Who bears the risk of the owner’s nonpayment in your contracts?

The Ohio Supreme Court recently announced that, in contracts between contractors and subcontractors, use of the term “condition precedent” in a pay-if-paid provision is sufficient to show the parties’ intent to shift the risk of the owner’s nonpayment from the contractor to the subcontractor.

In Transtar Electric, Inc. v. A.E.M. Electric Svcs. Corp., the contractor contracted with the subcontractor to provide electrical services on a project. The subcontractor fully performed its work under the subcontract. The contractor timely paid the subcontractor’s first eleven invoices, but did not pay the final three invoices because it did not receive payment for the subcontractor’s work from the project owner. The contractor argued that the payment provision of the subcontract, which stated that the contractor’s receipt of payment from the owner was a “condition precedent” to the contractor’s payment to the subcontractor, constituted a pay-if-paid provision, thereby shifting the risk of the owner’s nonpayment to the subcontractor.

The subcontractor disagreed and sued the contractor for breach of contract and unjust enrichment, but the trial court sided with the contractor, finding that the subcontractor’s claims failed as a matter of law. The appellate court, on the other hand, reversed the trial court’s judgment, stating that in order to shift the risk of nonpayment to the subcontractor, a pay-if-paid provision must state “in plain language” that a subcontractor must look to the owner for payment.

The contractor appealed to the Ohio Supreme Court. The court first noted that Ohio courts do enforce valid pay-if-paid provisions if the parties clearly demonstrate the intent to transfer the risk of nonpayment. The court found that by stating the contractor’s receipt of payment from the owner was a “condition precedent,” the parties demonstrated that intent. Because the term “condition precedent” clearly demonstrated the parties’ intent, it was not necessary to use additional language to say the same thing.

The ultimate take-away from this case is not that the term “condition precedent” carries some magical power. Rather, it is a reminder that pay-if-paid provisions must be clear and unambiguous about the parties’ intent to modify a fundamental custom between a contractor and subcontractor. In Ohio, as in many other states that enforce pay-if-paid provisions, the parties must clearly show that they intend for the risk of the owner’s nonpayment to be transferred from the contractor to the subcontractor. Although stating that receipt of payment from the owner is a condition precedent to the contractor’s payment to the subcontractor is one way of achieving that effect, it is one of many. It may, however, be the most efficient means.

This case may also be seen as a warning to subcontractors. Subcontractors should not assume that a valid pay-if-paid provision will take up a full paragraph. Subcontractors should review payment provisions so that they do not inadvertently accept the risk of the owner’s nonpayment where it was not specifically bargained for.

Lastly, keep in mind that not all states enforce pay-if-paid provisions. In fact, fourteen states have refused to enforce them. So be careful to know the law in the state of your project so as to avoid negotiating terms that may not be enforceable.

Read or download the Construction and Procurement Newsletter Q3 2014 >>