"Pay-if-Paid," Time to End a Dangerous Trend

by: Scott Holbrook, attorney with Crawford & Bangs, West Covina California

Recently the California Supreme Court ruled that the "Pay-if-Paid" clause (a condition precedent to the general contractor's obligation to pay the subcontractor is that the owner pay the general contractor) frequently used in construction subcontracts, is void and against public policy. This ruling followed a similar ruling in New York state and continues a trend started in North Carolina and Wisconsin prohibiting "Pay-if-Paid" clauses in construction subcontracts. Although many general contractors take exception to these recent decisions and legislation, in the long run, eliminating the "Pay-if-Paid" clause is in the best interest of the entire construction industry.

By way of example, in the recent California case, the general contractor knew there was no construction loan to fund the project and the partnership that had been formed to manage the building being refurbished (composed of two recently formed corporations) was not adequately capitalized to fund construction. The general contractor did not share this information with the subcontractors. Instead, the general contractor made sure that its contract contained a clause that payment to the general contractor was a condition precedent to any obligation to pay subcontractors for work they were performing, a "Pay-if-Paid" clause. Unfortunately, the general contractor was correct and funding was not sufficient for construction and the project was stopped without payment for the subcontractors' work. Since the general contractor was aware of this situation, it was in a position to pull off the job quickly when payment was not made. However, the subcontractors with their longer payment schedule and lack of any knowledge of problems with financing, were forced to carry large financial burdens including obligations to material suppliers.

When "Pay-if-Paid" is abused as illustrated in the California case, general contractors enter into projects with knowledge of the shaky financing and force many subcontractors out of business from non-payment on failed projects. As every subcontractor is painfully aware, material suppliers will not provide materials under a similar "Pay- if- Paid" clause and will refuse further supplies until a debt is paid. Thus, under the current "Pay-if-Paid" system the subcontractor is forced to carry the burden of failed projects.

General Contractor's argue that they should not be responsible for payment when an owner breaches its obligation. However, as the recent California case illustrates, general contractors are aware of risks of adequate financing that the subcontractor's are not, and are in a position to control those risks. General Contractors also argue that bonding requirements will increase and take jobs with bonding requirements away from small subcontractors. However, a subcontractor's ability to bond a job is not impacted by the presence or absence of a "Pay-if-Paid" clause. Furthermore, bonding requirements already eliminate small contractors from projects requiring bonding.

If "Pay-if-Paid" clauses are allowed to continue, general contractors will continue to take on questionable projects with little if any risks to themselves (especially with the current trend of subcontracting the great majority of work on projects), while subcontractors will continue to be put out of business by a risk they cannot protect themselves against. By eliminating "Pay-if-Paid," general contractors and their sureties on payment bonds will give projects the necessary scrutiny to assure that adequate financing is in place to protect the entire construction industry.