’s principles.