Risk Shifting in Payment Clauses
In continuation of our recent columns concerning protection of payment rights and due diligence in light of the forecasts that economic conditions may be ripe for a recession, the following column primarily addresses pay when paid clauses.
General contractors are often faced with claims from subcontractors which may arise from the acts or omissions of the project owner. The general contractor can choose to pass the claim through to the owner but may be put in the position of arguing in favor of the claim to the owner and against the claim to the subcontractor. To avoid this situation, general contractors can include pay-when-paid or pay-if-paid clauses into their subcontracts. As I will explain, each clause shifts risk in a different way.
On the one hand, pay-when-paid clauses shift risk from the contractor to the owner for not paying or delaying payment to the subcontractor. This clause addresses the timing of payment from the general contractor to the subcontractor, but it does not address the right to be paid. Simply, the subcontractor gets paid when the general contractor receives payment from the owner. A pay-when-paid clause typically provides that the “subcontractor will be paid within X days after receipt of payment from owner.” The number of days varies, but between five and 10 days is the typical timeframe in which the general contractor promises to pay the subcontractor. The owner’s payment triggers the general contractor’s payment obligations to its subcontractors within the contractual timeframe. But even if the owner fails to pay, or advises that payment will not be forthcoming, the general contractor remains obliged to pay the subcontractor. As I will touch on later, a pay-when-paid clause does not impose a condition before the general contractor is obligated to pay its subcontractor, unlike a pay-if-paid clause.
The inclusion of a pay-when-paid clause in a subcontract serves, in some capacity, to insulate a general contractor from the risk of the owner’s insolvency (which is certainly a credit risk contemplated by the general contractor). The general contractor can employ various legal and contractual provisions to reduce the credit risk, e.g., prompt pay act claims, liens, and the insistence of progress or installment payments.
The pay-when-paid clause permits a general contractor to delay paying a subcontractor when it does not have readily available funds. Importantly, this clause does not shift risk of nonpayment from the general contractor to the subcontractor. Rather, the clause serves to postpone payment until after the work is completed, during which time the general contractor has an opportunity to procure the funds necessary to pay the subcontractor from the owner. With regard to timeliness, however, courts have consistently held that a subcontractor is not required to wait for an indefinite period of time for payment. Requiring a subcontractor to do so interprets the clause in a way not intended by the parties. Instead, Texas courts find that, under a pay-when-paid clause, a general contractor must pay its subcontractor within a reasonable period of time. There is no clear answer on what “reasonable” means in this context. However, it is likely that a court would interpret a reasonable period of time as one which does not extend too far beyond the completion of a project.
Pay-when-paid clauses present a unique risk for a subcontractor. When contracting, a subcontractor has dual concerns: the general contractor’s solvency and the owner’s solvency. Of course, a subcontractor can also avail themselves to several legal and contractual provisions, such as mechanics liens and installment payments, to minimize the risk of the general contractor or owner’s insolvency. However, when entering into a contract that contains the pay-when-paid clause, the subcontractor can better gauge the allocated risk and determine whether to factor the same into their contract price.
Ordinarily, and legally, the owner’s insolvency will not defeat the claim of a subcontractor against a general contractor for nonpayment. This right remains intact because the protection afforded to a subcontractor renders the issue of nonpayment (or delayed payment) not one of whether the subcontractor will be paid, but when. Critically, pay-when-paid clauses state how long the general contractor has to pay a subcontractor once it is paid, but it does not indicate how long the general contractor has to pay a subcontractor if it is not paid by the owner. Texas courts have consistently held that the general contractor must pay the subcontractor – whether subject to a pay-when-paid clause or not – within a reasonable period of time after the work is completed. Taking the foregoing into account, it is a worthwhile endeavor to ensure that the parties are aware of the timelines for payment and the deadlines for liens to preserve the right to payment.
While a pay-when-paid clause may provide some assurance of payment, a subcontractor is well within their legal rights to preserve their right to payment by filing a lien on the project. In many cases, the subcontractor has the understanding that their payment is coming but the uncertainty of when predicates the filing of a lien.
On the other hand, pay-if-paid clauses shift the risk of nonpayment from the owner to the subcontractor. The Texas legislature and courts disfavor shifting risk in this manner, but permit such risk shifting because a subcontractor can consider such risk in contracting. Pay-if-paid clauses are also known as contingent payment clauses and regulated by Texas Business and Commerce Code Chapter 56. Pursuant to that chapter, the enforceability of a pay-if-paid clause is fairly specific. For example, the language used by the general contractor in a pay-if-paid clause must clearly indicate the general contractor’s intent to condition its payment obligations to the subcontractor on the receipt of payment from the owner. To avoid the result where a subcontractor can be required to wait an indefinite period of time to receive payment until such a time that the general contractor has been paid by the owner, a subcontractor may object to the enforceability of the clause by providing written notice 45 days after submitting a payment application in the correct form.