"Pay if Paid" Provisions
The "pay if paid" provision is amongst the most powerful provisions a subcontract may contain. It shifts entirely the risk of owner non-payment from the general contractor to subcontractors and suppliers. And it is often buried in the tiny print of a lengthy contract. Understanding the ramifications of this provision is critical to negotiating a fair contract and avoiding potentially disastrous downside risk.
The "Pay if Paid" Clause.
A typical "pay if paid" clause reads something like this:
Subcontractor will not be paid for work performed pursuant to the Work Order unless and until Contractor is paid for such work by the Owner. Payment to Contractor on Subcontractor's account by Owner is an absolute condition precedent to Contractor's obligation to pay Subcontractor under this Agreement. Subcontractor expressly agrees that it relied on the credit of Owner, not Contractor, for payment of its work. Subcontractor acknowledges that it, rather than Contractor, is accepting the risk of nonpayment by Owner for Work performed pursuant to this Agreement.
"Pay if paid" provisions are usually located in the payment provisions of the subcontract. However, "pay if paid" provisions can also be buried in other provisions of the subcontract such as the provisions governing change orders (e.g., "Contractor's obligation to pay change requests initiated by the Owner or Architect shall be expressly contingent upon receipt of a corresponding change order from Owner, and the amount payable to Subcontractor shall in no instance exceed the amount paid by Owner to Contractor for the change.") and retainage (e.g., "The 10% retainage shall be paid to Subcontractor upon full performance of Subcontractor's obligations, final completion and acceptance of its Work and all of its obligation and Contractors receipt of final payment from the Owner.")
The risks of this provision to subcontractors are enormous. Fundamentally, the "pay if paid" provision shifts the entirety of the risk of owner/client non-payment to the subcontractor. If, for instance, a developer collapsed (which happened with great frequency during the Great Recession) and failed to make payments to the general contractor, the general contractor would have no obligation to provide payment to subcontractors or suppliers. The general contractor, often a larger company with more capital, avoids all adverse consequences of the developer's collapse. This result is particularly harsh considering the fact that the subcontractors and suppliers normally have no direct contractual relationship with the developer. They did not choose the client.
While devastating, owner collapse is not the only or most common risk. "Pay if paid" provisions can be invoked where there are disputes between the owner and the general contactor leading to owner nonpayment. A common example is where the owner challenges a general contractor's change order, arguing that the work is within the original scope. Even if there is no dispute between the general contractor and the subcontractor regarding the latter's scope of work and entitlement to payment, the general contractor will sometimes refuse payment based on the owner's rejection of the change order. Back charges have the same effect. For example, if the owner holds back payment for the plumbing scope of work because the electrical work is defective and requires significant repairs, the plumbing subcontractor could be left holding the bag.
It's not that simple, however. While the plain language of the provision suggests the subcontractor will not receive payment if the specific payment is not received from the owner, the subcontractor can still argue that the intent of the provision was limited the owner collapse scenario, not disputes between the owner and general contractor. Specific language like the provision quoted above referencing the "credit" of the owner supports this argument. But other versions of "pay if paid" provisions refer to the creation of a "special fund" and state that "no payment will be made to subcontractor unless and until that fund comes into existence." It can get murky. Ambiguity breeds litigation. If the subcontractor does not have the benefit of an attorney fee provision (more on that here), the subcontractor could be forced to take a substantial haircut due to the economic reality of pursuing the claim.
"Pay if paid" provisions are fundamentally unfair to subcontractors and suppliers. Notably, the standard AIA subcontract (AIA Document A401-207 Standard Form of Agreement Between Contractor and Subcontractor) does not contain this provision. Yet, they appear often in general contractors' custom contracts, drafted by an expensive construction lawyer with the sole purpose of providing the general contractor the most protection possible at the expense of all others.
Subcontractors and suppliers should strike these provisions. As we all know, general contractors are often reluctant to accept substantive modifications. However, this provision is important enough that subcontractors and suppliers should consider rejecting the project if the general contractor will not agree to the deletion. Request that the general contractor explain what the "pay if paid" provision does and why the lower tier parties should bear all of the risk. No one ever claims that this provision is fair. If they insist on keeping it in the contract, subcontractors and suppliers should ask themselves if this is a company with whom they want to do business.
Alternatively, propose converting the "pay if paid" provision to a "pay when paid" provision. This would alleviate the general contractor's cash flow concerns while securing the ultimate right to payment if the developer folds.