Contractor Risk of Nonpayment

Derek D. Lick, Esq.
Sulloway & Hollis, P.L.L.C
July 2009

Arguably, no sector of the economy has suffered more in the current economic downturn than construction. Faced with suddenly tight finances, contractors and subcontractors alike are more aggressively pursuing prompt and full payments for their work because every dollar now seems to count more than ever before. In this environment, counsel for those in the construction and building trades must be alert to the controversial "pay-if-paid" contractual provision and the shifting of 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. The following are some examples of these provisions from reported cases:

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 applicationfor payment. This is a condition precedent to any obligation of contractor, and shall not be construed as a time-of-payment clause.

It is no surprise that general contractors want to include these types of provisions in their contracts, because they clearly attempt to shift the risk of an owner's nonpayment down the chain to subcontractors. It is equally no surprise that subcontractors want to avoid these provisions, if at all possible, because they want payment for their work, regardless of whether the owner pays for it or not.

Are Pay-If-Paid Provisions Enforceable?
Courts have split on whether pay-if-paid provisions are enforceable. The primary judicial consideration has balanced a materialperson's or laborer's right to be paid for his or her work against one's freedom to contract as one chooses. Some courts have expressly found these provisions void because they work against public policy. Some courts have upheld these provisions. Yet other courts have gone out of their way to interpret these provisions as "pay-when-paid" provisions, concluding that they only allow for the delay of payment, as opposed to avoiding payment altogether.

In the mid-1990s, the Supreme Court of California and the highest court in New York found pay-if-paid provisions unenforceable as contrary to public policy. See William R. Clarke Corp. v. Safeco Ins. Co. of Am., 938 P.2d 372 (Cal. 1997); West Fair Elec. v. Aetna Cas. & Ins. Co., 661 N.E.2d 967 (N.Y. 1995). In the New York case, the court concluded that pay-if-paid provisions violated public policy because they infringed on subcontractors' statutory lien rights. Specifically, the New York court found that these provisions precluded establishing a "debt due" for work that had been performed or labor that had been provided, a prerequisite for lien rights to accrue. Therefore, the court held that pay-if-paid provisions improperly undermined the state's mechanic's liens statutes. As for the California court, it reached the same conclusion, noting 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.

Just recently, in October 2008, the Supreme Court of Nevada joined the California and New York high courts in finding these provisions unenforceable. See Lehrer McGovern Bovis, Inc. v. Bullock Insulation, Inc., 197 P.3d 1032 (Nev. 2008). The Nevada court undertook the same analysis as the California and New York courts:

Because the pay-if-paid provision limits a subcontractor's ability to be paid for work already performed, such a provision impairs the subcontractor's statutory right to place a mechanic's lien on the construction project. As noted above, Nevada's public policy favors securing payment for labor and material contractors. Therefore, we conclude that pay-if-paid provisions are unenforceable because they violate public policy.

Id. at 1042.

Interestingly, the Nevada Supreme Court's decision is of little practical consequence, as the state legislature amended its mechanic's liens statutes to "proclaim" these provisions unenforceable, except in certain limited circumstances. See id.; Nev. Rev. Stat. § 624.624-624.626. These statutory changes place Nevada in the company of Illinois, Maryland, Missouri, North Carolina, and Wisconsin-each of which have statutorily either declared pay-if-paid provisions void and unenforceable or expressly precluded these provisions from abrogating a mechanic's lien or bond claim rights. See 770 Ill. Comp. Stat. Ann. 60/21; Md. Code Ann., Real Prop. § 9-113; Mo. Rev. Stat. § 431.183; N.C. Gen. Stat. § 22C-2; Wisc. Stat. § 779.135.

However, not all courts have refused to enforce pay-if-paid provisions. Some courts have taken the opposite position and found that pay-if-paid provisions are enforceable and protected by one's freedom to contract. See Wellington Power Corp. v. CNA Surety Corp., 614 S.E.2d 680 (W.V. 2005); see also MidAmerica Constr. Management, Inc. v. Mastec North America, Inc., 436 F.3d 1257 (10th Cir. 2006) (deeming a pay-if-paid provision enforceable under New Mexico and Texas law). In the Wellington case, the West Virginia Supreme Court first found that the pay-if-paid language was unambiguous, and therefore, indisputably created a clear and express condition precedent to payment. The court then focused on the "broad liberty of contract," which "should not be lightly dismissed." Ultimately, it concluded that the public policy of freedom to contract outweighed the public policy found in the applicable state statutes. Of note, the West Virginia case involved a public construction project, although this fact did not appear to have a significant impact on the court's decision, and West Virginia's mechanic's liens statutes at the time apparently did not include anti-waiver language, unlike California's and New York's statutes, which did include it.

Furthermore, the United Stated District Court for the District of New Jersey and a superior court in Connecticut recently upheld the validity of pay-if-paid provisions in construction contracts. See Fixture Specialists, Inc. v. Global Constr., LLC, No. 07-5614(FLW), 2009 WL 904031 (D.N.J. Mar. 30, 2009); Lindade Constr. Co. v. Continental Cas. Co., No. X10UWYCV5008768S, 2009 WL 765501 at * 4 (Conn. Super. Ct. Feb. 25, 2009). In these two cases, both courts concluded that these provisions did not violate the anti-waiver sections of their state's mechanic's liens statutes. However, the courts reached that conclusion because under the particular statutes at issue, the subcontractors had the right to file a mechanic's lien attachment, even if payment was not "technically" due. In the New Jersey matter, the federal court relied on a New Jersey Supreme Court case that had previously held that a contractor could file a mechanic's lien for work completed even though it had not met all the conditions for payment under its contract. Thus, the federal court concluded that just as in the New Jersey Supreme Court case, the subcontractor before the federal court could still file a mechanic's lien-though the subcontractor could not foreclose on its lien until all the contractual preconditions for payment were satisfied. By following the New Jersey Supreme Court's decision separating the right of a contractor to file a lien from the contractor's right to foreclose on the lien, the federal court found that the pay-if-paid provision did not violate the state's anti-lien waiver statute.

Still other courts have attempted a "middle ground" approach. These courts, if at all reasonably possible, will construe pay-if-paid provisions as "merely fixing the usual time for payment to the subcontractor, with the implied understanding that the subcontractor in any event has an unconditional right to payment within a reasonable time." Clarke, 938 P.2d at 373 (citing cases in Florida, Louisiana, Ohio and Tennessee). Other state courts, including those in Indiana, Iowa, Kentucky, Massachusetts, Minnesota, Nebraska and South Carolina, have also adopted this middle ground approach. See Midland Eng'g Co.; v. John A. Hall Const. Co., 398 F. Supp. 981 (N.D. Ind. 1975); Grady v. S.E. Gustafson Constr. Co., 103 N.W.2d 737 (Iowa 1960); New Amsterdam Cas. Co. v. Allen Co., 446 S.W.2d 278 (Ky. 1969); A.J. Wolfe Co. v. Baltimore Contractors, Inc., 244 N.E.2d 71 (Mass. 1969); Mrozik Constr., Inc. v. Lovering Assocs., Inc., 461 N.W.2d 49 (Minn. Ct. App. 1990); D.K. Meyer Corp. v. Bevco, Inc., 292 N.W.2d 773 (Neb. 1980); Elk & Jacobs Drywall v. Town Contractors, Inc., 229 S.E.2d 260 (S.C. 1976). It also appears that the federal courts of appeals in the Sixth, Seventh and Eighth Circuits have used this approach. See Thomas J. Dyer Co. v Bishop Int'l Eng'g Co., 303 F.2d 655 (6th Cir. 1962); Dancy v. Howard, 297 F.2d 686 (7th Cir. 1961); Trinity Universal Ins. Co. v. Smithwick, 222 F.2d 16 (8th Cir. 1955).

Factors Potentially Impacting the Enforceability of Pay-If-Paid Provisions
The courts, when considering whether to permit or preclude pay-if-paid provisions, often consider the practical impact of these provisions. For example, subcontractors will argue that they should not bear the risk of an owner's nonpayment because it is a general contractor, not a subcontractor, who has a relationship with an owner, and therefore, the means to directly encourage or demand prompt payment. Additionally, subcontractors will suggest that general contractors are usually larger and have greater financial resources than subcontractors-best enabling general contractors to investigate an owner's ability to make prompt payment and to absorb losses that might result from nonpayment. These arguments could persuade a court, particularly if made by someone who is deemed to have had little, if any, negotiating power when entering into a contract with a pay-if-paid provision.

Similarly, a court will attempt to read pay-if-paid provisions strictly, interpreting them as creating a condition precedent for payment, if the provisions clearly and unambiguously shift liability. See Dyer, 303 F.2d at 660-61; Lafayette Steel Erectors, Inc. v. Roy Anderson Corp., 71 F. Supp.2d 582 (S.D. Miss. 1997); Peacock Constr. Co. v. Modern Air Conditioning, Inc., 353 So.2d 840 (Fla. 1977).

Also, a court might be inclined to find a waiver of the pay-if-paid provision by a on the part of a general contractor if that general contractor had on occasion paid the subcontractor without first having received payment from the owner for the subcontractor's work. See Landmark Org., L.P. v. Delphini Constr. Co., No. 13-04-371-CV, 2005 Tex. App. LEXIS 8414, at *13 (Tex. App. Oct. 13, 2005). Or, alternatively, a court might not afford a general contractor protection of a pay-if-paid provision if the general contractor breached its agreement with the owner for non-subcontract-related work, causing failure to pay. See, e.g., Preload v. Marino Constr., 1991 WL 202651 (N.D. Ill. 1991).

Finally, a surety may not be permitted to use a pay-if-paid provision as a defense to payment, even if that provision is enforceable by the general contractor. See Everett Painting Co., Inc. v. Padula & Wadsworth Constr., Inc., 856 So.2d 1059 (Fla. Dist. Ct. App. 2003) (interpreting the application of a pay-when-paid provision); Fla. Stat. § 713.245 (imposing conditions upon bonds purporting to pay subcontractor claims only up to the amount paid to the general contractor).

Conclusion
Counsel must, of course, fully investigate the appropriate state's case law and statutes when determining whether a pay-if-paid clause is enforceable in a particular situation. For those jurisdictions in which the enforceability of these provisions is one of first impression, courts can pick and choose from a variety of paths taken by courts in other jurisdictions-paths that can take counsel in completely opposite directions.