One of the most significant financial risks faced by contractors is that of the “project banker.” Almost all contractors are expected to finance construction by supplying labor, equipment, and materials to a project before being paid. When this happens, there is always a risk that the owner might not pay in full, on time, or without additional demands. In the meantime, bills become due. Payroll, fuel, supplies, rent, overhead, and loans don’t wait for delinquent owners.
Prime contractors can attempt to shift these risks downhill by including “pay-if-paid” clauses in their subcontracts. While payment risks typically can be reallocated, the harder question is whether they should be. Depending on your role, the answer might seem obvious: “minimize my risk, shift it to the other guy.” As an industry, however, there are a few basic questions we should ask when writing and negotiating subcontracts, particularly when it comes to pay-if-paid clauses.
Payment risks can be reallocated.
The default rule in multi-tier, low-bid contracting is that prime contractors bear the loss if an owner fails to pay. The prime contractor remains obligated to pay regardless of an owner’s default. The most common application of this is sometimes called “pay-when-paid.” Under this arrangement, a subcontractor’s payment becomes due after the owner pays. However, if the owner never pays, the prime contractor ultimately owes payment anyway.
A valid pay-if-paid clause changes that ultimate risk: the subcontractor’s payment becomes due only if the owner pays. The prime contractor’s payment obligation is entirely contingent on the owner. If the owner never pays, then the prime contractor’s contractual obligation to pay never ripens.
Courts in most states will enforce pay-if-paid clauses as long as the intention is stated clearly. Earlier this year, the Supreme Court of Ohio added its endorsement to the majority rule and enforced a pay-if-paid clause because the contract made the owner’s payment an express condition that had to occur before payment was ever owed to the subcontractor. Transtar Electric, Inc. v. A.E.M. Electric Services Corporation.
High courts in Minnesota, Iowa, South Dakota, and North Dakota have not had occasion to decide in favor of, or against, enforcing pay-if-paid clauses. When the issue is litigated in those states, the courts will most likely decide in favor of enforcing these clauses, with certain limitations. Those potential limitations will likely be based upon the same questions contractors should ask when deciding whether to use a pay-if-paid a clause in the first place.
Should payment risks be reallocated?
In Transtar, five of seven justices decided to enforce the pay-if-paid clause on the sole condition that the clause was correctly written. Two justices disagreed. In his dissent, Justice O’Neill raised some important questions that both courts and contractors should ask when deciding how to allocate payment risks.
1. Is the intent clear?
Justice O’Neill recognized that “when a contract seeks to alter a fundamental custom between a general contractor and a subcontractor, such as shifting the risk of an owner’s default from the prime contractor to the subcontractor, the intent to do so must be clear.” This rule is pretty universally recognized, including by the majority in Transtar, and by other courts that have enforced these clauses.
2. Does the subcontractor have a remedy?
Justice O’Neill raised another important concern that has not been widely addressed by courts: “Even though it has completed all its work according to the contract, Transtar cannot bring an action against the project owner for breach of contract because no contract exists between Transtar and the owner, who now has the benefit of Transtar’s work essentially for free.”
Pay-if-paid clauses will undoubtedly work best when supported by a viable way for the subcontractor to pursue payment directly from the owner. Otherwise, there is a locked door with no key between the subcontractor and the owner, with a high potential for disputes among all parties.
3. Does the bid include the risk?
Risk affects prices. Deciding what risks are “included” in a bid may depend on whether the subcontractor should have been aware of the risk at the time of the bid, or whether the risk was specifically excluded from the bid.
Contractors working in Minnesota, Iowa, South Dakota, and North Dakota should assume that pay-if-paid clauses will be enforced, and should treat them accordingly. Effectively allocating risks requires a clear understanding of who bears the risk, what remedies are available, and how the job was bid. Well-written contract terms can not only help avoid disputes, but can help ensure reasonable expectations will be enforced in the event there is a dispute.
Build it right. Keep it real.
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