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.