Pay-when-paid and pay-if-paid clauses are pretty common in the construction industry. So what do they actually do, how effective are they, and how did they come about? This article will attempt to provide some answers to those questions.

But before pay-when-paid and pay-if-paid clauses are discussed specifically, the background of the issue giving rise to these clauses should be discussed.

Getting paid is hard, and getting paid in the construction industry is even harder than in most others. There are a lot of reasons for this, and pay-when-paid and pay-if-paid clauses are only the tip of the iceberg.

There are also scope-of-work issues, inspection problems, change orders, etc. All of these things can create payment problems — and that's before even mentioning the fact that failure rates in the construction industry are some of the highest in any market.

America believes that trade contractors and suppliers should be paid for their work. It is a strong belief in the American economy, and specifically, in the American construction sector, that people should be paid what they are owed. This is why the mechanics lien instrument was developed.

The concept that subs and suppliers (people further down on the payment ladder) deserved to be protected from nonpayment above them on the project dates all the way back to Thomas Jefferson. The offshoot of this is that America believes that GCs and property owners (those at the top end of the payment ladder) should be the ones to bear the burden of a project's financial risk.

However, since nobody likes to be forced to shoulder a financial risk, GCs and property owners have, throughout the years, attempted to shift the burden back to the parties below them on the chain. This battle of contract vs. lien is still continuing. It started with the mechanics lien, but beginning in the mid-20th century, certain contract provisions have been used in an attempt to shift this financial risk.

In the 1940s, contracts began to include "no-lien clauses" in an attempt to pass the financial risk to subs and suppliers. When cases involving these no-lien clauses made it to court, the clauses were routinely thrown out. The mechanics lien was deeply ingrained, and courts would not allow parties to explicitly contract around a right given by statute.

Because of this, GCs and property owners adapted and began including pay-when-paid clauses in their contracts. Again, however, courts came down on the side of the subs and suppliers.

Courts treat pay-when-paid provisions as a timing clause. That is, this type of clause allows the GCs to wait for a "reasonable period of time" to receive payment before they are obligated to pay the subs. But they are not absolved of that responsibility altogether — they still have to pay.

GCs and owners didn't want to give up and take that lying down, so pay-when-paid clauses that were easy to turn in timing mechanisms became pay-if-paid clauses. Since the effect of pay-when-paid clauses had been lessened, pay-if-paid clauses were drafted and inserted into contracts in another attempt to shift the risk of nonpayment to parties lower on the payment chain.

These clauses, again, have been the subject of much litigation, and the results have varied. Many courts have held these provisions to be akin to no-lien clauses and have declared them void as against public policy, but others allow the clauses to be effective, provided that certain specific language requirements are met.

So, on one hand there are statutory laws protecting subs and suppliers: mechanics liens, bond requirements, criminal statutes, payment timing provisions, etc. And on the other hand, there are contract provisions such as pay-when-paid or pay-if-paid clauses with which the GCs and property owners attempt to shift the project's financial risk back down the ladder.

Many states, either via court decision or through statutory law have decided that this risk-shifting is disallowed, and declared pay-if-paid clauses completely void as against public policy. These states are: California, Delaware, Illinois, Indiana, Kansas, Montana, Nevada, New York, North Carolina, Ohio, South Carolina, Utah and Wisconsin.

But just because a state hasn't explicitly outlawed pay if paid clauses doesn't mean they favor them, however. Courts in most states view pay-if-paid clauses with disfavor and require certain specific language to be included in the clause in order to trigger the shift in payment risk.

If the specific language is not included, the clauses will generally be treated as a pay-when-paid timing clause or be read out of the contract entirely. These specific language requirements can vary by state, but they generally require the clause to specifically state that the clause is meant to shift the risk of nonpayment to the sub or supplier, and that payment to the GC is a condition precedent to payment to the sub or supplier.

So where does that leave us regarding pay if paid clauses?

General contractors

Don't try to make law: If you are in a state that doesn't have clear law about your contract provision, it's probably a bad idea to be the company to make the law. The clear trend is toward disallowing pay-if-paid provisions, so don't get into a fight where new law will be made.

However, if you’re right, you’re right: Pay-if-paid clauses are not completely dead by any means. There are many jurisdictions that will entertain them. As noted above, you probably want to avoid making new law, but feel free to stick to your guns and require the subcontractor to wait — forever, if needed — if you have the contract provision and the accompanying law to protect you.

And, as always, you may want to entertain the idea that a settlement with the subcontractor may be a responsible option both fiscally, and business-wise.

Subcontractors

You have a good chance of eventually beating the general contractor on a pay-if-paid clause dispute, it just might be expensive and take a long time. Pay-if-paid clauses are strictly construed in your favor. Usually, this means that they will be pretty benign and allow you to collect even if the general contractor is never paid.

Don't get greedy, though. There's little point in trying to shoot for the moon in damages even if the general contractor abused the contract a bit by holding the money for too long. Many state laws will award subcontractors damages and penalties if a GC misbehaves, but getting into this fight is probably going to be more difficult than you or your lawyers predict.