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A question sometimes arises as to whether a payment clause in a subcontract creates an absolute bar to subcontractor payment in the event an owner fails to pay the prime contractor or creates merely a time frame for paying the subcontract, thereby requiring payment within some reasonable time even if no payment is received by the prime contractor from its own client. We often call the first type of clause that requires eventual payment within a reasonable time a “pay-when-paid” clause. And the clause that makes payment to the prime contractor a condition precedent to payment of the subcontractor is generally called a “pay-if-paid” clause.

Sometimes, however, a clause may use the “when” terminology but the court will nevertheless apply it as an “if paid” clause due to language in the clause that otherwise clearly and unambiguously makes payment by the owner/client a condition precedent to the prime’s obligation to pay the subcontractor.

(This decision was reversed on appeal by the Court of Appeals of Maryland, 185 A.3d 170 (2018))  In Young Electrical Contractors, Inc. v. Dustin Construction, Inc., 231 Md. App. (2016) the Maryland Court of Special Appeals, applying Virginia law due to a choice of law provision in the contract, concluded that where a project was allegedly delayed by the project owner and caused delay and impact costs to the subcontractor, the “pay-when-clause,” in combination with a separate clause addressing payments arising from owner-initiated changes, set a condition precedent such that the subcontractor was not entitled to payment since the owner failed to pay the prime contractor for the changes. Interestingly, despite concluding that payment was due to the subcontractor only IF the owner paid the prime, the court never referred to the clause as a “pay-if-paid” clause but instead called it a “pay-when-paid” clause with a clear “condition precedent” to the payment obligation.

Comment: The case demonstrates the importance of using clear and precise language for subcontract payment clauses. Regardless of what terminology the clause may use, the courts are going to look at the entirety of the language to determine whether it sets an absolute condition precedent or just a reasonable time after which payment must be made. Subcontractors may be able to avoid the draconian impact of a “pay-if-clause” by adding a sentence to the end of the clause stating something like the following: “In no event, however, shall payment of any invoice be made later than 45 days from the date the subcontractor’s invoice is submitted.”

 

The court explained that for a valid condition precedent to exist within a pay-when-paid clause, courts will look to the unambiguous language of the contract to see whether such a condition is established. The inclusion of conditions precedent in a subcontracting agreement involves a shift in the credit risk from the general contractor to subcontractor.

“A provision that makes receipt of payment by the general contractor a condition precedent to its obligation to pay the subcontractor transfers from the general contractor to the subcontractor the credit risk of non-payment by the owner for any reason (at least for any reason other than the general contractor’s own fault), including insolvency of the owner.”

According to the court, “This shift in risk accordingly demands an express reference in the subcontract to a condition precedent.”

The subcontract must therefore make an express reference to a condition precedent, regardless of reason for the condition, as long as subcontractor understands there is a shift in credit risk.

Section 2(c) is a valid pay-when-paid clause under Virginia law, concluded the court, and sets forth the understandings between the parties and the procedures for the prime contractor’s payments to its subcontractor for the electrical work under the Subcontract. The clause in Section 2(c) states, in relevant part:

“It is specifically understood and agreed that the Contractor’s obligation to pay all or any portion of the Subcontract Sum to Subcontractor, whether as a progress payment, retainage, or a final payment, is contingent, as a condition precedent, upon the contractor’s receipt of payment from the Owner of all amounts due Contractor on account of the portion of the Work for which the Subcontractor is seeking payment.”

(Emphasis added).

The Subcontract explicitly establishes that George Mason University’s payment to the prime contractor is the condition precedent to the prime’s payment of the Sub.

The second clause (Section 13 (c)) that the court concluded must be read to harmonize with the intent of Section 2 was one that specifically addressed payments arising from owner-initiated changes. It provided in pertinent part:

“In the event a change is made to this Contract as a result of the Owner’s change to the Prime Contract and such change causes an increase or decrease in the cost of and/or the time required for performance under this Subcontract, Subcontractor may submit to Contractor in writing in accordance with the requirements of the Changes Clause of the General Contract a request for an equitable adjustment in the Subcontract Sum and/or the Subcontract Time, or both …. Contractor shall pay to Subcontractor that amount paid by the Owner to Contractor on account of any such change to this Subcontract, less any markup and other amounts due Contractor on account of such change. Contractor shall have no liability to Subcontractor on account of any such Owner initiated change except for such amount, if any.”

The court found that although Section 13(c) did not contain an express condition precedent, it does contemplate payments to Young where George Mason has initiated a change in the Project. As Section 2(c) sets forth the procedure for payments to Young, its applicability to 13(c) should not be ignored. Accordingly, when both sections are read together, the Prime’s receipt of a change payment from George Mason is the condition precedent that must be met if the Sub is to receive that payment. “By consenting to Section 2(c), [the subcontractor] has accepted the credit risk and cannot hold [the Prime] liable for non-payment if it does not receive its change payment.”

(This decision was reversed on appeal by the Court of Appeals of Maryland, 185 A.3d 170 (2018))

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. 19, No. 5 (May 2017).

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