Why Many States Restrict ‘Pay if Paid’ Contract Terms in Construction Deals - LexisNexis Construction Law

By Steven G. M. Stein | Partner, Stein Ray LLP

Pay if Paid Provisions Shift Risk of Non-Payment Downstream

Pay if paid provisions are quite common in construction subcontracts, shifting the risk of non-payment by an owner to a general contractor (or a higher tier subcontractor) to the lower tier party. These provisions, unlike pay when paid provisions, leave subcontractors with no right to payment if the flow of cash from owners (or higher tier subcontractors) is interrupted.

Pay if paid provisions are not creatures of construction contracting only. Similar provisions exist in contracts in many industries and other commercial contexts. But the politics and equities surrounding their enforcement when included in construction contracts makes the application of the usual rules of contractual enforcement less applicable.

That a party may make it obligations to another subject to conditions precedent, including particularly events and risks outside of the obligor’s control is unremarkable and enforceable. Enforcement is not usually subject to dispute on grounds of public policy or is the enforcement eroded or controlled by limiting legislation.

This is less true in the construction industry. Although many states do enforce clearly drawn pay if paid provisions, the judicial hostility to them is reflected by the high standards for clarity and completeness of the provision. Where these strict standards are not met, the provisions are either not enforced or treated as pay-when-paid provisions where the duty to pay arises after a reasonable time even if the party owing the duty pay, a general contractor or upper tier subcontractor, has not been paid.

Controversy Stems from Perceived Inequities

Hostility to the enforcement of pay if paid clauses may be rooted in perceived equities. Subcontractors who are subject to the provisions often are smaller enterprises, as compared to the general contractors seeking to enforce such provisions, and it may be that courts are cognizant that many subcontractors have limited bargaining power and less sophistication than general contractors. Indeed, most of these provisions appear in standard contracts prepared by general contractors which may not be readily negotiable.

Also, the failure of a general contractor to be paid is often a product of its own conduct at least as a motive force if not legally. The breakdown in a relationship between an owner and a general contractor may arise from many circumstances, some subtle, and the refusal to pay a general contractor may be in part, or wholly, its own fault. But pay if paid provisions often do not differentiate between the failure to pay arising from events for which the general contractor is responsible and those which arise either because the subcontractor itself failed to perform or the owner is acting wrongfully without reasonable excuse.

The reluctance of courts to enforce in these circumstances is understandable as the risk of non-payment to the general contractor is shifted downstream without consideration of who is actually the party precipitating the conflict leading to non-payment.

These equitable considerations may be the driving force for judicial hostility and the reluctance in some jurisdictions to enforce such provisions.

Judicial Reluctance and Legislative Pushback

Subcontractors enjoy leverage not so much on an individual project or contract, but collectively in advancing protective legislation. Mechanics’ Lien acts are the most obvious example. But so too is the legislation reflecting resistance to the shifting of risks thought broad indemnity provisions (which general contractors also have protested) which have been made invalid through “Anti-indemnity” acts in most jurisdictions.

Thus, there are jurisdictions which invalidate pay if paid provisions. And in most jurisdictions Mechanics’ Lien acts have been amended to make clear that if a duty to pay is truncated by a pay if paid provision, nevertheless the Act is applicable and enforceable.

Subcontractors have also attempted to circumvent pay if paid clauses by contending that an anti-indemnity act’s invalidation of contractual provisions which shift losses arising from the indemnitee’s own negligence ought to be applied to prohibit enforcement of pay if paid clauses.

Careful Drafting is a Necessity

With both judicial hostility borne of perceived inequity of such provisions, and the existence of legislation protecting subcontractors, it is not surprising that enterprising counsel have mounted a variety of sometimes inventive attacks on pay if paid provisions.

Given the legal hostility, parties have mounted creative challenges to pay if paid provisions on public policy grounds or by arguing they violate anti-indemnity laws.

The ongoing controversy reflects the tension between freedom of contract and perceived fairness in allocating risk between parties of disparate bargaining power in the construction industry. Careful contract drafting remains essential for both general contractors and subcontractors navigating this complex area.

About Steven Stein

Steven G. M. Stein is a leading authority in construction law and specializes in the trial and arbitration of complex design and construction matters. He also works extensively in the drafting and negotiation of design and construction related agreements. Stein is the Editor-in-Chief of the nation’s leading treatise on construction law -- Construction Law from LexisNexis. He is also Editor-in-Chief of the LexisNexis Monthly Reporter Construction Law Digest.