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By J. Kent Holland, Esq.
ConstructionRisk Counsel, PLLC

Subcontracts may state that the subcontractor will be paid when the prime contractor is paid, or that the subcontractor will be paid only if the prime contractor is paid, and still others state that payment of the prime contractor is a condition precedent to the obligation of the prime to pay the subcontractor.   Where a contract provided that payment by the project owner to the general contractor was a condition precedent to the payment by the general contractor to the subcontractor, it was held that the use of the term “condition precedent” clearly and unequivocally shows the intent to transfer the risk of the project owner’s nonpayment from the general contractor to the subcontractor. Transtar Electric Inc. v. AEM Electric Services Corp., 16 N.E. 3d 645, (Ohio Supreme Ct., 2014).

Pay if Paid or Pay when Paid

The question for the court was whether the use of the term “condition precedent” was sufficient to establish a pay if paid payment provision.  The language in question provided: “Receipt of payment by contractor from the owner for work performed by subcontractor is a condition precedent to payment by contractor to subcontractor for that work.”  The contract did not otherwise refer to terms such as pay-if-paid or pay-when-paid.

The trial court granted the prime contractor summary judgment on the subcontractor’s claim for payment, ruling that the prime owed no contractual duty to pay the subcontractor since it had not been paid by the owner.  This was reversed by an intermediate court of appeals that held that the payment provision was not specific enough to show that both parties understood and agreed that the risk of the owner’s nonpayment would be borne by the subcontractor instead of the general contractor.  This was reverse by the Supreme Court of Ohio that found the language was clear and unambiguous in its intent to transfer the risk to the subcontractor.

In explaining its reasoning, the court began by reiterating that “The cardinal principle in contract interpretation is to give effect to the intent of the parties.”  The court then explained, “We will look to the plain and ordinary meaning of the language used in the contract unless another meaning is clearly apparent from the contents of the agreement.”

Curiously, the court used as an example of perfectly clear language the typical language found in a pay-when-paid contract clause.  It stated, “An unconditional promise to pay is a pay-when-paid payment provision.  Such a promise is not dependent on or modified by the owner’s nonpayment.”

I say this is a curious example because it is has never been clear to me why if the prime contractor agrees to pay only “when” it has been paid, how that constitutes an “unconditional promise to pay.”  But that is indeed how it is interpreted by courts.  The court further states: “A contract may include either a pay-when-paid or a pay-if-paid contract provision, but a contract cannot contain both.”

The court went on to state, “the general contractor may make a conditional promise to pay the subcontractor that is enforceable only if a condition precedent has occurred. A conditional promise to pay is a pay-if-paid payment provision.”

In this case, the court stated that it would “echo the Seventh Circuit Court of Appeals, that held in a case with similar contract language”, “This provision means just what it says—that [the contractor’s] duty to pay [the subcontractor] is expressly conditioned on its own receipt of payment—thus evincing the parties’ unambiguous intent that each party assumes it own risk of loss if [the owner] becomes insolvent or otherwise defaults.”

With regard to the express words “pay-if-paid,” the court found that “the use of the term “condition precedent” negates the need for additional language to demonstrate the intent to transfer the risk.

Comment

When reviewing the subcontract payment provisions, a subcontractor might want to consider negotiating language to revise the pay-if-paid clause, or the condition precedent clause, to state something to the effect that “In no event shall the subcontractor be paid the uncontested amounts of any invoice later than [X ] days from the invoice date.”  A pretty good argument can be made that the prime contractor should bear the brunt of the pain in the event that its client fails to pay since the prime was in the best position to exercise due diligence when entering into the prime contract to assure itself of the client’s financial ability.  The prime contractor is likewise in the better position to address payment delinquency during contract performance and stop work within a reasonable time if not being promptly paid.  Even if the subcontractor cannot negotiate an unconditional payment provision in the subcontract, we recommend that it insist on the right to stop or terminate its work in the event that it has not received payment of the uncontested amounts of an invoice within a specified number of days.

 

About the author: Article written by J. Kent Holland, Jr.,  a construction lawyer located in Tysons Corner, Virginia,  with a national practice (formerly with Wickwire Gavin, P.C. and now with Construction Risk Counsel, PLLC) representing design professionals, contractors and project owners.  He is founder and president of a consulting firm, ConstructionRisk, LLC, providing consulting services to owners, design professionals, contractors and attorneys on construction projects.  He is publisher of ConstructionRisk.com Report and may be reached at Kent@ConstructionRisk.com or by calling 703-623-1932.  This article is published in ConstructionRisk.com Report, Vol. 16, No. 10 (December 2014).

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