Wednesday, March 24, 2010

Are Pay If Paid Clauses Enforceable?

An age old story in construction is as follows: the owner doesn't pay the contractor, and a subcontractor, who has performed its work diligently and according to its contract, doesn't get paid either.

Most of these situations arise because the subcontract contains "pay when paid" or "pay-if-paid" clauses. These clauses shift the risk of nonpayment from a general contractor to its subcontractors.

What Is a "Pay-If-Paid" Provision?
When used, "pay-if-paid" provisions are typically found in contracts prepared by contractors between themselves and subcontractors. A pay-if-paid provision makes a general contractor's payment to a subcontractor conditional-dependent on whether the owner first pays the general contractor. Some examples of these provisions are as follows:

"Receipt of funds by contractor from owner is a condition precedent to the contractor's obligation to pay subcontractor, regardless of the reason for owner's nonpayment. Contractor shall have no obligation, legal, equitable or otherwise, to pay subcontractor for work performed by subcontractor unless and until contractor is paid by the owner for the work performed by the subcontractor. Furthermore, in the event contractor is never paid by owner for subcontractor's work, then subcontractor shall forever be barred from making, and hereby waives, in perpetuity, any claim against contractor therefor."

* * *

"Subcontractor agrees and acknowledges that payment of the subcontract sum shall be made only from funds which are due from owner that contractor has actually received in hand from owner and designated by owner for disbursement to subcontractor. Subcontractor agrees to look solely to such funds for payment. Subcontractor agrees that contractor shall have no liability or responsibility for any reason whatsoever for any amounts due or claimed to be due to subcontractor except to the extent that contractor has actually received funds from owner that are due from owner specifically designated for disbursement to subcontractor. "

* * *

"Subcontractor agrees that contractor shall never be obligated to pay subcontractor under any circumstances, unless and until funds are in hand received by contractor in full, less any applicable retainage, covering the work or material for which subcontractor has submitted an application for payment. This is a condition precedent to any obligation of contractor, and shall not be construed as a time-of-payment clause."

These provisions are popular among contractors because they shift the risk of an owner's nonpayment down the chain to subcontractors. While subcontractors try to avoid these provisions, the provisions have become standard in the construction industry and subcontractors usually have the choice of agreeing to "pay when paid" or not taking the job.

The question is whether these clauses are even enforceable, and the answer depends on what state you are in, and how the clause is written.

Courts are generally split on whether pay-if-paid provisions are enforceable. New York, Nevada and California have found pay if paid provisions unenforceable because they constitute waivers of mechanics' lien rights. The reasoning used by the California court was that pay-if-paid provisions have the practical effect of acting as an express waiver of statutory lien rights-rights that could not be waived, except in limited circumstances, according to the state's statute.

In addition to ruling by courts declaring pay if paid provisions unenforceable, the following states have enacted statutes have declared paid if paid contract clauses void: Nevada, Illinois, Maryland, Missouri, North Carolina, and Wisconsin.

The states that have taken the opposite approach, explicitly allowing pay if paid provisions in subcontractors, have done so on the theory that commercial enterprises should have the liberty to contract, a freedom with which the State should not interfere. Among these states are Connecticut, West Virginia, New Mexico, Texas, and New Jersey.

As always, there are states that are on the fence. Florida, Louisiana, Indiana, Iowa, Kentucky, Massachusetts, Minnesota, Nebraska and South Carolina, Ohio, and Tennessee have found that pay-if-paid provisions set a fixed time for payment to the subcontractor, but that the subcontractor does have unconditional right to payment within a reasonable time.

For more information on this topic, take a look at the following articles, which discuss "pay if paid" and "pay when paid" clauses in more detail.

Can a Contractor Shift the Risk of Nonpayment to Its Subcontractor?

Viability of "Pay When Paid" Clauses In New York & New Jersey

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