When does a subcontractor get paid for its work? Not surprisingly, this is one of the enduring major issues in subcontract agreements. The traditional provision is exemplified by AIA Document A401: “The Contractor shall pay the Subcontractor each progress payment no later than seven working days after the Contractor receives payment from the Owner.”
If taken literally, this language would mean that if the contractor never gets paid by the owner, then the contractor is never required to pay the subcontractor. With rare unanimity, every state that has considered the issue in a reported decision currently has come to the conclusion that it should not be construed in that way. Rather, the courts say, this type of clause is intended to cover the timing of payment in the normal course, but if the contractor does not receive payment from the owner in the normal course, or within a reasonable time thereafter, the contractor remains obligated to pay the subcontractor the amount otherwise due. Thus, the clause is construed to apply only to the timing of payment and has come to be known as a “pay when paid” clause.
Since these court rulings, for the most part, were based on the presumed intention of the parties, some general contractors have asked what would happen if there was clearer language reflecting an intent to shift the owner credit risk to the subcontractor. Hence the “pay if paid” clause, expressly making receipt of payment from the owner a condition precedent to the contractor’s obligation to pay the subcontractor. While far from universal (for example, it is still not used in AIA or ConsensusDocs forms), the pay if paid approach has been adopted by many general contractors. The reaction in the states to this development has been mixed. Most courts that have considered the issue have determined that the clauses should be enforced, based on freedom of contract between commercial parties. The common issue in the ensuing litigation has been the terminology that is required in order to avoid pay when paid designation. Is the word “provided” sufficient to make it pay if paid? Do the magic words “condition” or “condition precedent” have to be used? Is it mandatory to refer to the risk of owner credit failure being transferred from the contractor to the subcontractor? Results have varied, and any contractor desiring to use such a clause should check local court decisions. But an “all of the above” approach, making prior owner payment a condition precedent and stating that the intent is to transfer payment risk to the subcontractor, probably works from the contractor’s standpoint in every state that has considered the issue, except in a handful of jurisdictions where legislatures have declared pay if paid to be completely ineffective.
The Ohio Supreme Court recently considered pay if paid clauses for the first time in the case of Transtar Electric, Inc. v. A.E.M. Electric Services Corporation. In keeping with previous lower court decisions in Ohio and the general trend elsewhere, the court found such clauses, if sufficiently clear, to be valid. The additional issue before the court was whether the term “condition precedent” was sufficient, or whether the contractor was required to further state that the risk of owner nonpayment was shifted to the subcontractor. The court held that owner payment being a “condition precedent” of payment to the subcontractor was sufficient, and that no more was needed.
However, collection from the contractor is not the only way for a subcontractor to get paid. Mechanic’s lien rights are provided under varying terms in state laws, and on public projects and some private projects the contractor will have posted a payment bond. Can a subcontractor faced with a pay if paid clause make an end run around it by filing a lien or bond claim? Typically lien laws allow filings and bond terms allow claims for “amounts due” or some similar language. So, if no payment is “due” or “to become due” as a result of a pay if paid clause, there is the potential for lien and bond rights to be defeated as well. Many state courts have yet to decide these issues at an appellate level, but several state legislatures have been active in this area. In addition to a few state statutes invaliding pay if paid clauses entirely, approximately 10 other states (including Illinois, Indiana and Ohio) have enactments stating that presence of a pay if paid does not by itself prejudice lien rights (and in a couple of cases, does not affect bond rights either). The Ohio statute is particularly vague and arguably only affects the deadline to file a lien claim rather than actually allowing a lien to be enforced for amounts that never become “due”; thus, determination of its true effect must await judicial decisions. Moreover, advance waivers of the right to file mechanic’s liens in subcontracts may be enforceable in Ohio, thereby cutting off the mechanic’s lien avenue around pay if paid clauses in subcontracts containing such a waiver. Subcontractors should remember that such waivers can be stated in the owner’s contract with the contractor and then be incorporated by reference into the subcontract through a flow down provision.
Pay if paid will likely continue to be a contentious issue between contractors and subcontractors. Subcontractors, having largely failed to secure relief from enforcement of such clauses in the courts, have turned to state legislatures instead, with significant success at least in the area of lien right. But the presence of such a clause still increases the subcontractor’s risks in all but a few states and should be one of the key terms that a subcontractor looks for in reviewing a proposed subcontract agreement.