In the world of construction, it is essential for both prime contractors and lower-tier subcontractors to carefully manage financial risk when negotiating subcontract agreements. While a party’s ability to distinguish and understand pay-if-paid and pay-when-paid clauses—a critical first step in identifying financial risk—the analysis should not stop there. To protect the rights of both the prime contractor and subcontractor, proper management of financial risk also requires knowledge of applicable state laws and the circumstances affecting the enforceability of such clauses under a given subcontract. Visit this link to access Part 1 in this series.
Background
Pay-if-paid clauses are conditional payment provisions commonly included in construction subcontracts. The intent of a pay-if-paid clause is to shift the risk of loss from the prime contractor to its subcontractors by making the project owner’s payment to the prime contractor a condition precedent to the prime contractor’s obligation to pay its subcontractors.
Alternatively, pay-when-paid clauses relate to the timing of the subcontractor’s payment, allowing a contractor to delay payment until it receives payment from the owner, but not indefinitely. In other words, a pay-when-paid clause functions as a timing mechanism, permitting the prime contractor to delay payment to its subcontractors based on when it receives payment from the owner, provided such delay is reasonable under the circumstances and the applicable jurisdiction’s laws.
Whether a clause is a pay-if-paid or pay-when-paid clause depends on its how it is drafted and is often the subject of contract disputes.
Enforceability
Compared to pay-when-paid clauses, the enforceability of pay-if-paid clauses is more frequently disputed. Some states have enacted legislation voiding such clauses as against public policy, while the majority of states will enforce a clear and unambiguous clause in a subcontract. The enforceability of such clauses becomes more complicated when a prime contractor posts a payment bond protecting subcontractors and suppliers from non-payment on a public or private project. Some states have enacted laws that render pay-if-paid provisions unenforceable in connection with mechanics’ lien and payment bond rights. In the absence of legislation, some courts have held that such clauses contravene lien and bond laws and are unenforceable. For instance, federal courts have almost unanimously held that such clauses are unenforceable in the context of the Federal Miller Act.
Takeaway
To properly manage financial risk when negotiating construction contracts, parties must pay close attention to the express language of conditional payment provisions. They must further consider what, if any, state laws preclude or limit such provisions and assess how those laws impact a subcontractor’s bond and lien rights.
If you are a prime contractor or subcontractor and have questions regarding the enforceability of a contingent payment clause—or need assistance with a claim on a public or private construction project—please contact Jessica duHoffmann, Jonathan Neri, or another member of PilieroMazza’s Construction Group.
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