Pay-If-Paid Clauses

Pay-If-Paid Clauses

January 1, 2003

By Dean B. Thomson

Introduction

In any construction project, the general contractor typically bears the risk of the owner’s insolvency or inability to pay for the project. Over the years, general contractors have attempted to shift the risk of non-payment to their subcontractors. Those efforts have been met with varying levels of success. General contractors often attempt to shift this risk of owner non-payment to subcontractors by inserting a pay-when-paid or pay-if-paid clause into their subcontracts. While the construction industry, and even the courts, use these conditional payment terms interchangeably, they have drastically different meanings and can result in dissimilar outcomes when a subcontractor attempts to obtain payments.

Pay-When-Paid

When a general contractor inserts a conditional payment clause into its subcontracts, it inevitably does so because it is trying to condition its payment obligation to the subcontractor on the general contractor’s receipt of payment from the owner. However, use of a pay-when-paid clause will not accomplish that goal. Courts often construe pay-when-paid clauses as effecting only the timing of payments to a subcontractor, rather than excuse an unpaid contractor from its payment obligation to its subcontractors. See Seal Tite Corp. v. Ehret, Inc., 589 F.Supp. 701 (D.N.J. 1984). A typical pay-when-paid clause may look something like this:

Final payment including all retention becomes due and payable within 30 days after Architects’ certification of final payment. At all times the Subcontractor shall be paid to the extent that the Contractor has been paid on the Subcontractor’s account.

See Mrozik Const., Inc. v. Lovering Associates, Inc., 461 N.W.2d 49 (Minn.Ct.App. 1990). Most courts, including the Minnesota Court of Appeals, have interpreted a clause like this to merely outline the timing of payments to a subcontractor. If the clause does not specifically state a time for payment, the courts often require that payment be made within a “reasonable” amount of time.

Pay-if-Paid

For a conditional payment clause to relieve a general contractor of its obligation to pay its subcontractor unless and until it is paid by the owner, the subcontract must unequivocally and unambiguously create a condition precedent to payment, (i.e. it must explicitly state that payment from owner is a requirement for the contractor to have a payment obligation to the subcontractor). See Mrozik, supra. The Minnesota Court of Appeals interpreted the conditional payment language cited above and held that the language did not unequivocally shift the risk of the owner’s insolvency to the subcontractor and, therefore, the clause was merely a pay-when-paid clause. Mrozik, 461 N.W.2d at 52. The Mrozik court noted that a general contractor normally assumes the credit risk of the owner, and the subcontract must “expressly, unequivocally state an intent to alter this common understanding.” Id. (emphasis added) In the unpublished decision of Ryan Contracting, Inc. v. Brandt, 1997 Minn. Ct. App. LEXIS 982, the Minnesota Court of Appeals again held that a conditional payment clause did not create a condition precedent to payment. In Ryan, the developer contracted with Ryan Contracting to grade and install utilities and streets for a new residential development. The contract provided that the developer would pay Ryan after the sale of the first four lots. Specifically, the contract stated:

I have attached a tabulation of the lots in SUNSET HILL that shows how the money from the sales will be distributed at the closing. Lot 5, Block 1, is sold and will close 30 days after the plat is recorded. * * * You will get . . . a total of $35,334.79. * * * When the next three lots sell, I will also give you the amount of the real estate commission, if I don’t have to pay a realtor. * * *

Id. at 5. The court held that the contract did not contain “unequivocal, unambiguous language” that the sale of the lots was a condition precedent for the developer’s payment to Ryan and that Ryan exercised no control over the sale of the lots. The court concluded that the language in the contract merely provided for the timing of the payment, not a condition, so the developer had to pay Ryan even though the lots were not sold. Id.

The ACG Standard Subcontract Agreement Form (1996 version) contains conditional payment language very similar to that used in the Mrozik case and, as such, is treated as a pay-when-paid provision.

In an attempt to create a pay-if-paid clause, the AGC created Rider B-55 to its Labor and Materials Standard Subcontract Agreement, which the parties can agree to use if they so choose. Rider B-55 states, in part:

1.  Irrespective of any term or inference to the contrary in the Subcontract, Contractor and Subcontractor expressly agree that the Owner’s payment to Contractor on the Subcontractor’s account is an absolute condition precedent to Contractor’s obligation to pay Subcontractor any progress or final payment pursuant to the Subcontract, except to the extent Subcontractor establishes that the Owner’s failure to make payment to Contractor was caused by the fault of the Contractor.

* * *

3.  Subcontractor expressly agrees that it retains the risk of the Owner’s insolvency or inability to pay for Subcontractor’s Work, and such risk is not transferred to Contractor under the Subcontract.

The Minnesota courts have not yet interpreted this AGC rider, but it specifically addresses the Minnesota Court of Appeals’ concerns raised in its previous opinions and attempts to create a valid pay-if-paid clause.

Does a Pay-if-Paid Clause End the Discussion?

Even if the subcontract contains what appears to be a valid paid-if-paid clause, the subcontractor is not necessarily precluded from obtaining payment from the general contractor. As with other risk-shifting provisions, the party seeking to enforce the provision cannot enforce the clause if it is in some way to blame for the owner’s refusal to pay. In Moore Bros. Co. v. Brown & Root, Inc., 207 F.3d 717 (4th Cir. 2000), the court held that the general contractor’s misrepresentations and wrongdoing waived an otherwise valid condition precedent. The Moore case involved the construction of the Dulles Airport Toll Road Extension. The contract between the owner and the general contractor contained specific illustrations of what constituted a “change in scope” for design changes and specifically required payment of such changes in scope. Because the project’s lenders wanted relatively certain project cost, the illustrations were removed from the contract and the general contractor verbally assured the lenders that no substantial changes in work were anticipated. Despite these assurances, the general contractor reached a side agreement with the owner regarding changes in scope of work, specifically including in the illustrations that were removed from the general contract in the side agreement. The lenders were not informed of the side agreement and the subcontractors were not informed that the lenders did not know of the potential for changes in scope. Because the lenders were not told of the potential for changes in scope, the project was not properly funded. When design changes occurred, the general contractor instructed the subcontractors to proceed with their work. The lenders were subsequently unable to pay for the changes in scope work and the general contractor relied upon the pay-if-paid clauses in the various subcontracts and refused to pay the subcontractors for their work. The subcontractors sued the general contractor. The subcontracts contained the following conditional payment clause:

Notwithstanding any other provision hereof, payment by Owner to General Contractor is a condition precedent to any obligation of General Contractor to make payment hereunder; General Contractor shall have no obligation to make payment to Subcontractor for any portion of the Sublet Work for which General Contractor has not received payment from the Owner.

Id. at 720. While the court recognized that this was a valid condition precedent clause, it refused to apply it to prevent the subcontractors from collecting payment from the general contractor. The court applied the “prevention doctrine” to preclude the general contractor from relying on the pay-if-paid clause. [1] Under the prevention doctrine, if a promisor (here the general contractor) prevents or hinders fulfillment of a condition to his performance (i.e., hinders payment from the owner), the condition may be waived or excused. Id. at 725; see also Casino Resource Corp., v. Harrah’s Entertainment, Inc., 2002 U.S. Dist. LEXIS 5110 at 30 (D. Minn.) The Moore court held that the general contractor misled the lenders regarding its expectations that potentially costly design changes would occur and that by doing so, it made it less likely that the lenders would pay for the additional work. Id. Accordingly, the Moore court held that the general contractor “hindered” the fulfillment of the condition precedent of the owner’s payment and, therefore, was required to pay the subcontractors for the extra work despite the fact that it had not been paid by the owners. Id.

Does a Pay-if-Paid Clause Offer Protection to a Payment Bond Surety?

It is a basic principle of suretyship that the surety is entitled to assert against the obligee (the party benefiting from the bond) all of the defenses that the bond principal is entitled to assert. Said another way, a general contractor’s surety is entitled to assert the same defenses against a subcontractor that the general contractor would be entitled to assert. Despite this well-settled principle of law, courts have refused to allow a payment bond surety on public projects to rely on a pay-if-paid clause in the subcontract as a defense to a claim by a subcontractor for payment.

In Moore Bros. Co. v. Brown & Root, Inc., supra, the court acknowledged that the subcontracts contained a valid condition precedent payment clause, but refused to allow the surety to rely on that clause to deny payment to the subcontractors. Id. at 723. The court reasoned, in part, that the bond itself did not contain the condition precedent language that was contained in the subcontracts. The court stated that the subcontractor was suing under the bond, not the subcontract, and that the two were separate agreements. The court further noted that the “very purpose of securing a surety bond contract is to insure that claimants who perform work are paid for their work in the event that the principal does not pay. To suggest that non-payment by the Owner absolves the surety of its obligation is nonsensical, for it defeats the very purpose of a payment bond.” Id. at 723. The Moore court also found persuasive the fact that other jurisdictions had refused to allow a payment bond surety to rely on pay-if-paid language in a subcontract as a defense to a subcontractor’s claim. See OBS Co. v. Pace Const. Corp., 558 So.2d 404 (Fla. 1990); Brown & Kerr, Inc. v. St. Paul Fire and Marine Ins. Co, 940 F. Supp. 1245 (N.D. Ill. 1996).

Courts have made similar rulings in cases involving Miller Act payment bonds. [2] In United Sates for the Use and Benefit of Walton Technology, Inc. v. Weststar Engineering, Inc., 290 F.3d 1199 (9th Cir. 2002), the court held that a subcontract’s conditional payment clause was not a defense to a subcontractor’s Miller Act payment bond action. Id. Walton Technology was a subcontractor that furnished equipment for a federal project to repaint a Navy crane. the parties’ agreement provided that the general contractor would only make payments “when and if” the general contractor was paid by the Navy. Id. at 1203.

The general contractor failed to make additional payments so Walton sued the general contractor and its payment bond surety. The surety moved for summary judgment on the ground that since the general contractor had not been paid by the Navy, the pay-if-paid clause had not been satisfied and there were no sums justly due to Walton.

The court held that the Miller Act was “highly remedial in nature” and “entitled to a liberal construction and application.” Id. at 1205. The Walton court held that absent a clear and explicit waiver of the subcontractor’s rights under the Miller Act, such a conditional payment clause would not be enforced to preclude recovery under the federal statute. Id. at 1208-09. Under the Walton court analysis, there will be instances in which a payment bond surety will be required to pay a subcontractor sums that are not yet due under the terms of the subcontract. In addition, pursuant to indemnification obligations contained in the bond issued to the general contractor, the general contractor will probably be required to repay the surety for the amount it was required to pay the subcontractor.

Conclusion

So, what is the lesson learned regarding conditional payment clauses? It is probably that things are not always as they appear to be. Do not assume that a general contractor or its surety are protected from subcontractors’ claims when an owner fails to pay simply because the subcontract contains a “pay-if-paid clause.” Courts disfavor conditional payment clauses and often will look for ways to avoid enforcing them.

This discussion is generalized in nature and should not be considered a substitute for professional advice. © FWH&T

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