The Real Lemon in the Bunch: Understanding Pay-If-Paid Clauses in Construction Contracts

Matthew DeVries | Best Practices Construction Law | November 22, 2019

As you may be aware, one of the greatest risks on a construction project involves the payment process. Just like my kids expect to be paid for the lemonade they sell, contractors and subcontractors expect to be paid on a timely basis once the work has been performed.

Contractors have a means of shifting the risk of non-payment by the owner to its subcontractor by including a certain payment provisions in the subcontract agreement.  The enforceability of these types of clauses may be limited by your particular state or jurisdiction.

In Universal Concrete Products Corp. v. Turner Construction Company, the U.S. Court of Appeals for the 4th Circuit concluded that a “pay if paid” clause in a subcontract was not ambiguous and, therefore, enforceable against the subcontractor.  The work involved the construction of the Granby Tower Project in Norfolk, Virginia. The subcontract between the general contractor and the concrete subcontractor contained the following clause:

“The obligation of contractor to make payment under this agreement, whether a progress or final payment, or for extra or change orders or delays to the work, is subject to the express condition precedent of payment from the owner.”

The owner ultimately lost its construction financing on the project and abandoned the development. Since the contractor had not been paid for its work, it refused to pay the subcontractor’s work.  In a payment dispute between the subcontractor and contractor, the contractor argued that the “pay if paid” clause provided an absolute defense to payment. (Again, it should be noted that some states limit the enforceability of these clauses by either statute or case law. However, in Virginia, these types of clauses are enforceable so long as they are clear and unambiguous.)

The subcontractor argued that the prime contract between the owner and the contractor defined the cost of work to include “payments made” to subcontractors. Accordingly, the subcontractor argued that the contractor would, under the normal scenario, be paying its subcontractors and submitting the invoice to the owner as a “payment made” by the contractor. Both the trial court and the Court of Appeals disagreed, finding that payment from the owner was a condition precedent to payment from the contractor to the subcontractor.

Courts across the country vary in their treatment of these issues. For example, in the Universal Concrete Products case, the 4th Circuit reasoned that Virginia courts favor the freedom to contract and that parties are freely able to negotiate and draft these types of provisions. However, in Thomas J. Dyer v. Bishop International Engineering, the 6th Circuit refused to enforce a “pay when paid” clause because the court determined that the clause was sufficiently ambiguous. In that case, the contract stated that “no part of payment shall be due until 5 days after the owner shall have paid the contractor.”  Other jurisdictions, such as California, New York, Nevada and North Carolina, have expressly ruled that the “pay if paid” clauses are unenforceable as a violation of state public policy.

So, what should your contracts provide?  What should you do to determine the enforceability of a “pay if paid” clause in your state?

  • Contact an attorney to determine whether there are any limitations of the enforcement of these type of clauses.  Since each state differs dramatically, it is in your best interest to determine the applicable standard in your state or the applicable law where the project is located or the governing law of the contract to determine this information.
  • Determine as between the parties who should bear the risk of non-payment. If you are a general contractor, you should make sure that your subcontracts include clear and unambiguous language placing the risk of loss for non-payment on the subcontractor. In addition to putting a timing mechanism on payment of funds to the subcontractor following a certain number of days after payment by the owner, it is also advisable to include a clause that “payment by the owner to the contractor is a condition precedent to payment by the contractor to the subcontractor”. In addition, you can make your subcontracts explicitly clear by stating that “the subcontractor assumes the risk of non-payment by the owner due to insolvency or other inability to pay”.

For the contractors out there, Universal Concrete Products is a good reminder of the importance of drafting clear and unambiguous contact terms between the parties.  It is worth the effort to seek legal advice from an attorney in your jurisdiction about these issues prior to drafting and executing contracts with other parties.

Subcontractors Have Remedies, Even If “Pay-If-Paid” Provisions Are Enforced

John P. Ahlers | Ahlers Cressman & Sleight | January 23, 2019

In a recent case in Kentucky[1], a sub-tier subcontractor sued the general contractor and owner for failure to pay for extra work. At the trial, the court held the subcontractor was entitled to recover under the theories of implied contracts and unjust enrichment, even though the subcontract contained a “pay-if-paid” clause. All parties appealed. In particular, the general contractor asserted that the pay-if-paid provision in the subcontract precluded recovery by the subcontractor. The issue was petitioned to the Supreme Court of Kentucky.

The question to be resolved by the Supreme Court of Kentucky was whether a pay-if-paid provision was enforceable as between a general contractor and subcontractor, and if so, whether the subcontractor could nevertheless pursue the owner directly for payment notwithstanding a lack of privity between the owner and subcontractor.

The Supreme Court of Kentucky held that because the owner had not paid the general contractor, as a result of the pay-if-paid clause, the general contractor had not breached the subcontract for failure to pay the subcontractor’s extra work. The relevant subcontract provision was:

[P]ayment [to] the Contractor from the Owner for the Subcontractor Work is a condition precedent to payment by the Contractor to Subcontractor. The Subcontractor hereby acknowledges that it relies on the credit of the Owner, not the Contractor, for the payment of the Subcontract Work.

Another subcontract provision read that:

Unless the Contractor has collected corresponding additional compensation from the Owner or other party involved, no compensation for any claim arising out of the performance of the Subcontract is allowed.

Reading these two clauses together, the Supreme Court concluded that the general contractor’s receipt of payment from the owner was a condition precedent to the obligation to pay the subcontractor. It was established that the general contractor had not received payment from the owner. Therefore, there could be no breach.

The court ruled, however, that because the subcontractor was left with no useful contract remedy against the general contractor, the subcontractor was not barred from bringing unjust enrichment claims against the owner. The court acknowledged that typically “unjust enrichment is unavailable when the terms of the express contract control,” but noted that here the “adequacy” of a “legal remedy” (or the actual realization of that contract remedy) was absent due to the “contractual gridlock” caused by the owner. If the contract was the only avenue for contractors to obtain relief, the result would allow the owner to take advantage of its own failure to pay after receiving “a substantial benefit” from the subcontractor’s work.

Comment: Unjust enrichment and implied contract theories have been used to provide remedies to contractors caught in similar dilemmas in other jurisdictions. See Town Concrete Pipe of Washington, Inc. v. Redford, 43 Wn. App. 493, 717 P.2d 1384 (1986). This is another theory of recovery that a subcontractor should keep in mind if it has failed to recover because of the pay-if-paid provision, when the owner is the cause of the failure of the general contractor to make payment and the subcontractor has not for some reason perfected its lien rights.

[1]Superior Steel, Inc. v. Ascent at Roebling’s Bridge, LLC, 540 S.W.3d 770 (Ky. 2017).

. All parties appealed. In particular, the general contractor asserted that the pay-if-paid provision in the subcontract precluded recovery by the subcontractor. The issue was petitioned to the Supreme Court of Kentucky.

The question to be resolved by the Supreme Court of Kentucky was whether a pay-if-paid provision was enforceable as between a general contractor and subcontractor, and if so, whether the subcontractor could nevertheless pursue the owner directly for payment notwithstanding a lack of privity between the owner and subcontractor.

The Supreme Court of Kentucky held that because the owner had not paid the general contractor, as a result of the pay-if-paid clause, the general contractor had not breached the subcontract for failure to pay the subcontractor’s extra work. The relevant subcontract provision was:

[P]ayment [to] the Contractor from the Owner for the Subcontractor Work is a condition precedent to payment by the Contractor to Subcontractor. The Subcontractor hereby acknowledges that it relies on the credit of the Owner, not the Contractor, for the payment of the Subcontract Work.

Another subcontract provision read that:

Unless the Contractor has collected corresponding additional compensation from the Owner or other party involved, no compensation for any claim arising out of the performance of the Subcontract is allowed.

Reading these two clauses together, the Supreme Court concluded that the general contractor’s receipt of payment from the owner was a condition precedent to the obligation to pay the subcontractor. It was established that the general contractor had not received payment from the owner. Therefore, there could be no breach.

The court ruled, however, that because the subcontractor was left with no useful contract remedy against the general contractor, the subcontractor was not barred from bringing unjust enrichment claims against the owner. The court acknowledged that typically “unjust enrichment is unavailable when the terms of the express contract control,” but noted that here the “adequacy” of a “legal remedy” (or the actual realization of that contract remedy) was absent due to the “contractual gridlock” caused by the owner. If the contract was the only avenue for contractors to obtain relief, the result would allow the owner to take advantage of its own failure to pay after receiving “a substantial benefit” from the subcontractor’s work.

Comment: Unjust enrichment and implied contract theories have been used to provide remedies to contractors caught in similar dilemmas in other jurisdictions. See Town Concrete Pipe of Washington, Inc. v. Redford, 43 Wn. App. 493, 717 P.2d 1384 (1986). This is another theory of recovery that a subcontractor should keep in mind if it has failed to recover because of the pay-if-paid provision, when the owner is the cause of the failure of the general contractor to make payment and the subcontractor has not for some reason perfected its lien rights.

[1]Superior Steel, Inc. v. Ascent at Roebling’s Bridge, LLC, 540 S.W.3d 770 (Ky. 2017).

Pay IF Paid: It Means What it Says

Kyle M. Doiron | Bradley | March 2018

Pay when paid clauses are common in the construction industry. A typical pay when paid clause sounds something like this: “Prime Contractor will not pay Subcontractor until Prime Contractor receives payment from Owner.” A lay person might read that and interpret it to mean that if the Prime Contractor is never paid by the Owner, then at no point will the Prime Contractor be liable to pay the Subcontractor for the Subcontractor’s work. But courts generally disfavor conditions precedent (an event that must occur before another party’s performance is due) and will not observe their existence unless they are unambiguously laid out in the contract. Therefore, most courts interpret the above clause as dealing only with the timing of payments rather than shifting the risk of the Owner’s non-payment from the Prime Contractor to the Subcontractor. In other words, a court would likely hold that if the Owner defaulted and was unable to pay the Prime Contractor, then the Prime Contractor would still be contractually obligated to pay the Subcontractor for the work it completed; the clause above would only function to postpone payment by the Prime Contractor for a “reasonable time” after demanded by the Subcontractor.

However, subcontractors and general contractors should be aware that if language in a contract clearly establishes that the prime contractor is only obligated to pay the subcontractor if the owner pays the prime contractor for that work, and the contract states that the subcontractor is taking the risk of the owner’s potential insolvency, then courts are likely to enforce the contract as written—condition precedent and all. This language establishes what is known as a pay if paid clause.

For example, in Superior Steel, Inc. v. Ascent at Roebling’s Bridge, LLC, a Kentucky Supreme Court case, a subcontractor brought suit for non-payment by the general contractor for additional work it completed. The contract between the general contractor and subcontractor stated:

No additional compensation shall be paid by the Contractor to the Subcontractor for any claim arising out of the performance of this Subcontract, unless the Contractor has collected corresponding additional compensation from the owner, or other party involved, or unless by written agreement from the Contractor to the Subcontractor prior to the execution of the Work performed under said claim, which agreement and work order must be signed by an officer of the Contractor.

The contract further stated in a section labeled “Time of Payment” that:

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.”

The court in Superior Steel found the above clauses unambiguous and held that the pay if paid language coupled with the express use of the term “condition precedent” “unequivocally allocate[ed] the risk of nonpayment by the Project owner to [the subcontractor] …” The court was unpersuaded by the subcontractor’s argument that pay if paid clauses are void as against public policy, reasoning that the right to contract is valued in Kentucky (as it is in all states), and if the court held pay if paid clauses void for public policy purposes, it would not only upset the respected right to contract but would be usurping the role of the legislature. Accordingly, because the general contractor had not been paid by the owner for the work, the court joined the majority of other jurisdictions holding that the general contractor was not liable to the subcontractor for the additional work completed.

It is important to be aware, however, that while the above is the majority position, there are states where pay if paid clauses are unenforceable. For example, the Supreme Court of California has deemed pay if paid clauses unenforceable as contrary to public policy. Similarly, South Carolina has statutorily deemed unenforceable any agreement conditioning a subcontractor’s payment on an owner’s payment to a prime contractor. S.C. Code Ann. § 29-6-230.

Therefore, the take-away for general contractors looking to minimize liability and decrease the risk associated with an owner’s default is to consult with counsel about whether it makes sense to add a pay if paid clause to your subcontracts. If you are a subcontractor, lookout for language establishing payment from the owner as a condition precedent for payment and anything discussing shifting the risk of an owner’s non-payment from the general contractor to you. Because if the language is clear and the owner goes bust, chances are you may be left holding the bag.

Pay-if-Paid Enforced Opening Door to Subcontractor Claim Against Owner

Katharine E. Kohm | The Dispute Resolver | February 24, 2018

In Superior Steel, Inc. v. Ascent at Roebling’s Bridge, LLC, No. 2015-SC-000204-DG, 2017 WL 6380218 (Ky. Dec. 14, 2017), a subcontractor and a sub-subcontractor sued the general contractor and owner for the failure to pay for extra work. The general contractor and owner cross-claimed against the other for, inter alia, indemnification.  At the jury trial, the subcontractors recovered under theories of implied contract and unjust enrichment.  All parties appealed, in particular, as to the pay-if-paid jury instruction. The Court of Appeals vacated the judgment and remanded.  In turn, all parties petitioned to the Supreme Court of Kentucky.
The key questions in the petition were whether the pay-if-paid provision was enforceable as between the general contractor and subcontractors and, if so, whether the subcontractors could pursue the owner directly for payment notwithstanding the lack of privity between owner and subcontractors.
The Supreme Court concluded that, as a result of the pay-if-paid clause, the general contractor had not breached subcontract for the failure to pay for the subcontractor’s extra work.  The relevant subcontract provisions stated:
  • “no compensation . . . for any claim arising out of the performance of this Subcontract, unless the Contractor has collected corresponding additional compensation from the owner, or other party involved”
  • And more directly – “payment [to] the Contractor from the Owner for the Subcontractor Work is a condition precedent to payment by the Contractor to Subcontractor. The Subcontractor hereby acknowledges that it relied on the credit of the Owner, not the Contractor for payment of the Subcontract Work.”
Reading these together, the Supreme Court agreed that the general contractor’s receipt of payment from owner was a condition precedent to its obligation to pay the subcontractors.  Because the general contractor did not receive payment from the owner, there could be no breach. The Court did note that “pay-if-paid clauses have fallen out of favor in some states, [but] the prohibition against their use has come from the legislature rather than the courts.” In Kentucky, no such statutory prohibition existed.
However, because the subcontractors were left with no useful contract remedy against general contractor, the Court held that the subcontractors were not barred from bringing unjust enrichment claims against the owner.  The Court acknowledged that typically “unjust enrichment is unavailable when the terms of an express contract control.”  But noted that, here, the “adequacy” of a “legal remedy” (or the “actual realization of that contractual remedy”) was absent due to the “contractual gridlock” caused by the owner.  Indeed, if the contract was the only avenue for the subcontractors to obtain relief, that result would allow the owner to take advantage of its own failure to pay after receiving “a substantial benefit” from the subcontractors’ work.

Kentucky Supreme Court Holds “Pay-if-Paid” Provision in Subcontract Is Valid and Enforceable, Shifting Risk to Subcontractor

Michelle Beth Rosenberg | Pepper Hamilton LLP | January 25, 2018

Superior Steel, Inv. v. Ascent at Roebling’s Bridge, LLC, 2017 Ky. LEXIS 511 (December 14, 2017)

Corporex Development and Construction Management, LLC (“Corporex”), a design builder, contracted with Dugan & Meyers Construction Company (“D&M”), a construction manager and general contractor on the Ascent at Roebling’s Bridge (the “Project”), a 21-floor luxury condominium in Covington, Kentucky.

As a cost saving measure, D&M asked Superior Steel, Inc. (“Superior”) to fabricate the steel and to have Ben Hur Construction Company (“Ben Hur”) complete the erection and installation work. Superior and D&M entered into a fixed price contract for $1,814,000. In turn, Superior subcontracted with Ben Hur to erect the steel and metal decking for $444,000. As structured, the payments would flow from Corporex to D&M to Superior. Superior would then pay Ben Hur.

During the course of the Project, D&M instructed both Superior and Ben Hur to perform extra work. Ben Hur and Superior submitted work orders to D&M who in turn submitted work orders to Corporex. Ultimately, Corporex refused to pay for Superior and Ben Hur’s additional work and refused to pay Superior’s retainage.

Superior and Ben Hur filed a complaint against Corporex and D&M for breach of contract, among other claims, in order to recover monies owed. The trial court held that a contract existed between Superior and D&M and that an implied contract existed between Ben Hur and D&M, as a matter of law. The trial court entered judgment in favor of Superior for $124,017.26 for extra work performed and $195,143.40 for unpaid retainage. Additionally, the trial court entered judgment in favor of Ben Hur for $284,295.53 for extra work performed.

The Court of Appeals vacated the trial court judgment, reasoning that the jury should have been explicitly instructed as to the “pay-if-paid” provisions in the Superior/D&M contract. Such provisions essentially mandated that Superior was entitled to payment from D&M only if D&M received payment from Corporex. The Kentucky Supreme Court agreed with the Court of Appeals on this issue.

At the center of Superior and Ben Hur’s breach of contract claims, was the “pay-if-paid” provisions which condition D&M’s payment of Superior on D&M having first been paid by Corporex. “Pay-if-paid” conditions shift the risk of nonpayment from the contractor to the subcontractor. The Superior/D&M contract contains two sections with pay-if-paid language. First, Article 7.11 “Claims Payment,” states:

[n]o additional compensation shall be paid by the Contractor to the Subcontractor for any claim arising out of the performance of this Subcontract, unless the Contractor has collected corresponding additional compensation from the owner, or other party involved, or unless by written agreement from the Contractor to the Subcontractor prior to the execution of the Work performed under said claim, which agreement and work order must be signed by an officer of the Contractor.

Second, Article 8.2.4, “Time of Payment” states:

[r]eceipt of payment by the Contractor from the Owner for the Subcontractor Work is a condition precedent to payment by the Contractor to Subcontractor. The subcontractor hereby acknowledges that it relied on the credit of the Owner, not the Contractor for payment of the Subcontract Work.

The Supreme Court held that these provisions unambiguously created a condition precedent that D&M must receive payment prior to its obligation to pay Superior. Therefore, the provisions unequivocally allocated the risk of nonpayment by Corporex to Superior and relieved D&M of its obligation to pay Superior unless and until it received payment from Corporex. As it was undisputed that Corporex never paid D&M, D&M was not obligated to pay Superior under the contract terms. The Supreme Court held the “pay-if-paid” provisions were consistent with public policy because Kentucky has long respected freedom of contract and allowed the parties to allocate foreseeable risk among themselves. Furthermore, the Supreme Court refused to invalidate such a policy without clear direction from the Legislature.

Thus, because the Supreme Court held that the “pay-if-paid” provisions were valid and enforceable, those provisions precluded judgment in favor of Superior against D&M. Nevertheless, the Supreme Court also held that Superior and Ben Hur, which had obtained a judgment for unjust enrichment against Corporex for the extra work claims, could sustain that judgment.