Kent B. Scott
What are contingent payment clauses? How do they work? Are they legal? Contingent payment clauses provide parties involved in a construction project with a contractual method for determining who will absorb losses that may occur if the owner, perhaps because of insolvency, fails to pay for work performed on the project. The use of contingent payment clauses is common in the construction industry.
The distinctions between different types of contingent payment clauses can be subtle and the use of one clause over another can drastically affect the outcome of payment disputes.
In Utah, the law remains unsettled in this area, though some statutes clarify the treatment of contingent payment clauses in certain cases. Participants in the Utah construction market should understand the types of contingent payment clauses available and how those clauses might affect a participant’s ability to recover payment due or to defend against a claim for recovery. By understanding contingent payment clauses, participants can better assess the risks associated with the use of these clauses and can adjust their pricing to match that risk when they enter into a contract that includes one.
Contingent Payment Clauses
One type of contingent payment clause, called a “pay-when-paid” clause, requires a contractor to pay a subcontractor or supplier within a reasonable period of time for work or material furnished to a project. These clauses do not shift the risk of owner nonpayment to the subcontractor or supplier. If the owner fails to pay the prime contractor, the prime contractor is still liable to pay its subcontractors and suppliers.
A pay-when-paid provision might read, “Prime shall pay subcontractor within 10 days of receipt of payment from owner.” Pay-when-paid clauses are generally accepted because the risk of loss due to nonpayment is retained by the upper-tier contractor, who the courts view as the party in the best position to evaluate the risk of dealing with a particular owner and manage the jobsite.
“Pay-if-paid” clauses, the second type of contingent payment clause, provide more protection to the prime contractor. This type of contingent payment clause conditions the subcontractor’s payment on whether the prime contractor has been paid by the owner. A pay-if-paid clause shifts the risk of loss due to owner nonpayment from the upper-tier contractor to lower-tier contractor. A pay-if-paid clause may read: “The subcontractor assumes the risk of the owner’s nonpayment to the prime contractor and the subcontract price reflects this risk. Payment to the prime contractor will be a condition precedent to any funds being due the subcontractor.”
Pay-if-paid clauses are not as widely accepted by courts as pay-when-paid clauses and have sometimes been declared unenforceable in other jurisdictions. Some courts have interpreted a pay-if-paid clause as if it were a pay-when-paid clause, thereby keeping the risk for nonpayment in the hands of the upper-tier contractor.
A limited number of states have enacted legislation prohibiting the use of pay-if-paid clauses. In states where pay-if-paid clauses have been enforced, courts will generally enforce only clauses that use specific words or otherwise clearly demonstrate that the contracting parties intended to shift the risk of nonpayment.
While an enforceable pay-if-paid clause prevents a subcontractor from recovering unpaid funds from the prime contractor, the subcontractor may still be able to pursue other means of recovery, such as a mechanic’s lien against the project.
Utah Treatment of Contingent Payment Clauses
Utah has yet to determine many of the legal issues surrounding pay-if-paid and pay-when-paid clauses. The Utah Legislature has enacted some statutes, though, relating to these clauses that provide contracting parties with some direction.
In Utah, contingent payment clauses are generally not enforceable against mechanics’ liens, though they may be enforceable in residential contracts. The Utah Legislature has enacted Utah Code Section 13-8-4(3) which provides, “The existence of a contingent payment contract is not a defense to a claim to enforce a mechanics’ lien [but this section] does not apply to private construction work for the building improvement, repair, or remodeling of residential property…”
According to this statute, in most cases, even though a subcontract agreement may include a contingent payment clause that would otherwise bar the subcontractor or supplier from recovering from the prime contractor, that subcontractor may still pursue a mechanics’ lien claim against the property in order to recover unpaid funds. This statute does not apply to contingent payment clauses in residential contracts. Courts are likely to uphold pay-if-paid clauses in residential contracts, barring a subcontractor or supplier from enforcing a mechanics’ lien, but the subcontractor or supplier may still have a claim against the Residential Lien Recovery Fund.
Contingent payment clauses may still be a defense against payment bond claims, despite the similarities between mechanics’ lien and payment bond legislation. Utah has yet to clarify whether the protection against contingent payment clauses provided in mechanic’s lien cases extends to payment bond claims.
Additionally, Utah law states that when a subcontractor may be entering into a contract “that makes a payment from the contractor to the subcontractor contingent on the contractor receiving a corresponding payment from any other public or private party … the subcontractor may request from the contractor financial information that the contractor has received from the public or private party regarding: (1) the project financing; and (2) the public or private party” prior to signing the contract. This statute allows the subcontractor to evaluate the risk that they may be assuming.
Recent Enforcement of a Pay-If-Paid Clause
It may be helpful to contracting parties to look to treatment of these clauses in other jurisdictions. In 2009, a United States District Court in New Jersey upheld a prime contractor’s pay-if-paid clause, barring a subcontractor’s recovery under a payment bond claim. In that case, the plumbing subcontractor on a project sought to receive retainage and payment for change order work from the prime contractor. The prime contractor refused to pay the subcontractor because the owner had not paid for the work performed. In its defense, the contractor pointed to a provision in the subcontract that stated, “5.3 Pay When Paid. Subcontractor agrees that Contractor shall never be obligated to pay Subcontract under any circumstances, unless and until funds are in hand received by Contractor in full, less any applicable retainage, covering the Work or material for which Subcontractor has submitted an Application for Payment. This is a condition precedent to any obligation of Contractor, and shall not be construed as a time of payment clause.”
The court held that the contractor did not have to pay the plumbing subcontractor because the pay-if-paid clause included in their contract clearly conditioned payment on the funds being received first by the prime contractor.
The prime contractor’s surety also sought protection under the pay-if-paid provision in the subcontract, arguing that it had no responsibility to pay the subcontractor because the owner had not paid the prime contractor. According to the surety’s argument, if the contractor has not been paid by the owner and if the contractor included a valid pay-if-paid clause in its subcontract, the surety is not liable to the subcontractor because the surety only takes responsibility for the debts the contractor would have to pay. Agreeing with this view, the District Court held that the surety was able to assert the defenses available to the principal against the claimant because the surety “steps into the shoes of the contractor” in paying the debt. As a result, the subcontractor was not able to recover any monies in connection with either its contract claim against the prime contractor or its payment bond claim against the prime contractor’s surety.
Conclusion
Contingent payment clauses are common in the construction industry. They allow parties to allocate the risk of an owner’s nonpayment as part of the contract. By using a pay-when-paid clause, the upper-tier contractor retains the risk of owner nonpayment while providing itself with a reasonable timeframe to pay subcontractors and suppliers. Conversely, a pay-if-paid clause shifts the risk of owner nonpayment to the subcontractor or supplier. Defenses available to a prime contractor through a contingent payment clause may also be available to their sureties.
While most states have decided if contingent payment clauses will be enforceable in their jurisdiction, Utah has yet to settle many of the questions surrounding these clauses. The Utah Legislature has provided that subcontractors may request certain portions of the owner’s financial information from the prime contractor before signing the contract, which allows the subcontractors to evaluate the risk they may assume by agreeing to a contingent payment clause.
In most cases, suppliers and subcontractors in Utah may recover for work rendered via a mechanics’ lien no matter what contingent payment clause may be included in the contractual language. If the contract relates to residential construction, though, this protection does not apply.
As the applicability of contingent payment clauses in Utah is generally undecided, members of the construction industry should be aware of the potential vulnerabilities and benefits of entering contracts that include them. A contractor should seek legal counsel when determining the legal effect of contingent payment clauses that have been or will be included in their contracts.
Kent B. Scott is a shareholder and vice president at the Salt Lake City law firm of Babcock, Scott & Babcock. His practice is focused primarily on construction project disputes.
