June  1, 2004



Bulletin #76, When Can a Subcontractor Withhold Work Because of Non-Payment? (June 1, 2004)

Most large construction contracts call for progress payments. Problems can arise for the Subcontractor (“Sub”) when the General Contractor (“General”) fails to make timely payments. Much to the dismay of the Sub, it ends up becoming a financier of the project (i.e., the Sub is forced to finance its own costs). As a result, and not surprisingly, the Sub starts thinking about walking off the job or canceling the contract outright. Under what circumstances is the Sub justified in doing so? What should the Sub be aware of before deciding to “pull the plug” on a project? The answers to these questions are briefly discussed in this Contracts Bulletin.

It is important to keep in mind that the following is only a general discussion. The law can vary from state to state. Because the facts and circumstances of each case will determine whether you are justified in suspending services under a contract, it is recommended that you seek competent legal advice before you make the decision to suspend services because of non-payment.

Has There Been a “Material Breach?”

Generally speaking, a Sub may suspend its services for reasons of non-payment if, and only if, the General’s failure to pay constitutes a “material breach” of the parties’ agreement. The question then becomes, “What constitutes a material breach/violation of a contract?”

A material breach is a violation of the contract that goes to the very heart or essence of the parties’ agreement. In other words, a material breach is one that is serious and not just a trivial violation of the agreement. Whether or not a breach meets this standard is driven by the facts and circumstances of each case and, most importantly, the language in the agreement (discussed below). Numerous courts have held, however, that under certain circumstances, a General’s failure to make payments to a Sub can constitute a material breach of a construction contract. See e.g., Henson Construction Co. v. Davis, 43 P.3d 417 (Ok.App. 2002); Manganaro Corp., Hitt Corp., 193 F.Supp.2d 88 (D.D.C.2002). In this regard, one court has aptly observed:

The Subcontractor cannot and should not be expected to finance the project until such time that the prime contractor or the Government decides to pay the amount due. If the Subcontractor is ordered to perform the work or even required to do so, then the obligation in the absence of an express contract provision falls upon the party so ordering the work to be done to pay a reasonable amount for that work within a reasonable time. To hold otherwise would cast a burden upon the Subcontractor, which in many cases would be impossible to carry as the Subcontractors are usually smaller in size than the prime contractors.

United States for Use of F.E. Robinson Co. of N.C., Inc. v. Alpha – Continental, 273 F.Supp. 758, 775-76 (E.D.N.C. 1967).

Thus, under the proper circumstances, a Sub may indeed be justified in suspending its services when the General fails to timely make payment. This does not mean, however, that every delinquent payment on the part of a General will justify suspension of services.

If the General fails to make a progress payment that is only nominal or insignificant, the Sub will not be justified in suspending services. Stewart v. C & C Excavating, 877 F.2d 711 (8th Cir. 1989). For example, if the General fails to make a $1,000 payment on a contract that is worth $1 million dollars, the breach will not be considered material, and in such a situation, the Sub (by refusing to perform) would likely be considered to be in breach of the agreement. Therefore, before a Sub makes the decision to suspend services under a contract, it must put the alleged breach into its proper context - as it relates to the contract as a whole.

The Contract Controls

While it is true that some courts have upheld a Sub’s right to “walk” away from a job because of non-payment, it was only because the parties’ contract permitted such a result. Thus, whether a Sub can justifiably suspend services depends on the contract language used by the parties. For example, if the agreement expressly provides that a contractor is excused from making timely payments, as is the case under a “Pay-When-Paid” clause (see Contracts Bulletin #73), a Sub will have an uphill battle establishing a material breach. In other words, a court would view such a clause as evidence that the Sub granted the General “permission” to make late payments. Under Pay-When-Paid clauses, when the General exercises its right to withhold payment to the Sub (because the owner is late paying the General), the General has not breached the agreement.

Other contract language can have a bearing on whether a Sub is justified in suspending services. For example, some contracts contain language stating that “time is of the essence” regarding the parties’ performance (also discussed below). Some courts have relied upon this type of language in evaluating whether a General’s failure to make timely payments constitutes a material breach of the contract. In other words, if the parties expressly agreed each has a duty to perform in a timely manner (including the obligation to make progress payments), then the General’s failure to make timely payments to the Sub constitutes a material breach of the agreement.

Practical Tips

In light of the above, and as echoed throughout these Contracts Bulletins, it is very important that you carefully consider the contract language that is presented to you. Outlined below are some practical tips to keep in mind concerning payment issues when you are (1) negotiating a contract and (2) considering whether or not to suspend services.

During Contract Formation:

  • Pay-When-Paid: Beware of “Pay-When-Paid” clauses. (See Contracts Bulletin #73). If the other party presents you with a “Pay-When-Paid” clause, make sure you know what you are entering into. Best case scenario, reject it outright. If you cannot, consider negotiating for other language that will serve to limit the scope of the ‘Pay-When-Paid” clause.
  • Example:

    Language proposed by General:

    The General’s obligation to pay the Subcontractor is expressly contingent upon the General’s receipt of payment from Owner.

    Again, negotiate for the complete elimination of the language. In the alternative, consider the following:

    Notwithstanding the above, the General is obligated to pay the Subcontractor within sixty days after the Subcontractor’s invoice becomes due regardless of the General’s receipt of payment from the Owner. The General acknowledges that its failure to make timely payments under this clause constitutes a material breach of the contract.
  • Time is of the Essence: Negotiate for a “time is of the essence” clause. Even if the contract contains Pay-When-Paid language, a “time is of the essence” clause may serve to limit the ability of the General to withhold payment indefinitely.
  • Example:

    The parties hereby agree that time is of the essence regarding performance of their respective duties and obligations under the contract and this clause expressly includes the General’s obligation to pay the Subcontractor amounts due and owing.
  • Payment Terms: Provide a sufficient level of detail in the contract so the General knows what your expectations are concerning payment (i.e., how long the General has to pay, the process to be used if an invoice is disputed, etc.).
  • Dispute Resolution: Attempt to anticipate payment problems and address them in the contract. For example, if payment will be based on the percentage of the work completed, who comes up with the percentage? What happens if the parties don’t agree? Is there a mechanism built into the contract to address this issue?
  • Example:

    The Subcontractor shall be paid within ten days following its submission of an invoice to the General. The Subcontractor shall submit invoices to the General monthly based on the percentage of the work the Subcontractor completed in the preceding month. The percentage of work completed will be determined exclusively by the Architect. The Subcontractor will provide a certified copy of the Architect’s report with its invoices.

  • Say “No:” Finally, if you do not feel comfortable with the language presented to you, do not accept it. Negotiate for other language.
Before Deciding to Suspend Performance:
  • Review your contract carefully. As discussed above, you are justified to suspend performance if, and only if, the General has committed a material breach/violation of the contract. The contract language will control this determination. Before doing anything, review the contract provisions regarding the General’s duty to pay. Determine if your contract has an unrestricted “Pay-When-Paid” clause or equivalent language. Find out if your contract has a “time is of the essence” clause. Is there language concerning attorney’s fees (i.e., if you get sued and lose, do you have to pay the General’s attorney’s fees)?
  • Attempt to determine why the General is withholding payment. Try to determine why you are not getting paid. Is there a legitimate dispute over an invoice? Is there another legitimate reason (i.e., contractually based) that allows the General to withhold payment? Are you in material breach of the contract?
  • Evaluate the risks. Suspending performance is a drastic remedy and it should not be taken lightly. If you are not legally justified in suspending services, you will be the party in breach of the agreement. In other words, proceed cautiously in this area and understand the risks to your business.
  • Consider talking to the General. It may be possible to “iron out” your differences with the General by simply talking to it. Perhaps the reason(s) for non-payment is based on a misunderstanding.
  • Talk to your lawyer. If you walk away from a project, you can bet you will probably get sued. Your lawyer can give you guidance not only about your specific contract but also the law in your state. What may constitute a justifiable reason to suspend performance in North Carolina may not be the case in California.

Conclusion

Whether or not a Sub can withhold services for reasons of non-payment is a fact-intensive inquiry that will be driven by the language in the contract. With this in mind, when negotiating contracts, keep payment issues in mind and insist upon contract language that protects your interests. As you proceed under a contract, to the extent you are faced with a situation in which the General is not making timely payments, be cautious when deciding whether or not to suspend performance. While you may very well have legal grounds to suspend performance, it is important to carefully consider all of your options before employing this drastic remedy.

 

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