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February 28, 2023

The Shifting Tide Against Contingent Payment Provisions in Construction Subcontracts

In construction subcontracts, contingent payment provisions like “pay-if-paid” and “pay-when-paid” clauses are being banned in an increasing number of states. “Pay-if-paid” clauses state that a subcontractor will not be paid by the general contractor for their work unless the owner pays the general contractor for that work first. This passes the risk of owner non-payment onto the subcontractor. “Pay-when-paid” clauses are interpreted as a timing mechanism for payment. In other words, a “pay-when-paid” provision says that the contractor will pay the subcontractor within a certain amount of time after receiving payment from the Owner. But, if the contractor is not ultimately paid by the owner, a “pay-when-paid” clause will not work to absolve the contractor from its obligation to pay the subcontractors. These contingent payment provisions are seen as unfair and against public policy by many courts and legislators since they ultimately lead to the subcontractor facing added risk and duties in evaluating the owner’s financial position. This is often more difficult and unrealistic for a subcontractor since they are often smaller, more specialized businesses.

Virginia is the latest state to continue this trend. Pursuant to the state’s newly passed Senate Bill 550, contingent payment provisions are to be void and unenforceable in construction contracts signed after January 1, 2023. This is surprising for construction companies because Virginia has a reputation for allowing parties the freedom to negotiate and agree to almost any term in a construction contract.

In addition to the ban on contingent payment provisions, the law requires that any public contract include a provision that makes a contractor liable for the entire amount owed to the subcontractor, except for “amounts otherwise reducible due to the subcontractor’s noncompliance with the terms of the contract.” If withholding funds for non-compliance, the contractor must provide the reason for withholding the funds in a written notice. The law also enhances prompt payment protections for contractors in private contracts by stating that the owner shall pay the contractor within 60 days of an invoice of any undisputed portion of the work invoiced. Similarly, in a subcontract, the contractor must pay a subcontractor for undisputed portions of invoices “within the earlier of (i) 60 days of the satisfactory completion of the portion of the work for which the subcontractor has invoiced or (ii) seven days after receipt of amounts paid by the owner to the general contractor or by the higher-tier contractor.”

In passing this bill, Virginia joins California, Delaware, New York, North Carolina, Ohio, South Carolina, and Wisconsin in banning the use of these provisions for being against public policy. While Virginia has done so legislatively, some states have banned contingent payment provisions judicially. For example, in 1995, the Court of Appeals in New York held in West–Fair Electric Contractors v. Aetna Casualty & Surety Company that a provision that “forces the subcontractor to assume the risk that the owner will fail to pay the general contractor is void and unenforceable as contrary to public policy,” but “a pay-when-paid provision which merely fixes a time for payment does not indefinitely suspend a subcontractor’s right to payment upon the failure of an owner to pay the general contractor, and does not violate public policy.” Similarly, in 1997, the Supreme Court of California in Wm. R. Clarke Corporation v. Safeco Insurance Company of America held that such provisions are against public policy “because they effect an impermissible indirect waiver or forfeiture of the subcontractors’ constitutionally protected mechanic’s lien rights in the event of nonpayment by the owner.”

Many other states including Illinois, Massachusetts, Texas, Utah and Vermont restrict parties’ rights to use these provisions and narrow the provisions’ application. For example, Illinois permits these provisions but requires very specific language for them to be enforceable. Texas law states that contingent payment clauses are unenforceable to the extent that the owner’s nonpayment to the general contractor is the result of the contractual obligations of the general contractor not being met unless the nonpayment is the result of the subcontractor’s failure to meet the general contractor’s contractual requirements. Massachusetts law states that contingent payment provisions are void and unenforceable, except to the extent amounts not received are caused by the subcontractor’s failure to perform under its contract and to the extent of amounts not received are because of the owner’s insolvency. In Massachusetts, these exceptions must be expressly stated in any conditional payment provision for the party seeking enforcement of the provision to have the burden of proof as to each element.

While contingent payment provisions are still permitted in the majority of states, the above-mentioned case law and other authorities signal a shift in the tide throughout the country narrowing and/or banning the use of such provisions. It is reasonable to think that, in the coming years, more and more states will restrict and ban these provisions for being against public policy.

Source: Cohen Seglias Pallas Greenhall & Furman PC