By Michael C. Loulakis and Lauren P. McLaughlin
Given the adage, “he who holds the gold makes the rules,” payment clauses in construction disputes are one of the most often litigated topics. Many states have enacted legislation to address the timing of payment on projects, such as prompt pay statutes and retainage laws.
Pay-if-paid clauses, however, are those that condition a subcontractor’s right to payment on the general contractor’s receipt of funds from the owner. These contingent payment clauses are often at the center of debate in courtrooms and state capitols throughout the United States. Why? Pay-if-paid clauses are customarily viewed as unfair, as they arguably shift the risk of owner nonpayment to those least able to shoulder that risk. Additionally, since subcontractors are not in privity with owners, they have little, if any, ability to ascertain or verify the financial viability of the owner before a project commences.
The debate continues to mount in 2022, with three states recently weighing in. Virginia enacted legislation this spring declaring pay-if-paid clauses void in private and public contracts. The Connecticut Appellate Court ruled that unambiguous pay-if-paid clauses are patently enforceable. Finally, the Nevada Supreme Court decided that a pay-if-paid clause was unenforceable because it violated the state’s retainage protection statute. All of these are discussed below.
Pay-if-paid struck down by Virginia legislature
Virginia has long been known as a state where “contract is king.” That is, Virginia courts are much more likely to enforce the terms the parties bargained for, even if harsh or onerous. But in April, the Virginia legislature banned the pay-if-paid clause by finding them void as against public policy.
The new law changes not only the right to receive payment but the timing as well. First, it prohibits contractors and subcontractors on public and private construction projects from including provisions in their subcontracts that condition payment on the receipt of funds from the owner or contractor. Second, it establishes fixed deadlines for the payment of invoices on private projects. Under the new law, owners on private projects must pay their contractors within 60 days after receiving an invoice, and contractors and subcontractors on private projects must pay their subcontractors by the earlier of 60 days after receiving an invoice or seven days after receiving payment from the owner or higher-tier contractor for the subcontractor’s work. Owners, contractors, and subcontractors are still entitled to withhold payment for nonconforming work, but the law requires written notice articulating the specific reasons for the withholding. There are interest penalties associated with the nonpayment, and contract clauses contrary to this new law will be unenforceable.
This bill goes into effect on Jan. 1 and will apply to construction contracts executed on or after that date.
Pay-if-paid enforced in Connecticut as unambiguous
While Virginia legislated away pay-if-paid clauses, a court in Connecticut upheld one. In Electrical Contractors Inc. v. 50 Morgan Hospitality Group LLC, a developer (Morgan) awarded a contract to Greython Construction to construct and renovate its property. Greython subcontracted the electrical work to Electrical Contractors Inc. That subcontract contained the following provision, “ECI expressly agrees that payment by (Morgan) to (Greython) is a condition precedent to (Greython’s) obligation to make partial or final payments to (ECI).”
ECI performed the electrical work, but Greython failed to make final payment. ECI claimed it was owed $350,000, and Greython responded that it had invoiced the owner but was awaiting payment. Morgan told Greython it was obtaining new financing for the project and Greython would be paid after the loan’s closing. However, the closing was delayed twice and ultimately never occurred, leaving Greython and ECI unpaid.
ECI sued Greython for payment. Greython, in response, relied upon the pay-if-paid clause as a defense. ECI argued that the clause was a pay-when-paid clause and simply tied the timing of receipt of payment from the owner to the timing of payment to ECI. ECI argued that the clause was not intended to shift the ultimate risk of owner nonpayment to ECI but was intended to give Greython a reasonable amount of time to receive payment from Morgan. When a trial court disagreed with ECI’s interpretation, ECI appealed to the Connecticut Appellate Court.
The appellate court was not swayed by ECI’s argument that the pay-if-paid clause was ambiguous, stating, “We decline the plaintiff’s invitation to find ambiguity in the payment provision… when we see none. Rather, we rely on the plain language of the contract, which has just one possible reasonable interpretation. … It is well settled that ‘(a) condition precedent is a fact or event which the parties intend must exist or take place before there is a right to performance.’”
Neither was the court swayed by the subcontractor’s argument that it would be contrary to public policy to interpret the clause to shift the risk of owner nonpayment to the subcontractor. There was no Connecticut precedent disfavoring pay-if-paid clauses, and the sub was asking the court to rewrite the subcontract.
Like most courts enforcing contingent payment clauses, the court supported its reasoning by noting that the parties were free to contract as they wished.
In any construction project, there is a risk that an owner will become insolvent and therefore be unable to pay its general contractor. The plaintiff in the present case is a sophisticated construction company. It could have added language to the contract specifying that Greython’s duty to pay would be postponed only temporarily if Greython did not receive payment from 50 Morgan. Instead, the plaintiff now asks this court to write such clarifying language into the contract. We are not inclined to make a new and different agreement by adding terms to which the plaintiff and Greython did not agree.
The ruling enforcing the pay-if-paid clause was perhaps not surprising, as the term “condition precedent” in any contingent payment clause is widely considered as shifting the ultimate risk of nonpayment to the subcontractor.
Pay-if-paid struck down in Nevada due to conflict with retention statute
In Nevada, a different ruling was reached on a clause similar to the one described above. In Helix Electric of Nevada LLC v. APCO Construction Inc., the facts unfolded on a condominium project in Clark County. The owner awarded a contract to APCO as general contractor, who in turn, subcontracted the electrical scope to Helix. The subcontract allowed APCO to withhold 10% of each progress payment. The subcontract also had several conditions related to the release of retainage to Helix: 1) the entire project had to be completed, 2) the owner had to accept the project, 3) the owner had to make final payment to APCO, and 4) Helix had to provide APCO with close-out documentation.
Helix performed the electrical work, and APCO retained the agreed funds. The relationship between APCO and the owner soon soured, and the owner stopped making progress payments. APCO left the project, and each party claimed it had terminated the contract. Helix, however, continued to work under the direction of the owner’s new construction manager.
Helix sued APCO to recover $505,021 of retained funds still held by APCO. The contractor responded that Helix was not entitled to retainage because it had not complied with the preconditions of the subcontract, namely, the owner had not made final payment to APCO. Helix responded that the clause was an impermissible pay-if-paid clause, and the question went to Nevada’s highest court.
The Supreme Court of Nevada held that pay-if-paid clauses are not unenforceable as a matter of course. Rather, if a clause violates a subcontractor’s statutory right to retainage, it is unenforceable. Under Nevada law on retained funds, a clause is void if it requires a lower-tiered subcontractor to waive, release, or extinguish a claim or right for damages “for which (it) is not responsible.”
Here, the court found that subjecting Helix’s right to retainage on whether APCO received monies from the owner was void. That is, even if Helix met all its obligations, it would still not be paid its retention if APCO did not receive payment. However, the court only struck the portion of the clause requiring payment from the owner. The court did not strike the other provisions of the clause that conditioned payment on completion of the project, the owner accepting the project, and Helix providing close-out documentation.
While we highlighted Virginia’s recently enacted legislation banning pay-if-paid clauses, we can hardly say it is likely to become a trend. Only a handful of states have put laws on the books voiding pay-if-paid clauses. The majority of states have case law precedent allowing parties to contract freely, including the use of harsh pay-if-paid clauses. The Kentucky Supreme Court, for example, recently recognized the enforceability of pay-if-paid clauses.
One note on pay-when-paid clauses — they are typically viewed by most courts as timing tools and not as a risk transfer scheme to bypass responsibility for payment downstream. Pay-when-paid clauses will be void if they are deemed to have the subcontractor wait “too long” for payment. A California court recently struck down a pay-when-paid clause that made the subcontractor wait until arbitration concluded between the owner and general contractor.
The bottom line is that pay-if-paid and pay-when-paid clauses are extremely jurisdiction sensitive. Every subcontractor should be mindful to achieve an understanding of precisely what payment clauses exist in the owner-contractor agreement and, of course, its own contract.