Most standard subcontracts contain a contingent payment clause that provides that a subcontractor’s payment from a general contractor is contingent upon the GC’s receipt of payment from the owner. Under such a clause, if the owner fails to pay the GC, then payment is neither due nor owing to the subcontractor. Are these enforceable?
From the GC’s perspective, the need to make such payments conditional or contingent upon being first paid by the owner is obvious. The GC does not want to end up being the involuntary financing agent for the project if for some reason the owner delays payment to the GC or withholds payment altogether, especially if the reasons for that withholding are no fault of the GC. In other words, the GC wants to avoid getting “gapped,” where it would find itself in the position of receiving nothing from the owner and having to front the money to pay the subcontractor. From the subcontractor’s perspective, the subcontractor does not want to risk nonpayment due to a contractual relationship upstream to which it is not a party.
Despite being in virtually every GC’s standard subcontract form, there remains uncertainty in the construction industry as to the effectiveness of the clause. A recent Indiana case, however, has once again shed light on its application. This is the case of BMD Contractors, Inc. v. Fidelity and Deposit Company of Maryland, 679 F.3d 643 (7th Cir. 2012).
Distinguishing ‘pay-when-paid’ and ‘pay-if-paid’ clauses
The typical contingent payment provision is one of two types, either providing (1) that payment will not be made until payment is received from the owner (“pay-when-paid”) or (2) that the obligation for payment will not arise at all unless payment is made by the owner (“pay-if-paid”). The latter type of clause is a true contingent payment clause, making performance of a contractual precondition by the owner the predicate for the contractor’s obligation to pay the subcontractor.
A number of cases from other states have upheld contingent payment clauses where the contract between the contractor and the subcontractor contains an express condition clearly showing that it is the intention of the parties that payment to the contractor is a condition precedent to the subcontractor’s right to payment. Courts have upheld such clauses where the parties expressly contemplate shifting the burden of forfeiture under a subcontract to the subcontractor by promising payment only if the primary contractor is paid. Clauses that clearly state the intent to make owner payment a condition precedent are routinely held to be adequate to transfer the risk of nonpayment by the owner to the subcontractor. It is not the use of the word when or if that is dispositive on whether the clause is enforceable but whether there is clear evidence of an intent by both parties to shift the risk of collection altogether. Consequently, to be enforceable as a pay-if-paid clause, a majority of the courts from other jurisdictions have ruled that the term condition precedent must be used in the clause itself.
Absent such definitive language, contingent payment clauses in many other jurisdictions have been interpreted as failing to represent a condition precedent that excuses payment altogether, but rather as constituting a covenant to pay within a reasonable time. In these cases, the courts have held that the contingent payment clause did not create a condition precedent for payment, but established the time and means of payment. In other words, it is a way of deferring the subcontractor’s payment for a reasonable length of time but is not an ultimate bar to recovery. Traditionally, Indiana was among those states interpreting contingent payment clauses this way.
Indiana’s position on contingent payment clauses
Indiana courts first addressed the contingent payment clause in Midland Engineering Co. v. John A. Hall Construction Co., 398 F. Supp. 981 (N. D. Ind. 1975). There, the District Court interpreted a contingent payment clause contained in a subcontract and concluded that such a clause constituted a covenant by the contractor to pay within a reasonable time, in the absence of payment from the owner. The standard by which the contingent payment clause’s enforceability is to be weighed is that of a reasonable period of time for payment. The determination of what constitutes a reasonable time period is a question of fact. The Midland court declared that a delay in payment from the GC to the subcontractor of more than three years was unreasonable.
The viability of a contingent payment or pay-when-paid clause next was addressed in the unpublished opinion of Envirocorp Well Services, Inc. v. Camp Dresser & McKee, Inc., 2000 WL 1617840 (S.D. Ind. 2000). In this case, the pay-when-paid clause was in an engineer’s subcontract with its consultant and stated that payments would be made to the engineering subconsultant after the engineer received payment from the owner. After noting that no Indiana state court had directly addressed the issue, the federal court reasoned that an Indiana court would conclude that the pay-when-paid clause does not permanently deprive the consultant of its right to payment if the owner refuses to pay the engineer. Rather, citing Midland, the court in Envirocorp concluded that such clauses simply provide the contractor with a reasonable time to obtain payment from the owner before the contractor is contractually bound to the subcontractor for immediate payment.
In a non-Indiana case, Moore Bros. Co. v. Brown & Root, Inc., 207 F.3d 717 (4th Cir. 2000), the GC and its payment bond surety were found liable to the subcontractor for nonpayment even though the subcontract contained a contingent, pay-when-paid clause. The surety was found liable under the bond and was not afforded the defense of the contingent payment clause because the surety had failed to expressly include it in the terms in the bond itself. The bond terms stated that valid claims would be paid if the claimant had not been paid by the contractor within a set number of days, the surety unconditionally promising to pay any claimant who had not been paid in full within 90 days after work was completed for “sums as may be justly due.” The court found that to allow the surety to avoid payment based upon this contingent payment defense would let the surety escape its liability and contravene the purpose of the payment bond, which was to ensure that valid claims of subcontractors and suppliers were paid. In reaching its conclusion, the court cited three other courts that had rejected attempts by sureties to invoke the pay-when-paid defense that is available to the principal-contractor.
The BMD Contractors case
In the recent decision of BMD Contractors, Inc. v. Fidelity and Deposit Company of Maryland, the 7th Circuit Court of Appeals (which covers Indiana) addressed the issue of contingent payments in the context of a suit on a payment bond. In that case, the owner of an automobile transmission manufacturing plant, Getrag Transmission Manufacturing LLC, hired Walbridge Aldinger Company as the GC. Walbridge hired numerous subcontractors, including Industrial Power Systems Inc. to complete mechanical piping work. The Walbridge subcontract included provisions stating that Industrial acknowledged that it was relying upon Getrag’s credit and ability to pay and was further accepting the risk that Getrag may not be able to perform its contract with Walbridge. Industrial subsequently hired BMD Contractors Inc. to perform piping work, who in turn, ordered supplies from another company. Industrial also executed a payment bond with Fidelity and Deposit Company of Maryland, whereby Fidelity was the surety for Industrial’s payment obligations to BMD.
Sometime after construction began, Getrag filed for bankruptcy and, as a result, failed to pay Walbridge. Walbridge subsequently failed to pay Industrial, and Industrial failed to pay BMD. Both BMD and its supplier filed mechanic’s liens, and BMD assigned a portion of its rights under the payment bond to that supplier. After Fidelity refused to pay, BMD and the supplier filed suit on the payment bond.
The District Court found in favor of Fidelity on the basis that its principal, Industrial, was not liable to BMD or its supplier for payment under the pay-if-paid provision in the subcontract. The District Court had determined that the condition precedent language in the subcontract was properly construed as a pay-if-paid provision, even though the subcontract did not include an express provision stating that BMD was assuming the risk of Getrag’s insolvency, as did Walbridge’s subcontract with Industrial. The District Court also determined that the subcontract did not need to be expressly incorporated into the terms of the payment bond, because Fidelity as surety was liable only to the extent that its principal, Industrial, was liable for payment (thereby contravening the prior ruling in Moore).
In affirming the District Court, the 7th Circuit analyzed the provisions of both the payment bond and the subcontract. The bond allowed claimants such as BMD to prosecute claims for such “sums as may be justly due claimant,” so the key question was whether BMD was entitled to payment under the subcontract. The court rejected BMD’s arguments that the conditional language was ambiguous, or for other reasons should be construed as a pay-when-paid clause, which would govern the timing of payment but not the ultimate obligation to pay. The court concluded that the condition precedent language in the subcontract was sufficient to create a pay-if-paid provision under Indiana law. BMD relied upon prior Indiana caselaw, which is often cited for the proposition that Indiana is a pay-when-paid jurisdiction. The court distinguished those cases, noting that the subcontracts at issue did not include condition precedent language such as that included in the subcontract between Industrial and BMD. Based upon this, among other reasons, the court concluded that Fidelity, no less than Industrial, may rely on the pay-if-paid clause in the Industrial-BMD subcontract.
Where we are today and how to negotiate the middle ground
Practically speaking, the BMD case is important as it could lead to Indiana courts (BMD was a federal court applying Indiana law) likewise holding that a contingent payment clause that states the express condition precedent language will be interpreted as a true pay-if-paid clause. This result is not unexpected. Perhaps more important yet is the court’s shifting analysis of the Moore case in the context of the payment bond surety. Moore previously held that where a pay-if-paid clause excuses the GC’s nonpayment, the subcontractor can still recover against the surety. However, the court found Moore “unpersuasive and contrary to basic Indiana surety-law principles” as it cited to three separate cases, each of which were decided after Moore and each of which rejected the position held therein. This means that the payment bond surety will have this same defense to claims as does its principal. Subcontractors are now faced with the risk of true contractual risk shifting on the ability to get paid with no surety recourse likely being available.
So how can the puzzle of the contingent payment provision be solved? First and foremost, a subcontractor will want to strike or at least limit the contingent payment clause in its subcontract. It does not want the contractor’s duty to make progress and final payments absolutely conditioned upon the contractor’s prior receipt of payment from the owner. Terms that take a clause from a timing device to a true pay-if-paid clause thus should be limited. The counterbalancing consideration for the GC is to have some opportunity to ensure that it gets paid first by the owner before its own downstream payment obligations ripen. A middle ground for the subcontractor and GC is to provide that acceptance by the GC of the owner’s tendered payment or unreasonable delay in receipt of payment from the owner will not excuse the contractor’s primary obligation to pay the subcontractor within a set time (for example, 60 or 90 days) after payment otherwise is due and payable. In this fashion, the GC gets more time to ensure that it is paid first, but the subcontractor ultimately has assurance that it will be paid one way or the other. Another option for the parties is to provide for the contractual escrowing of monies – even if limited to retainage – that would be otherwise due and owing, though the GC may not have the financial wherewithal to do this. Notwithstanding the contingent payment clause, from the subcontractor’s perspective, if all else fails, the indebtedness can still be secured through use of the statutory claim remedies (i.e., mechanic’s lien and personal liability notice on a private project, or a payment bond claim and verified statement of claim on a public project).
Regardless of how the negotiations proceed and the type of contingent payment clause that may ultimately be included in the subcontract, it is imperative that the parties have a full understanding of exactly what they are intending with respect to the contingent payment provision. Whether it is the subcontractor’s receipt of payment or the GC’s liability exposure associated with making payments downstream despite not having received payment from the owner, the puzzle of the contingent payment clause could make all the difference on a construction project.•
Mr. Drewry is a partner in Drewry Simmons Vornehm in Indianapolis. He chairs the DTCI Construction Law Section. The opinions expressed in this article are those of the author.