“Pay when Paid” versus “Pay if Paid”

Most subcontracts contain language, which state that the contractor shall pay the subcontractor within so many days after the contractor’s receipt of payment from the owner.  The question then becomes, “what happens if the owner never pays the contractor?”  It is a complicated question that has been the subject of much litigation.  The general rule is that – provided the owner is not withholding payment due to a failure by the subcontractor – the subcontract will be interpreted as requiring payment within a reasonable time. In other words, even if the owner does not pay the contractor for the subcontractor’s work, the contractor will still be expected to pay the subcontractor despite the fact that the subcontract requires the owner to first pay the contractor.

Of course, as with almost every legal issue, there are exceptions to the general rule.  For example, there are “magic words” that will make it more likely that the court will find that the subcontractor has given up its right to payment should the owner not pay the contractor.  Examples of such “magic words” are as follows:

• Contractor’s receipt of payment from owner is a “condition precedent” to the subcontractor’s right to payment; and

• Subcontractor expressly “assumes the risk of the owner’s insolvency.”

Courts look for these magic words because a contract is interpreted based upon the parties’ intent. The first way a court determines what the parties intended is by looking at the contract language.  While many may argue that a subcontractor does not have sufficient bargaining power to request changes in subcontract language, courts tend to assume that sophisticated commercial entities know the risks associated with the agreements they enter.  Moreover, the law recognizes that people are free to enter any agreement they wish – provided it does not involve illegality or a violation of public policy – and that freedom of contract includes the right to make a bad deal.  A court must enforce the agreement the parties entered and cannot relieve a party from its obligations unless the contract was the result of mistake, fraud or unconscionability.

IMPORTANT UPDATE:  As of November 8, 2010 “Pay if Paid” clauses are prohibted by statute in Massachusetts.  (The Act Promoting Fairness in Private Construction Contracts also has other important aspects such as deeming pay applications and proposed change orders approved if they are not acted upon within a specified time. )

“Pay when paid” clauses are just one example of an important contract provision that is subject to interpretation.  It is important that you understand any agreement you sign.  Please feel free to call us with any questions regarding contract interpretation or the new Massachusetts law.