“Pay-if-paid” and “Pay-when-paid” provisions are used in construction contracts between a contractor and a subcontractor. These provisions are designed to limit the contractor’s cash flow risks by requiring the owner to pay the contractor before a subcontractor can expect payment. This way, the contractor is not footing the bill for a construction project for which the contractor has not been paid.
While these provisions are advantageous to the contractor, they may strain the relationship with the subcontractor. Because of the unbalanced nature of this provision, there are three considerations every contractor (and their lawyer) must address before including either a “Pay-if-paid” or “Pay-when-paid” clause in their subcontractor agreement.
Is a “Pay-if-paid” clause enforceable in the jurisdiction?
“Pay-if-paid” provisions are distinctly different from “Pay-when-paid” provisions because most jurisdictions have outlawed “Pay-if-paid” payment provisions A “Pay-if-paid” payment term is a term where the subcontractor only gets paid if the contractor is paid by the owner. This puts the subcontractor at risk for not being paid solely because of the nonpayment of the owner.
However, “Pay-when-paid” provisions are allowed in most jurisdictions under the theory that a “Paid-when-paid” provision is simply addressing timing. Under a “Pay-when-paid” provision, it is understood that the subcontractor will be paid after the contractor is paid and it is understood that the subcontractor will be paid. The catch is, when will the subcontractor be paid if the owner does not pay the contractor?
A well drafted “Pay-when-paid” term will expressly address this scenario to:
- give the subcontractor certainty that they will be paid for the successful completion of their services; and
- avoid a court determining that the provision is really a forbidden “Pay-if-paid” provision because the “Pay-when-paid” provision failed to address what happens if the owner does not pay the contractor.
If the court determines payment terms are unenforceable, the contractor will have breached its payment obligation and owe the subcontractor (plus legal fees). Knowing which term is legally allowed and how specific that term needs to be is crucial in deciding how to draft a “Paid-when-paid” or a “Pay-if-paid” provision.
Is the General contractor prepared not to pay Subcontractors for work they performed if the owner bails?
This is the big, “what kind of operation are you running here” question. Even if the jurisdiction allows such drafting freedom, does the general contractor’s company want to be known as the one that will not pay its subcontractors for successful and timely completed work? Further, having a harsh payment provision in the subcontract for “just in case” purposes only hurts a general contractor’s reputation if they know they will never enforce such a harsh result. Even if the general contractor happens to run into a troublesome owner that refuses to pay, if it does not intent to enforce the harsh “Pay-if-paid” term, then it should not be in the contract. Also, the subcontractor is likely to file a lien or sue regardless of whether there is a legally enforceable payment term. However, if the general contractor plays out this scenario (or yet remember the last time this happened) and knows it will not pay the subcontractor, and a “Pay-if-paid” (or poorly a drafted “Pay-when-paid”) provision is allowed; then inclusion of a “Pay-if-paid” clause may be appropriate.
Does the General contractor have the capital to pay out before getting paid by the owner?
After determining what is allowed in the jurisdiction, and what kind of business the general contractor wants to be, the last consideration is what kind of business can it be? Unfortunately, not all general contractors have the liquidity to pay their subcontractors out of pocket if the owner either delays payment or refuses to pay. While the general contractor may not want to be in the business of not paying subcontractors who successfully completed work; it also does not want to over promise. In this case, it is best to draft a provision that mirrors financial reality.
One of the ways drafting can mitigate the harsh outcome to subcontractors is by having a provision that gives the contractor a long period of time to make payments to the subcontractor. This is often referred to as “Net 45” or “Net 90,” meaning the that the subcontractor will be paid 45 or 90 days respectively from when it submits an accepted pay application. Depending on cash flow, including an express but long-term payment obligation usually gives the contractor enough time to either resolve any issues with the owner, or come up with the cash to pay its subcontractor.
As discussed above, the decision on how to draft the “Pay-if/when-paid” provision comes down to:
- the law;
- the business identity; and
- the contractor’s liquidity.
The construction business is filled with risks. Each tier of contractor to subcontractor and subcontractor to sub-subcontractor adds to the likelihood of having issues with payment. Addressing these considerations will help with drafting a “Pay-if/when-paid” clause that fits a general contractor’s needs.
