The Consequences of "Pay-If-Paid" and "Pay-When-Paid" Construction Contracts Clauses
By Michelle Fiorito, Esq., Principal, Zetlin & De Chiara LLPDuring these stressful financial times, many general contractors, suppliers and especially subcontractors find themselves last in line to get paid on projects. Generally speaking, the payment process is risky in any project, more so now in light of the construction market's continued financial challenges.
So here's the scenario: A subcontractor's work is complete and accepted and payment applications have been submitted to the general contractor. A subcontractor expects to be paid in a timely fashion for work performed. In a perfect world, the general contractor receives payment from the project owner and the subcontractor in turn receives payment from the general contractor for its services. In reality, the project owner fails to pay the general contractor and the general contractor fails to pay the subcontractor. In failing to pay the subcontractor, the general contractor points to the subcontract which contains language shifting the risk of non-payment by the project owner to the subcontractor. These clauses are commonly referred to as "pay-if-paid" or "pay-when-paid" provisions. Result, the subcontractor is left waiting to get paid, if it gets paid at all, and is in no position to exert pressure on the owner non-payor.
"Pay-if-paid" and "pay-when-paid" provisions have become increasingly standard in the construction industry and in subcontracts in particular. The subcontractor is usually faced with accepting such payment language or not taking the job.
Depending on particular state law and how such provisions are crafted, the enforceability of these clauses may be limited and may be challenged. It is essential for general contractors, subcontractors and suppliers to become aware of the pitfalls of working on a project that is conditional on the acceptance of such contract language. Legal guidance in such circumstances is key, since the law governing these clauses is different from one state to another. This article will focus on the enforceability and limitations of "pay-if-paid" or "pay-when-paid" clauses in New York and New Jersey.
The Distinction between "Pay-If-Paid" Clauses and "Pay-When-Paid" ProvisionsA "pay-if-paid" provision typically seeks to make payment to a lower tier subcontractor or supplier conditioned on the general contractor receiving payment from a higher tier party, namely the project owner. The variations of such phraseology are numerous, i.e., "conditioned upon," "only if," and "to the extent" paid by another. In reality, a "pay-if-paid" provision limits the general contractor's liability and shifts the risk of the project owner's non-payment to the subcontractor. Any way you phrase it, the outcome is the same – a condition precedent to receiving payment.
On the other hand, a "pay-when-paid" clause requires payment to the subcontractor when the general contractor gets paid. A contractor's obligation to pay under the "pay-when-paid" provision is triggered upon receipt of payment from the project owner. Courts have interpreted "pay-when-paid" clauses to mean that the contractor's obligation to make payment is suspended for a reasonable amount of time for the contractor to receive payment from the project owner. This type of provision essentially creates a timing mechanism, not a condition precedent, to the obligation to make payment, and does not expressly shift the risk of the project owner's non-payment to the subcontractor. See Fixture Specialist, Inc. v. Global Construction, LLC, 2009 WL 904031 (D.N.J. 2009).
New York vs. New JerseyGenerally, New York courts rule that "pay-as-paid" or "pay-if-paid" clauses are unenforceable as a violation of state public policy (i.e., waivers of mechanics' lien rights), see, West-Fair Elec. Contractors v. Aetna Cas. & Sur. Co., 87 N.Y.2d 148, 638 N.Y.S.2d 394 (1995); whereas New Jersey courts are split as to whether such clauses are valid relying on freedom of contract principles without state intervention. See Fixture Specialist, Inc., 2009 WL 904031.
New YorkNew York courts have held that "pay-if-paid" clauses force a subcontractor to assume the risk of a project owner's non-payment, which is in violation of the state's public policy on lien law. On the other hand, New York courts have held that "pay-when-paid" clauses (which merely fix a time for payment) do not necessarily indefinitely suspend a subcontractor's right to payment upon the owner's failure to pay and thus may not violate public policy. See West-Fair Elec. Contractors, 87 N.Y.2d 148; see also Otis Elevator Co. v. Hunt Const. Group., 52 A.D.3d 1315, 859 N.Y.S.2d 850 (App. Div. 4 Dep't, 2008) (holding that despite "pay-when-paid" clause in subcontract, subcontractor was entitled to payment since the clause merely regulated the time of payment and did not shift the risk of nonpayment to subcontractor).
It should be noted that where an owner's failure to make payment is attributable to the act or omissions of the subcontractor itself, the subcontractor is not entitled to compel payment in any event. See Grossman Steel and Aluminum Corp. v. Samson Window Corp., 78 A.D.2d 871, 433 N.Y.S.2d 31 (2d Dep't 1980), order aff'd, 54 N.Y.2d 653, 442 N.Y.S.2d 769, 426 N.E.2d 176 (1981); see also Ferguson Elec. Co., Inc. v. Kendal At Ithaca, Inc., 302 A.D.2d 709, 754 N.Y.S2d 588 (3d Dep't 2003) (holding that subcontract did not require general contractor to provide subcontractor with written explanation of its refusal to honor subcontractor's request for payment where general contractor accepted nonconforming work and took a credit for the nonconformity).
New JerseyUntil recently, the only New Jersey case applying New Jersey law to this payment issue was Seal Tite Corp. v. Ehret, Inc., 589 F.Supp. 701 D.N.J. (1984), which held that the "pay-if-paid" contract clause did not contemplate the owner's failure to pay (due to bankruptcy) would forever exonerate the general contractor from paying the subcontractor sums that were due. The Seal Tite case is in accord with the majority of jurisdictions which permit deferral of payment until payment is received from the owner ("pay-when-paid" clause), but which do not forever relieve a general contractor from payment obligations ("pay-if-paid" clause).
However, New Jersey courts have recently upheld a general contractor's defense against a subcontractor's payment claim relying on the "pay-if-paid" clause. In so doing, the New Jersey federal court in one case relied on surety principles to determine the validity of the clause (holding that a surety's liability is triggered only when the principal's debt matures, hence, if the "pay-if-paid" condition has not been met, the general contractor's debt has not matured and the surety is not obligated to pay). See Fixture Specialist, Inc, 2009 WL 904031.
Relying on Thomas Group v. Wharton Senior Citizen Housing, the Fixture Specialist, Inc. court, unlike New York courts, ruled that the "pay-if-paid" clause did not violate the state's lien laws. See Thomas Group v. Wharton Senior Citizen Housing, 163 N.J. 507, 750 A.2d 743 (2000) (holding that preconditions to payment do not prevent a lien from being filed in order to preserve lien rights). In the Fixture Specialist Inc. case, the court explained that the provision in the contract between the contractor and subcontractor essentially created a condition precedent "pay-if-paid" clause and such language clearly and unambiguously expressed that the subcontractor agreed to assume the risk of the project owner's non-payment. See Fixture Specialist Inc., 2009 WL 904031 at * 5-6; see also, Avon Bros., Inc. v. Tom Martin Construction Co., 2000 WL 34241102, at *7-9 (N.J. Super. App. Div. 2000)1 (holding "if a subcontractor is to undertake the collection of risk, contrary to the usual allocation of risks among the parties to a construction contract, the undertaking must appear in clear and unequivocal language in the subcontract."); and Titan Stone, Tile & Masonry, Inc. v. Hunt Construction Group, Inc., 2007 WL 869556 at *6-7 (D.N.J. 2007) (in denying the subcontractor's summary judgment motion, the court found the payment clause language was insufficient to establish a condition precedent but that there may be other provisions in the agreement that would indicate a clear intent of the parties to shift the risk to the subcontractor). Ultimately, however, the Fixture Specialist, Inc. court held that New Jersey's anti-waiver statute does not automatically invalidate "pay-if-paid" clauses on public policy grounds.
Like New York, New Jersey's Mechanics' Lien Law may still give subcontractors a defense in taking legal action challenging the enforceability of "pay-if-paid" clauses as against public policy (i.e., improperly shifting risk of the owner's non-payment to the subcontractor which may be construed as an illegal lien waiver because a lien claim may not be enforced until payment is actually due and owing, which may never occur under such clause). For example, a New Jersey Appellate Court ruled that a "pay-if-paid" clause was found to be a violation of the covenant of good-faith and fair dealing. See O.A. Peterson Construction Co., Inc. v. Englewood Hospital and Medical Center, 2010 WL 2696758 (N.J. Super., App. Div. 2010).
Essentially, in New Jersey, whether these provisions are valid basically depends on the contract language and whether such clauses are clear and unambiguous.
ConclusionAlthough there are no magic words or phrases to ensure the validity or challenge the enforceability of such clauses, contractors may consider substituting a "pay-if-paid" clause with a "pay-when-paid" clause which will more than likely continue to allow a general contractor reasonable time to secure payment from the owner and avoid totally shifting payment risks to the subcontractor.
Also, to control the risk of not knowing whether such clauses will assist in defending a payment action vis-à-vis a general contractor, or protect a subcontractor from non-payment, favorable governing law provisions should be set forth in your subcontracts. However, it should be noted that New York courts have held that even if the parties select a choice of law for a state that permitted enforcement of "pay-if-paid" clauses, enforcement of such a choice of law provision would be contrary to the interests of New York State. See Welsbach Electric Corp., v. Mastec North America, Inc., 7 N.Y.3d 624, 825 N.Y.S.2d 692 (2006).
The above article is an overview only, and should not be considered legal advice, which is dependent upon specific facts and circumstances. For more information, please contact Michelle Fiorito at 212.682.6800.