Contractors have been using many different ways to shift risk in contracts with owners for as long as the industry has existed.  Contractors have also shifted risk when it comes to subcontractors.  One of the ways to shift risk is the use of “paid-when-paid” and “paid-if-paid” clauses in contracts.  Often these terms are used interchangeably, but in actuality, the two terms are slightly different.  Pay-if-paid clauses state that the party responsible for making the payment will not make the payment unless and until they are paid for the work.  Pay-when-paid clauses usually state that the party responsible for making the payment must pay within a set amount of days from which they receive their payment for the work.  Pay-when-paid usually does not excuse responsibility of the payment, but establishes a reasonable time to make payment.

Courts have been looking at pay-if-paid clauses for some time now to analyze their values, legality, and fairness.  The issue is whether it is fair to shift the risk of nonpayment to the subcontractor that does not have control over the insolvency of the owner.  The issue is being addressed at the state level in three different ways.  The first approach simply states that the clause is illegal and therefore unenforceable.  In this case the courts interpret the payment obligation to mean payment is required within a reasonable time from the completion of the work invoiced.  The second approach states that the provision violates public policy.  The reasoning of the clause violating public policy is that it eliminates the subcontractor’s lien right.  A mechanics’ lien is a statutory right to preserve the contractor’s security for payment of sums due.  This approach is then interpreted the same as the first in that the payment obligation is required to be made within a reasonable time rather than a condition to be paid.  The third approach is that some states will enforce the clause as it is written.  This approach usually requires precise language that clearly indicates the parties intend for the subcontractor to assume the risk.  If the court decides the language states a pay-when-paid rather than pay-if-paid, the clause is deemed to establish a reasonable time for payment.

State courts are also taking positions on the responsibility of the surety.  Some states are of the position that is the pay-if-paid clause is enforceable as to the claim of the subcontractor against the general contractor, then the surety is not responsible to pay the subcontractor.  Other states view the payment bond as the insurance for when the owner or general contractor does not make payment and allows the subcontractor to make claims against the surety.

It is important to remember when preparing subcontractor agreements to use language that clearly states that the risk of insolvency of the owner passes to the subcontractor.  Also, it is important to know which state will have jurisdiction over the contract and consult your attorney as to that state’s position on enforcing pay-if paid clauses.

If you would like more information please contact Hunter Stout at hstout@ddfky.com