July  30, 1999



Bulletin # 29: Paid When Paid Clauses

ZZZ Sheet Metal had bid the design and installation of the HVAC system on a large shopping center. Its price was accepted and the general contractor forwarded a form of subcontract that ZZZ would be expected to sign. The general contractor (with which ZZZ had not previously worked) described the subcontract as a “standard form” and insisted that the terms were never negotiated or changed. Excited about taking on the new project, the subcontractor flipped quickly through the form, filled in the blanks (by inserting the pricing and schedule) and returned the signed form to the general contractor. Project work began almost immediately.

After a year, ZZZ was nearing the completion of its work. Due to the project schedule, a disproportionate amount of the subcontractor’s work had come during a relevantly short period of time. In fact, ZZZ’s monthly payment request being submitted represented over one-third of the total bid amount. Prior draws had been paid on time and ZZZ had no reason to expect that this would change.

On this occasion, however, the date for payment under the subcontract passed without delivery of a check. The subcontractor called the project manager to inquire about the payment. The subcontractor was told that the general contractor had yet to be paid on its payment request for the entire project and that the general contractor could not pay ZZZ until it received payment. While the reasons given were not terribly clear, it appeared that the developer’s delay of payment to the general contractor involved a combination of lender issues, budget issues, and disputes over the project schedule.

When ZZZ protested that it was not the cause of those problems and should be paid, the general contractor pointed to language in the (small print) form contract stating “Receipt of payment by the contractor from the owner for the subcontractor’s work is a condition precedent to the contractor’s obligation to pay the subcontractor, regardless of the reason for the owner’s nonpayment.” ZZZ management, facing large payroll and supplier obligations, was stunned.

The non-payment situation continued for additional weeks and the subcontractor’s management contemplated walking off of the job, filing a mechanic’s lien, or terminating the subcontract altogether. Its threats were met with counter-threats from the general contractor, along with reassurances that payment would be forthcoming. ZZZ elected to continue working in the hope that it would be paid immediately, and without legal wrangling, when the funds became available to the general contractor. The subcontractor was led to believe, on each occasion, that payment was expected “next week.”

The news of the developer’s bankruptcy made the front page of the local papers. Obviously, a bad situation had gotten much worse. Project work stopped as the lender, numerous other creditors, the general contractor, architect, and hordes of attorneys and judges attempted to figure out what would happen to the nearly completed project. At this point, ZZZ lost patience and demanded that the general contractor (which was a solvent well-established firm) pay for its work. The general contractor again refused and sent the subcontractor a copy of the page of the subcontract with the payment section highlighted. It now appeared that the “condition precedent” language tucked away deep in the body of the subcontract could have the effect of destroying the subcontractor’s business.

As a last resort, ZZZ management went to meet with the firm’s attorney. The subcontractor’s management had suspected for some time that this saga might end up in court or arbitration and had put together some theories to defeat the subcontract language. First, ZZZ management hoped to hang its hat on the argument that it had not been given sufficient time to review the subcontract and had been misled as to its contents by the “standard form” statements by the general contractor. Second, the subcontractor intended to argue that the general contractor’s continuing representations as to when payment would be made (on which ZZZ had clearly relied in continuing its work on the project) had been false and that the subcontractor had been defrauded by the general contractor. The subcontractor had supplied the labor and materials required by the subcontract, the general contractor had the ability to pay, and the subcontractor was confident that its arguments would persuade a court to force the general contractor to pay.

After reviewing the facts and documents, the subcontractor’s attorney informed ZZZ that the “we did not have time to read the subcontract” argument would not be persuasive nor would the “its just the standard form” argument. The misrepresentation argument appeared to have somewhat greater merit, but only if it could be demonstrated that the general contractor knew at the time that the developer was failing financially and would not pay. The attorney informed the client that this would be difficult to prove, since the general contractor would presumably have terminated its own work on the project if it had known that it was not going to be paid. The subcontractor’s management was on the verge of panic, thinking that its next trip to an attorney might involve its own bankruptcy attorney.

A week later, ZZZ’s attorney called and suggested a new approach. The subcontractor promptly commenced a legal action against the general contractor asserting that the “pay if paid” clause should be held unenforceable as a violation of law and public policy. Under the laws of the state where the project was located, waivers of mechanic’s lien rights were prohibited. However, the right to file a mechanic’s lien would only arise when an amount was due to the subcontractor and had not been paid. The “pay if paid” clause meant that the general contractor only owed sums to the subcontractor when it had received payment. Given the bankruptcy of the developer, the general contractor might not be paid for years, if at all. The subcontractor argued that this structure created, in effect, an illegal waiver of the subcontractor’s mechanic’s lien rights since those rights were rendered unenforceable under the circumstances. After a trial, the court ruled in favor of the subcontractor and ordered the general contractor to pay for the subcontractor’s work (this is a hypothetical situation and the outcome in such a case would vary significantly from state to state and fact situation to fact situation).

Few issues in construction contracting are more controversial than the “pay when paid” or “pay if paid” clauses. This was most recently demonstrated in the negotiations over a new Standard Form Subcontract (AGC No. 640/ASA No. 4100/ASC No. 52). The seemingly final Subcontract form, which had been extensively negotiated by the AGC, the ASA and the ASC, was ultimately rejected by the AGC over the payment risk issue. Obviously, the general contractor does not factor in the costs and risk of bankrolling a project when its submits its bid. On the other hand, the subcontractor expects to get paid for materials supplied and work performed without taking on financial responsibility for a dispute or problem at a higher level.

If confronted with “pay when paid” or “pay if paid” language, the subcontractor should always try to delete or at least modify the terms. If there is to be a contingency as to subcontractor payment, it should be related only to deficiencies in the subcontractor’s work. If subcontract language cannot be changed, the subcontractor should perform additional due diligence on the project finances and obtain advice as to the enforceability of the contingent payment provision under the laws of that jurisdiction. The results of that review may cause the subcontractor to take on the risk of the contingent payment clause or to walk away from the project. By performing the analysis upfront, the subcontractor can make a reasonably informed decision instead of finding out, after the fact, that it will not be paid.

 

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