“Pay When Paid” and condition precedent “Pay IF Paid” clauses are important features of most conduit or pass through relationships and have become very common in the marketplace. If the subcontract clearly states that payment by the owner is a “condition precedent” and state law does not say otherwise, then the general contractor is not obligated to pay unless and until the general contractor has been paid.[i] Condition precedent pay if paid provisions can obviously impact a subcontractor’s right or ability to collect for changes, delays and other claims.

This essentially shifts the credit risk of project failure or owner insolvency to the subcontractor. Subcontractors obviously would prefer to eliminate this term from the contract if possible. In any event, however, it is important to recognize this situation when analyzing risks. A subcontractor now must analyze the creditworthiness of the owner and the quality of that project. If the owner of the project becomes insolvent or if this project fails, the general contractor will have no obligation to pay subcontractors. It also becomes more important to have the right to stop work if payments stop and the right to require evidence of adequate funding for the project if payments slow down or in the event large cost increases are evident in a project budget.[ii]

If a condition precedent pay when paid clause is in your contract, you will want the same term in lower tier subcontracts. If the credit risk has been shifted to you, you want to keep passing it down the line. In modern construction contracts, the cost of a payment problem usually ends up with the contractor down the line who was handed the hot potato and failed to hand it to the next contractor.

If a pay when paid clause says only that the customer will pay “within five days after receiving payment,” this is not a condition precedent. Courts have held that such a “pay when paid” term simply defines the time for payment and does not eliminate the need to pay eventually.[iii] This type of pay when paid clause is found in AIA contract documents, for example, and is not as big a concern to subcontractors as the condition precedent pay if paid clause. AIA contract documents also have the right to require evidence of adequate funding for the project if payments stop or large cost increases are evident in a project budget.[iv]

Some states do have laws that limit the effectiveness of condition precedent “pay if paid” clauses. In Maryland, “pay if paid” clauses are generally enforceable, but do not constitute a defense to a mechanic’s lien, Little Miller Act or private payment bond.[v] In other words a subcontractor could not sue the general contractor for “breach of contract” for non-payment if the owner had not paid. However, the subcontractor could file suit to establish its mechanic’s lien or payment bond rights. Note that a condition precedent “pay if paid” clause could be a surety defense in a federal Miller Act payment bond claim.[vi]

In Virginia, payment by the owner cannot be a condition precedent to payment to any lower-tier subcontractor, except that a private project general contractor can still have a condition precedent Pay if Paid subcontract clause that is effective in the event the owner is “insolvent or a debtor in bankruptcy.”[vii]

The Virginia Code states that any state public contract shall include “A payment clause that obligates a contractor on a construction contract to be liable for the entire amount owed to any subcontractor.”[viii] Any private subcontract “shall be deemed to include a provision under which any higher-tier contractor is liable to any lower-tier subcontractor.”[ix] Any public subcontract must also require each subcontractor to include the same payment requirements in any lower-tier subcontracts.[x] However, private subcontracts are “deemed to include” this lower-tier subcontract requirement.[xi]

A private project general contractor can still enforce a condition precedent Pay if Paid subcontract clause if the owner is “insolvent or a debtor in bankruptcy.”[xii] A public project general contractor does not have this same protection. However, there should be less risk of an insolvent or bankrupt state, county, or municipal government owner.

A general contractor can still withhold payment for noncompliance with the terms of the subcontract. The contractor must notify the subcontractor in writing of the intent to withhold and the reason for withholding payment. However, the penalties for failing to provide this notice are not clear.[xiii]

Curiously, material suppliers with no on-site presence do not have the protection of this Pay if Paid prohibition, at least on private projects.[xiv] This revised law will impact suppliers’ customers more than the suppliers themselves, although it will impact suppliers indirectly and probably means they are more likely to receive payment.[xv]

In Virginia, general contractors have a greater burden of pursuing payment for subcontractors from solvent owners and cannot use a Pay if Paid clause for protection if the owner did not pay because of general contractor default. Experience has also shown that courts often will not enforce a Pay if Paid clause if a subcontractor can show that general contractor default caused the owner nonpayment, usually based on the “prevention doctrine.”[xvi] One party to the contract cannot prevent occurrence of the condition precedent and then take advantage of the nonoccurrence to excuse performance. If a general contractor prevents or hinders payment from the owner, the condition may be waived or excused.

Also, in Virginia, a contract provision that waives or diminishes the right to assert mechanic’s lien rights or payment bond claims or the right to assert claims for demonstrated additional costs in a contract signed in advance of furnishing any labor, services, or materials is null and void.[xvii] It is not yet clear whether a pay if paid clause “diminishes” these rights within the meaning of the statute and would be void. A pay if paid clause probably does not diminish lien rights in Virginia and would not be void on that ground. Some courts have held that a payment bond is an independent obligation and that a “pay if paid” clause in a separate contract has no impact on the payment bond obligation.[xviii] Courts may recognize the “pay if paid” defense to a payment bond claim, however, if the bond includes a “pay if paid” provision or “incorporates by reference” the pay if paid clause.[xix] In any event, however, this argument now seems to be lost to general contractors and sureties in Virginia. If the pay if paid clause would have diminished the subcontractor’s bond rights, then that pay if paid clause is now null and void.

Readers are welcome to reprint or republish this article with the following attribution:

Use the Free Construction Law Survival Manual at www.FullertonLaw.com

James D. Fullerton
Fullerton & Knowles, P.C.

12642 Chapel Rd.
Clifton, VA 20124
(703) 818-2600, Ext. # 205
JFullerton@FullertonLaw.com

[i] Galloway Corp v. S.B. Ballard Constr. Co., 250 Va. 493, 464 S.E.2d 349, 354 (1995); Moore Bros. Co. v. Brown & Root, Inc., 207 F.3d 717, 723-24 (4th Cir. 2000); Lane Constr. Corp. v. Brown & Root, Inc., 29 F. Supp. 2d 707, 723-724 (E.D. Va. 1998); Universal Concrete Prods. Corp. v. Turner Constr. Co., 595 F.3d 527, 529-30 (4th Cir. Va. 2010); James River Iron, Inc. v. Turner Constr. Co., No. LR-1763-3, 2004 Va. Cir. LEXIS 230 at *12 (Cir. Ct. City of Richmond Sept. 30, 2004) [“unambiguous pay-if-paid” clauses are enforceable in Virginia]; Fairfax Co. Redevelopment v. Ulico Casualty Co., Chancery No. 146724, 1997 Va. Cir. LEXIS 689, at *2 (Fairfax County 1997) Gilbane Bldg. Co. v. Brisk Waterproofing Co. Inc., 86 Md. App. 21, 585 A.2d 248, 252 (Ct. Spec. App.1991) [a provision that makes receipt of payment by the contractor a condition precedent to its obligation to pay the subcontractor transfers to the subcontractor the credit risk of non-payment by the owner “for any reason,” including insolvency of the owner].

[ii] See chapter, Contract Terms and Preserving Rights; section, Reviewing and Revising Contracts Received; subsections, The Right to Stop Work and Monitoring and Verifying Funds for the Project.

[iii] Thos. J. Dyer Co. v. Bishop Int’l Engineering Co., 303 F.2d 655 (6th Cir. 1962); Hunt v. Kadlick, 972 F. Supp. 2d 772, 776 (D. Md. 2013).

[iv] See chapter, Contract Terms and Preserving Rights; section, Reviewing and Revising Contracts Received; subsections, The Right to Stop Work and Monitoring and Verifying Funds for the Project.

[v] Gilbane Bldg. Co. v. Brisk Waterproofing Co. Inc., 86 Md. App. 21, 585 A.2d 248, 252 (Ct. Spec. App.1991); Maryland Real Property Code Section 9-113(b); Maryland State Finance and Procurement Code Section 17-108(d)(2).

[vi] See chapter, Performance and Payment Bonds; section, Payment Bonds; subsections, Enforcement of Payment Bond Claims; sub-subsection Pay When Paid Clauses.

[vii] Va. Code Anno. §11-4.6 (C) (Michie 1950.

[viii] Va. Code Anno. §2.2-4354(1) (Michie 1950.

[ix] It is not clear why public general contracts must affirmatively include this payment provision, while private general contracts “shall be deemed to include” it. In any event, a condition precedent Pay if Paid clause will generally be unenforceable in private and public subcontracts.

[x] Va. Code Anno. §2.2-4354(5) (Michie 1950.

[xi] Va. Code Anno. §11-4.6 (C) (Michie 1950. It is not clear whether this results in any difference in enforcement or application.

[xii] Va. Code Anno. §11-4.6 (C) (Michie 1950.

[xiii] Neither § 11-4.6 (B) nor (C) make the penalty clear for failure to give the required notice. What happens if no notice is sent? Does the higher-tier contractor lose the right to charge back for the noncompliance? Is there no penalty?

There are also significant differences between private general contracts and private subcontracts. The revised § 11-4.6 (B) states that in any private general contract:

An owner shall not be required to pay amounts invoiced that are subject to withholding pursuant to the contract for the general contractor's noncompliance with the terms of the contract. However, in the event that an owner withholds all or part of the amount invoiced by the general contractor under the contract, the owner shall notify the general contractor, in writing and with reasonable specificity, of his intention to withhold all or a part of the general contractor's payment with the reason for nonpayment.

The revised § 11-4.6 (C) mandates with respect to any private subcontract that:

. . . . in the event that a contractor withholds all or a part of the amount invoiced by any lower-tier subcontractor under the contract, the contractor shall notify the subcontractor, in writing, of his intention to withhold all or a part of the subcontractor's payment with the reason for nonpayment, specifically identifying the contractual noncompliance, the dollar amount being withheld, and the lower-tier subcontractor responsible for the contractual noncompliance.

This puts general contractors and lower-tier subcontractors in a difficult administrative position with their subcontractors. There is also some question whether the last portion is workable from a practical point of view.

The two statutes also have a different standard for withholding payment. An owner on a public or private contract and a general contractor on a public contract[xiii] can withhold payment for “noncompliance with the terms of the contract.” However, on a private project, a “higher-tier contractor” shall not be liable for amounts otherwise reducible pursuant to a breach of contract by their subcontractors or subcontractors[xiii]. It is not clear whether this results in any difference in enforcement or application.

[xiv] Va. Code Anno. §11-4.6 (D) (Michie 1950) states that "’General contractor’ and ‘subcontractor’ have the meanings ascribed thereto in § 43-1, except that those terms shall not include persons solely furnishing materials.” Va. Code Anno. §2.2-4354 does not adopt the definitions in Va. Code Anno. §43-1 (Michie 1950) or the specific exclusion of “persons solely furnishing materials.”

[xv] Va. Code Anno. §2.2-4354 (Michie 1950 eliminating condition precedent Pay if Paid clauses applies to “every agency of local government that acquires goods or services, or conducts any other type of contractual business with a nongovernmental, privately owned enterprise.” This seems to include not only public construction contracts, but also other types of public procurement.

[xvi] See chapter, Changes, Delays & Other Claims; section, Contract Clauses and Theories, subsection Implied Duties and Other Legal Theories, sub-subsection, Prevention of a Condition Precedent or Implied Duty for further discussion of the Prevention Doctrine; Aarow Equip. & Servs. v. Travelers Cas. & Sur. Co. of Am., 2011, 417 Fed. Appx. 366 (4th Cir. Va. 2011); Moore Bros. Co. v. Brown & Root, Inc., 207 F.3d 717 (4th Cir. 2000).

[xvii] Va. Code Anno. §43-3(C) (Michie 1950); Va. Code Anno. §2.2-4341(C) (Michie 1950); Va. Code Anno. §11-4.1:1 (Michie 1950).

[xviii] Moore Bros. Co. v. Brown & Root, Inc., 207 F.3d 717, 723 (4th Cir. Va. 2000), citing Brown & Kerr, Inc. v. St. Paul Fire and Marine Ins. Co., 940 F. Supp. 1245 (N.D. Ill. 1996) [the subcontractor is suing under the Bond and not the sub contract. The two are separate agreements. The inability to proceed against the general contractor because of a “pay when paid” clause in the subcontract does not necessarily prevent recovery against the surety under the payment bond, because such an argument runs counter to the underlying purpose of the payment bond, the assurance of payment to subcontractors]. See also United States ex rel. Aarow Equip. & Servs. v. Travelers Cas. & Sur. Co. of Am., 2010 U.S. Dist. LEXIS 24042 (E.D. Va. Mar. 16, 2010), vacated and remanded on other grounds at 417 Fed. Appx. 366; United States ex rel. U.S. Glass, Inc. v. Patterson, 2014 U.S. Dist. LEXIS 13827, 4-7 (E.D. Pa. Jan. 31, 2014), but see BMD Contrs., Inc v. Fid. & Deposit Co. of Md., 679 F.3d 643, 654-57 (7th Cir. Ind. 2012).

[xix] Moore Bros. Co. v. Brown & Root, Inc., 207 F.3d 717, 723 (4th Cir. Va. 2000; M&T Elec. Contrs., Inc. v. Capital Lighting & Supply, Inc. (In re M&T Elec. Contrs., Inc.), 267 B.R. 434, 440 (Bankr. D.D.C. 2001), decided on Virginia law and stating that a surety cannot rely upon a “pay-when-paid” clause in a subcontract unless the bond explicitly gives the surety the right to rely upon the defenses provided in that subcontract. Servs. v. Travelers Cas. & Sur. Co. of Am., 2010 U.S. Dist. LEXIS 24042 (E.D. Va. Mar. 16, 2010).