Overcoming the dread 'pay if paid' clause
One of the most onerous construction contract clauses for subcontractors is a contingent payment clause, commonly referred to as a "pay if paid" clause. An enforceable "pay if paid" clause makes the subcontractor, instead of the general contractor, bear the risk of nonpayment by the owner.
Contingent payment clauses come in all sizes and colors. The precise wording of the clause will make the difference whether a clause is construed as simply setting forth the time when payment is to be made, which in no event will be longer than a reasonable time, or whether the clause effectively makes payment by the owner to the general contractor a condition precedent to the general contractor's duty to pay its subcontractor.
The issue of whether and when subcontractors get paid affects not only subcontractors and general contractors, but owners as well, in that owners are faced with the threat of double payment if subcontractors place mechanic's liens against their property. In addition, the owner's project will undoubtedly benefit by avoiding delays and disruption caused by unhappy subcontractors.
Protecting your interests
In order to minimize the subcontractor's risk of nonpayment due to the owner's failure to pay, the subcontractor should consider the following:
Some states, notably California and New York, have by court decision declared this type of clause to be void as against public policy. Other states, such as North Carolina and Wisconsin, have done the same by statute. Still others —Missouri, Illinois, and Maryland among them —have statutes that say that a "pay if paid" clause will not be an impediment to the subcontractor's right to enforce a mechanic's lien.
Try to avoid contract language that makes payment by the owner to the general contractor a "condition precedent" to the contractor's duty to pay the subcontractor.
If all else fails, negotiate language that assigns to the subcontractor the general contractor's right to sue the owner for the amount owed.
Seeking a compromise
From a general contractor's point of view, the GC generally wants language that clearly and unambiguously states that the subcontractor assumes the risk of owner nonpayment and owner insolvency. Further, the general contractor will state that payment by the owner to the general contractor for the subcontractor's work is a "condition precedent" to the general contractor's duty to pay the subcontractor, notwithstanding any other language in the contract to the contrary. With some notable exceptions, this will generally shift the risk to the subcontractor.
The subcontractor, on the other hand, will strive to negotiate language which omits any "condition precedent" language and instead states that the general contractor will pay the subcontractor within a set period of time, say, 10 days, after the general contractor receives payment from the owner. If this type of language is used, courts will usually interpret it as meaning that the general contractor must pay the subcontractor within a reasonable time even if it is never paid by the owner.
In those jurisdictions enforcing pay-if-pay clauses, if the subcontractor is unable to keep the dreaded "condition precedent" language out of the subcontract, it should attempt to soften the language somewhat by adding a provision saying that it has the right to payment from the general contractor if the reason for the nonpayment by the owner to the general contractor is due to the fault of the general contractor or other subcontractors, as opposed to the fault of the subcontractor signing the subcontract.
In addition, the subcontractor should provide a claim's procedure whereby it has the option of pursuing its claim in the event of nonpayment, including the right to sue the owner directly after the general contractor assigns to the subcontractor the account receivable.
A clause giving the subcontractor the right to pursue the owner gives the parties at least some of what they want. The general contractor has avoided having to pay its subcontractor without a corresponding payment from the owner, unless the reason the owner did not pay was due to the fault of the general contractor or one of its other subcontractors, in which case, the general contractor should be liable to its nondefaulting subcontractor. It's not a perfect solution, but it's better than nothing.
The subcontractor faces the risk that the owner will not be solvent enough to pay the claim and that the property will not have sufficient equity to satisfy all liens. Generally, however, there should be sufficient equity, especially in those jurisdictions where mechanic's liens will trump mortgages placed on a property to secure repayment of construction loans. As assignee, the subcontractor will have to contend with any defenses the owner may have against the general contractor, but it will at least have improved its position had it been faced with an unambiguous "pay if paid" clause.