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Contractor Payment Obligations: “Pay-When-Paid” vs. “Pay-If-Paid”

Contractors often include “pay-when-paid” clauses in their subcontracts. These clauses provide that the contractor will pay its subcontractor after the contractor has received payment from the owner. A typical pay-when-paid clause might read: “Contractor shall pay Subcontractor within seven (7) days of Contractor’s receipt of payment from the Owner.” Thus, under this type of clause, the receipt of payment from the owner will trigger the contractor’s obligation to pay its subcontractor. But what happens if the owner never pays? Does the contractor have any payment obligations to its subcontractor?

Generally, clauses like the one above do not shield the contractor from payment liability. Rather, most courts hold that a pay-when-paid clause only suspends the contractor’s obligation to make a payment for a reasonable amount of time for the contractor to secure payment from the owner. In the event that the owner refuses to pay, or cannot pay, the contractor will be responsible for paying its subcontractor. A pay-when-paid clause does not establish a condition precedent (i.e., make the subcontractor’s right to payment contingent upon the contractor’s receipt of payment from the owner), but rather, only serves to create a timing mechanism for the contractor’s payment to the subcontractor. The ultimate risk of non-payment by the owner remains with the contractor.

Contractors that intend to shift the risk of non-payment by the owner to the subcontractor must include explicit language in their subcontracts stating that payment by the owner is a “condition precedent” to the subcontractor’s right to be paid. These types of clauses are generally referred to as “pay-if-paid” clauses. A typical pay-if-paid clause might read: “Receipt of payment by the Contractor from the Owner for the Subcontract Work is a condition precedent to payment by the Contractor to the Subcontractor. The Subcontractor hereby acknowledges that it relies on the credit of the Owner, not the Contractor, for payment of Subcontract Work.” Unlike a typical pay-when-paid clause, this language makes it clear that the subcontractor’s payment is conditioned upon receipt of payment from the owner, and that the subcontractor agrees to assume the risk of owner non-payment. If used properly, a pay-if-paid clause can shield the contractor from payment liability in cases where the owner refuses to pay.

It should be noted, however, that many courts are reluctant to enforce these types of agreements. Therefore, contractors must be sure that their “pay-if-paid” clauses clearly express an intent, and agreement, to shift the payment risk from the contractor to the subcontractor. If the provision is at all ambiguous, courts will construe the provision as a pay-when-paid clauses (rather than pay-if-paid clauses), and refuse to shield the contractor from payment liability.

Moreover, even where the language is clear, some Courts have held that “pay-if-paid” clauses are unenforceable as a matter of public policy. Similarly the Commonwealth of Massachusetts has enacted a statute that prohibits, or limits, the use and enforceability, of pay-if-paid clauses in certain construction contracts. See Mass. Gen. Laws. ch. 149 § 29E(e).

It is important for contractors and subcontractors to understand the differences between a pay-when-paid and a pay-if-paid clause, and to determine whether the applicable state law will enforce these types of clauses. A failure to understand the issues can result in a contractor or subcontractor holding the bag at the end of a job (in place of an owner that can no longer pay).

Perkins Thompson regularly helps owners, contractors, subcontractors, and material suppliers in connection with construction contract issues. If you would like to speak with the firm about such an issue, you can send an e-mail to Joe Talbot or call him directly at 207-774-2635.