Pay-if-Paid in 2023: A Sea Change in Virginia
By: Jackson S. Nichols and Paul Felipe Williamson
For contractors, timely receipt of payment is crucial to a healthy and thriving business. As a result, contractors and higher-tier subcontractors alike frequently try to shift the risk of an owner’s non-payment onto their subcontractors through contingent payment clauses to protect themselves and their cash flow. One such provision is widely known as the pay-if-paid clause. Pay-if-paid clauses state that a contractor is obligated to pay its subcontractors only if and to the extent that the contractor receives payment from the owner for that work performed. In other words, if an owner never pays the contractor for certain work, the contractor has no duty to pay its subcontractors for that work. This shifts the risk of non-payment from the contractor or subcontractor to its lower-tier subcontractors.
Given the significant risk-shifting power of a valid pay-if-paid clause, jurisdictions are taking different approaches to mitigate the potential harm they pose to subcontractors. These efforts range from outright bans of pay-if-paid clauses in construction contracts to specific language requirements to guarantee enforceability to codified preservation of subcontractors’ rights to pursue a mechanics’ lien. Until recently, the District of Columbia, Maryland and Virginia all mostly enforced contingent payment provisions with limited exceptions. However, Virginia amended its statutory framework to ban pay-if-paid clauses in construction contracts as of January 1, 2023.
A New Year Brings Changes to the Enforceability of Pay-if-Paid in Virginia
The new year marks the beginning of Virginia’s new stance on pay-if-paid clauses in construction contracts signed on or after January 1. Virginia joins a limited but growing number of jurisdictions that have, by statute, prohibited contingent payment provisions on construction projects. The new law amends VA ST §§ 2.2-4354 and 11-4.6 and provides that “[p]ayment by the party contracting with the contractor shall not be a condition precedent to payment to any lower-tier subcontractor, regardless of that contractor receiving payment for amounts owed to that contractor.” In other words, Virginia no longer permits pay-if-paid provisions in construction contracts.
This change is surprising given Virginia’s reputation for allowing parties to negotiate and agree to almost any terms in a contract. The departure from this history removes contractors’ and higher-tier subcontractors’ ability to use pay-if-paid provisions to shift the risk of an owner’s non-payment downstream to lower-tier subcontractors, with limited exceptions involving the owner’s bankruptcy.
In addition to the ban on contingent payment provisions, the amendments require any public contract to include a provision that makes a contractor liable for the entire amount owed to the subcontractor, except for “amounts otherwise reducible due to the subcontractor’s noncompliance with the terms of the contract.” If withholding funds for non-compliance, a contractor must provide the reason for withholding the funds in a written notice.
Contractors and subcontractors should start looking at their contracts, making necessary revisions, and understanding how those revisions affect their operations.
Washington, DC and Maryland Maintain the Status Quo
DC, by contrast, enforces pay-if-paid clauses. DC’s highest court, the District of Columbia Court of Appeals, has not provided specific guidance for what language is required for such clauses to be enforceable. DC courts, however, do require pay-if-paid clauses to be stated clearly and without ambiguity. Moreover, a party’s intent to shift the risk of owner non-payment from a contractor or subcontractor to its subcontract must be clearly demonstrated.
Though DC will enforce pay-if-paid clauses, it has codified an exception to the enforceability of pay-if-paid clauses where a subcontractor has a right to pursue a mechanics’ lien upon a contractor’s failure to make payment. Specifically, § 27-134 of the DC prompt payment act states that “conditions of payment to the subcontractor on receipt of payment from the owner may not abrogate or waive the right of the subcontractor to . . . [c]laim a mechanic’s lien.” Thus, while pay-if-paid clauses remain powerful risk-shifting tools in DC, an attentive contractor can still secure its rights by availing itself of the DC mechanics’ lien law.
Similarly, Maryland courts continue to permit pay-if-paid clauses in construction contracts. Such clauses are strictly construed, however. Absent an express condition and clear expression of intent, Maryland courts do not enforce a purported pay-if-paid provision. Therefore, contractors or subcontractors who wish to successfully shift the risk of owner non-payment downstream should include express conditions in their subcontracts that clearly demonstrate the parties’ intent.
As in DC, a subcontractor looking to circumvent a pay-if-paid clause in Maryland can pursue its statutory right to a mechanics’ lien against the owner or sue on a contractor’s payment bond. In fact, Maryland law does not permit a provision in an executory contract between a contractor and a subcontractor to abrogate or waive the right of the subcontractor to bring a mechanics’ lien claim or sue on a contractor’s bond, including by conditioning payment to the subcontractor on receipt by the contractor of payment from the owner. Maryland law essentially rules out pay-if-paid provisions that limit mechanics’ lien or bond rights, and thus a subcontractor still has options to obtain a recovery even if an otherwise valid pay-if-paid clause exists.
Conclusion
The main takeaway for contractors and higher-tier subcontractors in 2023 is that, depending on the project’s jurisdiction, the ability to shift risk as desired will change. The careful drafting and negotiation of contracts continues to be essential in determining a contractor’s ability to shift risk downstream. In the event a project is located in Virginia, however, it becomes more important than ever to evaluate an owner’s financial condition and reliability on a project since, in the event of an owner’s non-payment, contractors will now be liable for payment to their subcontractors. Additionally, all contractors and subcontractors should review and revise their contracts to ensure they comply with current laws regarding contingent payment provisions. As always, it is important to seek legal advice if you are unsure about the enforceability of your contract or the latest developments in local law.
