Legal Ease

Subcontract payment provisions commonly state that a subcontractor is not entitled to receive payment until the general contractor has been paid. Although this ubiquitous provision may appear to be substantively the same from contract to contract, what appears to be an insignificant variation in the exact language might determine whether a provision is viewed as a pay-when-paid versus pay-if-paid clause.

If a payment provision is considered a pay-when-paid clause, courts in most states have ruled that a subcontractor still will be entitled to payment from a general contractor after a reasonable period even if the building owner has not paid the general contractor. Although there is no set time period to define what constitutes a reasonable period, the critical legal point is that the subcontractor ultimately is entitled to payment.

If a payment clause is a pay-if-paid provision, it is a contingent-payment provision and the subcontractor is not entitled to payment unless the contingency, or condition precedent, of payment by an owner to a general contractor has occurred. If an owner does not pay a general contractor because of insolvency, the general contractor’s fault or any other cause, the subcontractor still is not legally entitled to payment.

How can you tell?

If a payment provision states only that a subcontractor will be paid a certain number of days after the general contractor receives payment from the owner, the provision likely will be interpreted as a pay-when-paid clause. Therefore, the subcontractor still would be entitled to payment even if the general contractor never receives payment.

Courts in most states favor a pay-when-paid interpretation unless a contract contains language that unambiguously expresses the parties’ intent was that the general contractor has no obligation to pay if he is not paid. To express this intent, the language courts most commonly look for is whether a contract states payment to the general contractor is a condition precedent to the general contractor’s being obligated to pay the subcontractor.

If a contract explicitly states a general contractor’s receipt of payment is a condition precedent or the general contractor’s obligation to pay the subcontractor is contingent upon the general contractor’s receipt of payment, a court will interpret the clause as a pay-if-paid provision and the subcontractor will not be able to compel payment. As a result of court decisions, many general contractors include the words “condition precedent” or “contingent payment” in standard form subcontracts.

Court decisions

In Peacock Construction Co. Inc. v. Modern Air Conditioning Inc., the Florida Supreme Court in 1977 stated that most contracts do not make payments to subcontractors condition precedents “because small subcontractors, who must have payment for their work in order to remain in business, will not ordinarily assume the risk of the owner’s failure to pay the general contractor.” For the courts to find against subcontractors, a contract must unequivocally shift the risk of nonpayment from the general contractor to the subcontractor.

The Florida Supreme Court, in DEC Electric Inc. v. Raphael Construction Corp., put it most succinctly in 1990 when it stated that “if the provision is clear and unambiguous, it is interpreted as setting a condition precedent to the general contractor’s obligation to pay, but if the provision is ambiguous, it is interpreted as fixing a reasonable time for the general contractor to pay; the burden of clear expression is on the general contractor.”

In the 1999 case Main Electric Ltd. v. Printz Services Corp., the Colorado Supreme Court considered subcontract language that stated the subcontractor would be paid “provided like payment shall have been made by owner to contractor.” The court found such language to be insufficient to constitute a condition precedent.

Following the reasoning that had been incorporated in decisions in other states, the Colorado Supreme Court stated: “If there is any doubt as to the parties’ intention, we interpret a clause in a contract as a promise rather than a condition. This rule of contract interpretation expresses the recognized policy of avoiding the harsh results of forfeiture against a party who has no control over the occurrence of the condition.”

The court concluded the contract provision lacked the precision and clarity necessary to show the contracting parties intended to shift the risk of the owner’s nonperformance to the subcontractor.

The Supreme Court of Louisiana was called upon to construe payment language stating that the contractor was to pay the subcontractor “upon receipt of payment from the owner” in the 1987 case Southern States Masonry Inc. v. J. A. Jones Construction Co., which arose from the bankruptcy of the owner of the 1984 Louisiana World’s Fair.

The court ruled the payment provision did not constitute a condition that negated the obligation of the general contractor to make payment but rather delayed the general contractor’s obligation to make payment. Again, the absence of unequivocal terms in the contract drafted by the general contractor was critical to the court’s finding.

Common language

The standard subcontract form issued by The American Institute of Architects (AIA Document A401—1997) contains a pay-when-paid provision. Article 11.3 of AIA Document A401 states, “The Contractor shall pay the Subcontractor each progress payment within three working days after the Contractor receives payment from the Owner.”

Article 11.3 also states that if the architect does not issue a payment certificate or contractor does not pay the subcontractor for any reason that is not the subcontractor’s fault, the contractor must make a progress payment upon the subcontractor’s demand. Similarly, Article 12.1 states that the contractor is obligated to make final payment to the subcontractor if nonpayment to the contractor is not the subcontractor’s fault.

In 1998, the Associated General Contractors of America (AGC) published two new subcontract forms, AGC Document Nos. 650 and 655.

Document No. 650, “Standard Form of Agreement Between Contract and Subcontractor,” is subtitled “Where the Contractor Assumes the Risk of Owner Payment.” Document No. 650 states that payment to the subcontractor is to be made within seven calendar days after the contractor’s receipt of payment for the subcontractor’s work and “within a reasonable time” if payment is not received by the contractor through no fault of the subcontractor.

In contrast, Document No. 655, which is subtitled “Where the Contractor and Subcontractor Share the Risk of Owner Payment,” includes a contingent-payment clause. Document No. 655 states, “receipt of payment from the Owner for the Subcontract Work is a condition precedent to payment by the Contractor to the Subcontractor.” The form goes on to state the subcontractor acknowledges he relies on the owner’s credit, not the contractor, for payment.

State statutes

Because of contingent-payment clauses’ harsh effects, several states have statutes that negate or limit such clauses’ applicability. Three states—Delaware, North Carolina and Wisconsin—have statutes declaring contingent-payment provisions void and unenforceable.

Several other states, including Illinois, Maryland, Ohio and Oregon, have adopted statutes stating contingent-payment clauses cannot negate mechanic’s lien rights or claims on payment bonds. In addition, the highest courts in California and New York have issued decisions that make contingent-payment clauses unenforceable.

In West-Fair Electric Contractors v. Aetna Casualty & Surety Co., the Court of Appeals of New York ruled in December 1995 that “a pay-when-paid provision which forces the subcontractor to assume the risk that the owner will fail to pay the general contractor” violates New York public policy.

The subcontract form promulgated by the general contractor and construction manager stated, “It is specifically understood and agreed that the payment to the trade contractor is dependent, as a condition precedent, upon the construction manager receiving payments, including retainer from the owner.”

The court ruled the provision resulted in an improper waiver of a subcontractor’s right to enforce his right to a mechanic’s lien. If the payment provision merely fixed a time for payment, the clause would not violate public policy.

Similarly, in a 4-3 decision rendered in June 1997, the California Supreme Court in Wm. R. Clark Corp. v. Safeco Insurance Co. ruled that a subcontract’s pay-if-paid clause was contrary to public policy and unenforceable because it resulted in an impermissible indirect waiver or forfeiture of a subcontractor’s constitutionally protected right to a mechanic’s lien. Therefore, the court concluded, neither a general contractor nor his payment bond surety could rely on a contingent-payment clause to avoid paying subcontractors.

This decision quickly was followed by a 1997 decision of the California Court of Appeals in Capitol Steel Fabricators Inc. v. Mega Construction Co. Inc. that invalidated a contingent-payment provision in a public construction project.

The New York and California decisions are in marked contrast to decisions in most other states that allow general contractors to transfer the risk of owner nonpayment to subcontractors as long as the contract language clearly and unambiguously does so.

For instance, in the 1991 case Gilbane Building Co. v. Brisk Waterproofing Co. Inc., the Court of Special Appeals of Maryland considered the same language in the subcontract form that the New York Court of Appeals examined in West-Fair Electric Contractors v. Aetna Casualty & Surety Co.

Although the Maryland and New York courts found the language to be a pay-if-paid clause that made the general contractor’s receipt of payment a condition precedent to paying the subcontractor, the Maryland court emphasized that courts are not at liberty to ignore the clear, unambiguous language of a contract and did not even consider that the clause might violate public policy. Therefore, because the general contractor had not been paid as a result of the owner’s insolvency, there was no obligation for the general contractor to pay subcontractors.

Bond claims

If a general contractor and his surety issue a payment bond, a subcontractor who has not been paid naturally would look to the payment bond surety to obtain payment and make a claim on the payment bond.

A basic legal principle of surety law is that a surety/bonding company generally has the same rights and defenses as the contractor whom it is bonding. Therefore, a bonding company would be able to avoid liability to a subcontractor based on a pay-if-paid clause in a state that has no restrictions on contingent-payment provisions. However, several courts have ruled that a contingent-payment clause will not defeat an otherwise valid claim on a payment bond.

For instance, in the 1996 case Brown & Kerr Inc. v. St. Paul Fire and Marine Insurance Co., the U.S. District Court for the Northern District of Illinois concluded that a roofing contractor was entitled to recover payment from the general contractor’s bonding company even though the general contractor had not been paid.

In its ruling, the court pointed out that the contractor was suing under the payment bond and not the subcontract. The court stated the surety had not cited any legal authority for the proposition that the subcontractor’s inability to recover payment because of a pay-when-paid clause necessarily precluded recovery against the surety under the payment bond.

In the case, the payment provision was interpreted as a pay-when-paid clause rather than a condition precedent because the contract stated final payment was to be made to the subcontractor when the subcontractor’s work was fully performed, the owner’s representative had issued approval for payment and the prime contractor had received payment. However, even in a case where the payment provision clearly made payment to the prime contractor a condition precedent, courts have ruled a contingent-payment provision may not provide a defense to a bonding company.

In Sherman & Associates Inc. v. Continental Casualty Co., a federal district court disregarded a subcontract’s condition precedent language to allow a subcontractor to recover against the payment bond that had been issued in substitution for mechanic’s lien rights.

The Florida Supreme Court also has ruled that a surety is liable under a payment bond to subcontractors even if a subcontract did not require the general contractor to make payment until the owner paid the general contractor.

In review

Subcontractors always should review payment provisions carefully before signing subcontract forms. If a payment provision includes the term “condition precedent” or otherwise expressly states the subcontractor agrees there is no obligation on the part of the general contractor to pay the subcontractor unless the general contractor has been paid, the subcontractor either will need to revise the language to establish a pay-when-paid clause or assess the risk of owner nonpayment.

For a public project or project being undertaken by a reputable owner, the risk of owner insolvency is slight and the risk of the owner not paying because of its financial condition may be acceptable.

On the other hand, a pay-if-paid clause in a contract pertaining to a more speculative project or an owner that is a legal entity created just for that project are good reasons to pause before signing a subcontract form. In such situations, a subcontractor should work closely with the prime contractor to minimize the risk of nonpayment.

M. Sindy Felin is a legal assistant and Stephen M. Phillips is a partner with the Atlanta-based law firm Hendrick, Phillips, Salzman & Flatt.