By: Jackson S. Nichols and Paul Felipe Williamson
For a general contractor or subcontractor, timely receipt of payment can be the difference between continuing to grow a business and closing its doors. Because of this harsh reality, contractors and subcontractors frequently try to shift the risk of an owner’s non-payment onto their subcontractors through contingent payment clauses. Most commonly, these take the form of what are known as “pay-if-paid” or “pay-when-paid” clauses in their contracts. However, a contingent payment clause’s ultimate effect depends on its language and the law applicable to its interpretation.
Pay-if-Paid vs Pay-When-Paid
A pay-if-paid clause is a payment clause that states that the 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 the owner never pays the contractor for certain work, the contractor has no duty to pay its subcontractor for that work. In general, courts tend to view pay-if-paid clauses under the legal concept known as a “condition precedent.” Just as a subcontractor would not be entitled to payment if it did not perform the work, it would not be entitled to payment if the owner never paid the contractor. When this type of payment clause appears in a subcontract, the owner’s payment to the contractor is added to the list of conditions, such as satisfactory work performance and submission of a payment application, that must be fulfilled before the subcontractor is entitled to payment. This shifts the risk of non-payment from the contractor or subcontractor to their subcontractors.
By contrast, where there is a pay-when-paid clause, the risk of owner non-payment is more limited since a pay-when-paid clause only controls the timing of payment, not whether any payment is ultimately due. Specifically, a pay-when-paid clause is a payment clause that states that the contractor or subcontractor is obligated to pay its subcontractors following receipt of payment from the owner. In other words, if the owner delays three months in paying the contractor, the contractor has no duty to pay its subcontractor during that delay. However, a subcontractor waiting on payment can, after a reasonable period, seek to enforce a contractor’s or subcontractor’s obligation to pay.
Given the significant risk-shifting power of a valid pay-if-paid as opposed to a pay-when-paid clause, jurisdictions take various approaches to mitigate the potential harm they pose to subcontractors. These efforts range from specific language requirements to guarantee enforceability, codified preservation of subcontractors’ rights to pursue a mechanics’ lien in the face of a valid pay-if-paid clause, to outright bans of pay-if-paid clauses in construction contracts. Until recently, the District of Columbia, Maryland and Virginia all mostly enforced contingent payment provisions with limited exceptions. Recent developments in Virginia, however, have changed the law as a bill passed in 2022 severely limits the enforceability of such provisions.
District of Columbia
DC enforces both pay-if-paid and pay-when-paid clauses. DC’s highest court, the District of Columbia Court of Appeals, has not provided specific guidance as to what language is required for such clauses to be enforceable. DC courts, however, do require a pay-if-paid clause to be stated clearly and without ambiguity. Moreover, a party’s intent to shift the risk of owner non-payment from the contractor or subcontractor to its subcontractor must be clearly demonstrated.
While an appropriately crafted contingent payment clause may bar or impede a subcontractor’s recovery to payment until and unless an owner pays the contractor, subcontractors are not without recourse. DC has codified certain exceptions to the enforceability of pay-if-paid clauses, which include a subcontractor’s 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 may still secure its right through the DC mechanics’ lien law.
Maryland
Like DC, Maryland courts differentiate between pay-if-paid and pay-when-paid clauses. For a contractor or subcontractor to shift the risk of owner non-payment to their subcontractors, the contract should contain an express condition clearly showing that to be the parties’ intent. Absent an express condition and clear expression of intent, Maryland courts will not enforce a purported pay-if-paid provision.
Similar to DC, Maryland allows a subcontractor to circumvent a pay-if-paid clause by filing a mechanics’ lien against the owner’s property or suing on a contractor’s bond. This right has been codified in the Maryland Annotated Code, Real Property § 9-113, which provides that a provision in an executory contract between a contractor and a subcontractor cannot abrogate or waive the right of the subcontractor to bring a mechanic’s 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. Essentially, a subcontractor still has options to obtain a recovery even if a valid pay-if-paid clause exists.
Virginia
A new bill signed into law in Virginia, however, goes further to protect subcontractors from the risk of non-payment than either DC or Maryland. Virginia has joined a limited number of jurisdictions that have, by statute, prohibited contingent payment provisions on construction projects, and its new law applies to contracts signed on or after January 1, 2023. 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 will no longer permit 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. This departure from that tendency will remove a contractor’s and a higher-tiered subcontractor’s ability to use pay-if-paid or pay-when-paid provisions to shift the risk of an owner’s non-payment downstream to lower-tiered subcontractors, with limited exceptions involving the bankruptcy of the owner.
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, the contractor must provide the reason for withholding the funds in a written notice.
These amendments also enhance prompt payment protections for contractors in private contracts. The new law provides that in prime contracts, the owner shall pay the contractor within 60 days of an invoice for any undisputed portion of the work. Similarly, in a subcontract, the contractor must pay a subcontractor for undisputed portions of invoices “within the earlier of (i) 60 days of the satisfactory completion of the portion of the work for which the subcontractor has invoiced or (ii) seven days after receipt of amounts paid by the owner to the general contractor or by the higher-tier contractor.” The amended law extends the protection of the state’s prompt pay act to private contracts as well, providing that the “[f]ailure of a contractor to make timely payment as provided in this subsection shall result in interest penalties consistent with § 2.2-4355.”
With the new law coming into effect on January 1, 2023, contractors and subcontractors should start looking at their contracts, making necessary revisions, and understanding how those revisions affect their operations.
Conclusion
The main takeaway for contractors and higher-tiered subcontractors is that, depending on the project’s jurisdiction, the ability to shift risk as desired will change. The careful drafting and negotiation of contracts will continue to be essential in determining the efficacy and availability to shift risk downstream. In the event a project is located in Virginia, however, it becomes more important than ever to evaluate the financial condition and reliability of an owner 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.