Enforceability of Conditional Payment Provisions in Construction Subcontracts


Clauses in construction subcontracts that condition payment to the subcontractor on the general contractor's receipt of payment from the owner are generally referred to as "pay when paid" or "pay if paid" provisions. American courts differ on the enforceability and interpretation of such clauses. Courts closely examine the contract language to determine whether the clauses are valid. Generally, such a clause must be clear and unambiguous to be enforceable. The Michigan Court of Appeals has held that an ambiguous pay if paid clause is enforceable. However, the enforcement of such clauses may be excused under some circumstances, and they may be unenforceable on public policy grounds.

Overview

Throughout the country, courts have differed on the interpretation of clauses which purport to make a general contractor's duty to pay a subcontractor conditional on its receiving payment from the owner. Some courts maintain that these clauses should be loosely construed to mean that the general contractor's obligation to pay is not excused in the event of nonpayment by the owner. Rather, the clause is interpreted to merely allow a "reasonable delay" in the event the owner does not pay. Other courts have held that these clauses should be strictly construed as pay if paid provision excuses payment by the general contractor if payment is not made by the owner. Courts generally will construe the clause as pay if paid only if the intent of the parties is clear and unambiguous.

A leading case interpreting conditional payment clauses, and a decision followed by many courts, is the 1962 6th Circuit United States Court of Appeals decision in Dyer vs. Bishop International Engineering Co. The approach taken in Dyer, which has been followed by most courts, is to examine the language of the clauses with the following principles in mind:

  1. the clear intention of the parties controls;
  2. ambiguous contracts should be construed against the drafter; and
  3. conditions precedent are generally disfavored.

In Dyer, the court reviewed a provision which stated that payment to the subcontractor shall not be due "until five days after the owner shall have paid the contractor." The owner became insolvent before full payment was made to the general contractor, who in turn refused to make full payment to the subcontractor. The court rejected the general contractor's argument that its obligation to pay the subcontractor was excused:

"It seems clear to us under the facts of this case that it was the intention of the parties that the Subcontractor would be paid by the General Contractor for the labor and materials put into the project. We believe that to be the normal construction of the relationship between the parties. If such was not the intention of the parties it could have been expressed in unequivocal terms dealing with the possible insolvency of the owner.

***To construe it as requiring the Subcontractor to wait until the general contractor has been paid by the Owner, which may never occur, is to give it an unreasonable construction which the parties did not intend at the time the Subcontract was entered into."

Courts in several jurisdictions have followed the reasoning of Dyer to conclude that such a clause merely establishes a reasonable time in which the general contractor can delay payment, but that it does not completely excuse payment.

Michigan Authority

There are very few court decisions on this subject in Michigan. In the only reported Michigan case to explicitly address a conditional payment clause, Merkel & Co. Contractors vs. Christian Co., the court determined that the clause created a condition precedent which excused the general contractor from any obligation to pay the subcontractor. In Merkel, the Court held that there was no ambiguity in a contract that provided that "all payments to the subcontractor are to be made only from equivalent payments received by (the general contractor) for the work done, the receipt of such payments by (the general contractor) being a condition precedent to payments to the subcontractor." Unlike Dyer, the contract in Merkel explicitly used phrase "condition precedent".

United States District Court Judge Stewart Newblatt reached a similar conclusion in Fisher & Wright Inc. vs. Flakt, Inc., where the subcontract provided that "it is specifically understood and agreed that the payment to the subcontractor is dependent, as a condition precedent, upon (the general contractor) receiving contract payments including retainage from the owner." Judge Newblatt determined that the creation of a condition precedent was obvious and stated it "is clear that such conditions precedent leave courts with no discretion to imply a reasonable time period into the contract".

Standard form agreements developed by the Associated General Contractors of America have alternative provisions that unequivocally address whether or not the subcontractor is sharing in the risk of owner nonpayment. AGC standard form agreement No. 650, endorsed by the Associated Specialty Contractors, Inc., shifts the entire risk of owner nonpayment to the contractor.

TIME OF PAYMENT: Progress payments to the Subcontractor for satisfactory performance of the Subcontract Work shall be made no later than seven (7) days after receipt by the Contractor of payment from the Owner for the Subcontract Work. If payment from the Owner for such Subcontract Work is not received by the Contractor, through no fault of the Subcontractor, the Contractor will make payment to the Subcontractor within a reasonable time for the Subcontract Work satisfactorily performed.

On the other hand, AGC standard form agreement No. 655, provides for a sharing of the risk of owner nonpayment between contractor and subcontractor:

"TIME OF PAYMENT: Receipt of payment by the Contractor from the Owner for the Subcontract work is a condition precedent to payment by the Contractor to the Subcontractor. The Subcontractor hereby acknowledges that it relies on the credit of the Owner, not the Contractor, for payment of Subcontractor work. Progress payments received from the Owner for the Subcontractor for satisfactory performance of the Subcontract Work shall be made no later than seven (7) days after the receipt by the Contractor of payment from the Owner for the Subcontract Work."

The latter provision leaves no doubt that the parties intend that the subcontractor will share the risk of nonpayment. Under Merkel, such a provision should be clearly enforceable. However, there are at least two other issues, not addressed in Merkel, that contractors need to be aware of.

Exceptions to Conditional Payment

Several courts have indicated that even unambiguous pay if paid clauses may not be enforceable. For instance, in Fisher & Wright, after finding that the subcontract did create a valid condition precedent, Judge Newblatt went on to state that in order for the subcontractor to succeed, it must show that the condition precedent was either fulfilled or excused. That if nonpayment by the owner has occurred "***because of (the general contractor's) own conduct, a waiver may exist. For instance, if (the general contractor) breached the contract with (the owner) then (the general contractor's) misconduct prevented (payment) from occurring." Similarly, in Kasler Electric Co vs. Insurance Co. of North America, the court found a valid condition precedent to payment in a construction subcontract, but went on to say that if the general contractor "breached the contract, then (the subcontractor) will be entitled to damages according to accepted measures of damages for breach of contract, and in that event the pay as paid provision appears to be irrelevant."

Furthermore, subcontractors in other states have successfully argued that conditional payment clauses are unenforceable because they violate public policy embodied in lien statutes. The Court of Appeals of New York held in West Fair Electric Company vs. Aetna Casualty & Surety Co. that such conditions precedent were contrary to the public policy found in that state's construction lien stature. The court in West Fair reasoned that the subcontractor's right to enforce a mechanic's lien against the owner was wrongfully impaired by a pay if paid provision. If operative, it would "extinguish plaintiff subcontractor's ability to enforce a lien against the owner...". Therefore, the New York court concluded that a pay-when-paid provision, which forces the subcontractor to assume the risk that the owner will fail to pay the general contractor, is void and unenforceable as contrary to the public policy. The California Supreme Court reached a similar conclusion in Wm. R. Clark Corp vs. Safeco Ins. Co. of America where it stated that "...a pay-if-paid provision is in substance a waiver of mechanics lien rights because it has the same practical effect as an express waiver of those rights."

The Michigan Construction Lien Act is similar to the New York and California lien statutes. It specifically provides that a waiver of lien rights obtained as part of a contract "...is contrary to the public policy and shall be invalid

Conclusion

General contractors and subcontractors need to give careful consideration to the effect of a conditional payment provision and be sure it states the knowing intention of both parties. Unequivocal pay-if-paid provisions in construction subcontracts result in a sharing of the risk of owner nonpayment and could result in nonpayment to the subcontractor even though it has fully performed its contract with the general contractor. The Michigan Court of Appeals has held that such provisions are enforceable and that they indefinitely suspend the contractor's obligation to pay subcontractors until it has received payment from the owner.

However, such a provision may be excused when the non-payment is caused by the contractor's own misconduct. It may also be irrelevant if the contractor has breached the subcontract. It also remains to be decided by Michigan courts whether pay-if-paid provisions are always enforceable as contrary to Michigan public policy. But until that decision is made, general contractors and subcontractors alike must deal with Merkel and understand that, absent general contractor misconduct, a clear and unequivocal pay if paid clause will be enforced.

(This article previously appeared in the August 1999 edition of CAM Magazine.)