Pay-when-paid clauses continue to be popular throughout the construction and design industries. Although many states have court decisions or statutes that completely void or limit the effect of these clauses, we still see many subcontracts and sub-subcontracts with the pay-when-paid clauses.
We also pretty routinely see contractors and subcontractors who rely on the clause as a basis or reason for not paying their lower tiers. (Perhaps you've heard this from an upper tier, or perhaps you've told this to your lower tier: "We are not a bank—we will pay the requisition when we get paid.") We even see recent situations where sureties on labor and material payment bonds use a pay-when-paid clause in the principal's contract as a basis for refusing to pay lower tier subcontractors or suppliers, at least until the principal on the bond is paid.
Making this clause more challenging are the various state prompt payment acts, which give statutory time frames for payment of lower tiers and differing remedies and penalties if the time frames are missed or the procedures are not followed.
How They Operate
Let's take a look at the status of the pay-when-paid clauses and see how they function in light of the Prompt Payment Act requirements. Let's also take a look at how you can better handle pay-when-paid situations when they arise on your project. (Please keep in mind these are general suggestions and are not a substitute for advice from a relatively competent attorney.)
Early pay-when-paid clauses were pretty simple and straightforward. They basically said that a lower tier had to wait to be paid until the upper tier was paid. Courts generally enforced the clauses. However, courts wrestled with projects where an upper tier simply refused to pay a lower tier since the upper tier was not paid or where the lower tier had to wait an excessive amount of time before being paid based on delay in paying the upper tier. There were many situations where contractors were involved in disputes with owners, and the contractors used those disputes as a reason not to pay a lower tier—even though the dispute had nothing at all to do with the lower tier.
Court Response
In response, some courts adopted a rule holding that a pay-when-paid clause would be valid as long as the language did not say that payment of the upper tier was a "condition precedent" to the payment of the lower tier. If the clause simply set up a time frame for payment of the lower tier, then the clause would be valid. Some courts also said that a pay-when-paid clause would be valid as long as the lower tier understood that there was a credit risk in getting paid and acknowledged, in the agreement, that it was assuming the risk of not getting paid if the owner failed to make payment.
For example, a number of years ago in my home state, the New York Court of Appeals (New York's highest court) addressed the validity of the following standard pay-when-paid clause in a trade contract between a construction manager and a trade contractor.
It is specifically understood and agreed that the payment to the trade contractor is dependent, as a condition precedent, upon the construction manager receiving contract payments, including retainer from the owner.
The court stated the following.
In [a prior case] we held that the pay-when-paid provision fixed a time for payment because the document containing the provision lacked express language imposing a condition on the general contractor's legal responsibility to pay. In contrast, the face of the subcontract here explicitly makes payment from the owner to the general contractor a "condition precedent" to any payment to plaintiff. Since the unambiguous language of section 3.2 places the risk of the owner's inability or failure to pay the general contractor squarely upon plaintiff /subcontractor, the pay-when-paid provision here cannot be construed as a time for payment clause. We hold that a pay-when-paid provision which forces the subcontractor to assume the risk that the owner will fail to pay the general contractor is void and unenforceable as contrary to public policy set forth in the Lien Law § 34. By contrast, a pay-when-paid provision which merely fixes a time for payment does not indefinitely suspend a subcontractor's right to payment upon the failure of an owner to pay the general contractor, and does not violate public policy as stated in the Lien Law.
Source: West-Fair Elec. Contractors v. Aetna Cas. & Sur. Co., 87 N.Y.2d 148, 661 N.E.2d 967 (N.Y. 1995)
Of course, the court's language hardly resolved the issue. It left confusion over instances where the pay-when-paid clauses created a conditions precedent to payment (i.e., where the clause shifted to the lower tier, the risk that the upper tier would not be paid) or when the clause simply "fixed a time for payment" of the lower tier. (I admit being confused. I thought that a clause which says that the lower tier will be paid after the upper tier gets paid does fix a time for payment. I also did not understand how any court could say that a pay-when-paid clause somehow violates a party's right to file a mechanic's lien.)
Options Considering Prompt Payment Acts
In any event (and despite my confusion), to a large extent, the issues seem to be addressed and clarified (and even resolved) by the various Prompt Payment Acts that have been enacted throughout the country. Given the specific language in a state's Prompt Payment Act, what are the consequences of having a pay-when-paid clause in your contract? If you are a construction manager or general contractor, should you still put a pay-when-paid clause in your subcontract? If you are a lower tier subcontractor or supplier, should you agree to a pay-when-paid clause in your agreement? Following are some suggestions.
Exclude the Pay-When-Paid Clause from Your Contract
Upper tiers may want to consider excluding the pay-when-paid clause in their lower tier contracts and subcontracts. I say this more from a business point of view. When I started practicing construction law in the early 1980s, one of my first general contractor clients, David Mandl, told me that he always tried to pay his subcontractors on a weekly basis, even though he was not paid by the owner. Mr. Mandl said that, while it was, at times, a struggle to pay weekly, the subs and suppliers obviously loved it. That "love" translated into better and more efficient work. Just as important, if Mr. Mandl needed something done quickly or on a weekend, he always got great responses.
I have other contractors and subcontractor clients who do the same thing and get the same results over the years. The clients find that, once the lower tier knows that payment is routinely coming, ahead of normal turnaround times, the work is much better and, the response times for added work or favors become exceptional. So, just because you have the negotiating strength to add a pay-when-paid clause to your agreements, perhaps you shouldn't, considering the better work and response times you may get by excluding those clauses.
Be Familiar with the Pay-When-Paid Laws That Apply to Your Project/Agreement
The local state law that applies to your agreement may severely limit your ability to include a valid pay-when-paid clause in your agreement. A number of prime contracts and subcontracts that I've reviewed for clients recently still have pay-when-paid clauses that clearly are not consistent with the state court decisions on appropriate language for a pay-when-paid clause or contradict the local Prompt Payment Act requirements. Sometimes I will raise that issue with the other party's attorney, who then says, "Well, if the clause is not valid, then let's keep it in, and it won't be enforced if there is an issue." But I never buy that. If a clause is not enforceable, then I do not want it in my agreement.
There are exceptions. I have clients who will not ask an upper or lower tier to remove an unenforceable contract section. Their theory is that the fewer changes they ask for, the better off they are. For example, a client recently asked me how to handle a pay-when-paid clause in a subcontract that said the clause applied to all payments, and the state's Prompt Payment Act did not apply to the agreement. I advised the client that the applicable state's Prompt Payment Act did not allow a general contractor to say the Act did not apply, and the statutory times for payment would be enforced, notwithstanding the language added by the general contractor. The client decided not to try to delete that general contractor's language, figuring that the clause would not be enforced and the fewer changes asked for, the better.
When you are researching the Prompt Payment Act requirements for your project, make sure that you review the actual statute. There are many so-called construction law experts on the Internet, but I would not feel comfortable taking their word about what the statute requires. Their suggestions or their articles or summaries could be outdated or incorrect. So, make sure you check the applicable law for yourself. You can get excellent leads from an Internet search. I searched the term "Fifty State Prompt Payment Act survey" and came up with at least a handful of charts that gave the status of prompt payment statutes and time frames in all the states and on federal projects. These charts are good places to start, but be sure to download the actual statutory language so you can confirm the rules for yourself.
Make Sure You Know Which State Law Applies
Although you should become familiar with the law concerning pay when paid and prompt payment, sometimes, it is not easy to figure out which state's law applies to your project or your agreement. Typically, the law where the project is located will apply. In many instances, your contract will also say which state's law applies. But if you are a general contractor from Texas, doing work in Florida, and order supplies from a vendor in North Carolina, which state law would apply? What if you are a New York general contractor working with a New York subcontractor on a project in Massachusetts, where the contract says that Florida law applies?
Usually, it is not an issue. Still, it does not hurt to check with your attorney to make sure you are clear on what law applies.
Determine the Prompt Payment Act Requirements That Apply to Your Project
Since almost all states have some form of Prompt Payment Act, it is well worth your time to make sure you know what the applicable requirements are.
For lower tiers, you will know what the statutory time frame is for payment and what conditions you have to meet in order to start those time frames. For example, the applicable Prompt Payment Act may give you the right to be paid within 30 days after submitting a requisition. But the Act may also say that the time frame does not start unless you submit your requisition and other records that the general contractor may reasonably require. Those could include lien waivers, releases, daily reports, certified payrolls, or other routine documents typically asked for. The failure to submit those added records may stall the time for you to get paid.
For construction managers and general contractors, review the applicable Prompt Payment Act since it may set time frames within which you must be paid by the owner. The language may also say what the conditions are for the release of payment if there is a lender involved.
For upper tiers, make sure you know what your obligations are once a requisition is submitted. Prompt Payment Acts tend to require upper tiers to review and approve requisitions within certain time frames. The failure to respond to a lower tier can be deemed an approval. That's not good—you never really want to be in a position where your silence is deemed to be an approval or consent.
Typically (and probably obviously) defective work by a lower tier is a valid excuse not to approve or process a requisition. Also, an issue with the quality of work can stop the running of the times in which payments have to be made under the applicable Prompt Payment Act. Therefore, not only should an upper tier timely review the lower tier's requisition, but upper tiers should also ensure that they highlight and advise the lower tier of any defective work.
Understand what the risks are for delays in payment to a lower tier. Lower tiers (including a general contractor under its prime contract with an owner) are given varying rights for delays in payment. The rights obviously depend on the Prompt Payment Act that applies to your agreement, but they can include the right to demand immediate and expedited arbitration and the right to be awarded interest and perhaps attorney fees as a result of nonpayment or delays in payment.
Consider whether to make a claim under the applicable Prompt Payment Act. This is another business decision. Just because you have the right to make a claim under a Prompt Payment Act does not mean that it is the best business decision to do so. Lower tiers who push their rights will likely find that they do not get more work from that general contractor (which may be a good thing, if that general contractor does not pay). However, lower tiers may also find that the brotherhood of general contractors regards the sub as uncooperative, so there may be more work forfeited as a result of making the Prompt Payment Act claims.
You should stand firm. If you are a lower tier and are told that you are not being paid based on the pay-when-paid clause, you probably have good grounds to push back and say that the pay-when-paid clause is not enforceable under your circumstances. While you may not want to make a formal claim (as mentioned in the preceding paragraph), you can still let the upper tier know that you are aware of your rights and that the pay-when-paid clause is not enforceable.
If you make a claim against an upper tier's labor and material payment bond, do not cave to the surety's argument that payment under the bond is not due since the principal has not been paid by the owner. There was a relatively recent case in New York where a surety took that position (Blandford Land Clearing Corp. v. National Union Fire Ins. Co. of Pittsburgh, 260 A.D.2d 86 (N.Y. App. Div. 1st Dep't 1999)). The court rejected the surety's argument and held that the payment bond created a separate obligation on the part of the surety to pay the "claimant" regardless of any pay-when-paid clause in the underlying construction agreement. The court seemed a tad irked at the surety, saying that the surety was disingenuous and made a "specious distortion" of the contract language.
Keep in mind, however, that to get the benefit of Prompt Payment Act time frames and remedies, you typically should be sure that your submissions, including the requisition and related items, are true, correct, and accurate. Mistakes in percentages of completion or amounts due are usually legitimate reasons to reject a requisition and force a "do-over."
It is also a good idea to be sure that your certifications are accurate. Some upper tiers want releases and waivers from you saying that you've paid all your lower tiers for all work performed through the date of the requisition. Often that is not the case—the lower tiers usually are paid for all work through the prior requisition and not the one that is being submitted.
Also, keep in mind that many states have Prompt Payment Acts that apply to both public and private projects, and the rights that you are given under Prompt Payment Acts are usually "cumulative." That is, even though you have rights under the applicable Prompt Payment Act, you will still likely have the right to file a mechanic's lien, make a trust fund claim, make a claim against an applicable labor and materials payment bond, or sue for breach of contract.
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