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 554  Contingent Payment Update

 Overview

             Payment terms can be one of the most, if not the most, contentious issues affecting the negotiation of construction subcontracts and purchase orders at nearly every tier.  A variety of circumstances and risks can affect payment such as inadequate owner financing, insolvency of an upper tier firm, performance disputes, etc.  Similarly, the right to be paid can be affected by state lien laws, as well as the availability of payment bonds (public or private).  Regardless of the potential complexity of the issues, an appreciation of the terms and conditions of  payment and their interpretation under the applicable law is as essential as a solid grasp of the scope of the work.

            Any analysis of risks or rights associated with payment should start with the payment clause and any conditions or contingencies affecting payment.  Generally, many conditional payment clauses are classified as “pay-if-paid” or “pay-when-paid” clauses.  The distinctions between these two types of payments can materially affect the parties’ payment rights and obligations.       For example, a valid and enforceable pay-if-paid clause in a subcontract would make the owner’s payment to the general contractor a condition precedent to the general contractor’s obligation to pay the subcontractor.  In contract law, a condition precedent is an event that must take place before a party to a contract must perform a specific duty or obligation.  Thus, if the owner never pays the general contractor for work performed by the subcontractor, the general contractor’s obligation to pay the subcontractor is never triggered. 

            In contrast to  a pay-if-paid clause, a pay-when-paid clause does not necessarily establish a condition precedent to payment.  Rather, it addresses the timeliness of the payment.  A court may interpret a payment clause as a “pay-when-paid” clause when the contract between the parties does not clearly shift the risk of the owner’s nonpayment from the general contractor to the subcontractor.  If the subcontract does not clearly shift the risk of nonpayment, a court may interpret the subcontract as establishing a reasonable waiting period after which the general contractor must pay the subcontractor regardless of whether or not the owner has paid the general contractor.  This distinction can be critical.

            State legislation may affect the enforcement of payment terms.  In some states, statutes declare pay-if-paid clauses to be unenforceable under mechanic’s lien laws or as a matter of public policy.  In North Carolina, for example, payment by the owner to a contractor cannot be a condition precedent to payment to a subcontractor.  See N.C.G.S. § 22C-2.  Wisconsin law prohibits pay-if-paid clauses, but allows pay-when-paid provisions.  See W.S.A. § 779.135.           

            Recognizing the policy that commercial entities have substantial freedom to contract on mutually acceptable terms, courts in other jurisdictions enforce contingent payment clauses if that clause clearly addresses the situation.  This policy is sometimes labeled as “freedom of contracting.”  Obviously, a public policy limiting the application or enforcement of a contract provision creates a tension with a policy allowing commercial entities broad freedom to contract on mutually agreed terms and conditions.  When a construction project involves entities from different jurisdictions that have different policies on the enforcement of a contract provision such as “pay-if-paid” clauses, that tension can lead to frustrated expectations and litigation.  

            A recent New York decision analyzed conflicting public policies in order to determine the more important fundamental public policy  in New York: freedom of contract or the state’s prohibition of pay-if-paid clauses.  Welsbach Electric Corp. v. MasTec North America, Inc., 859 N.E.2d 498, 7 N.Y.3d 624 (2006).   

Background

            In 1999, Telergy Metro LLC (“Telergy”) engaged MasTec to construct a fiber optic network in New York.  In 2000, MasTec subcontracted with Welsbach Electric (“Welsbach”) to perform the electrical work on the project.  The subcontract agreement between MasTech and Welsbach contained a pay-if-paid clause stating that: “Upon final acceptance of the Work by Contractor and Owner, Contractor will pay Subcontractor for the Work … provided that, all payments to Subcontractor by Contractor are expressly contingent upon and subject to receipt of payment for the Work by Contractor from Owner….”  (emphasis added).

            In 2001, Telergy went belly-up and terminated its contract with MasTec, effectively terminating the subcontract agreement between MasTec and Welsbach.  MasTec, and in turn, Welsbach, were not fully paid for their work.  Welsbach sued MasTec for the unpaid balance under the subcontract. 

            MasTec is a Florida corporation and Welsbach is a Delaware corporation; under the terms of the subcontract the parties agreed that Florida law would govern any disputes.  The suit was brought in New York where the project was being constructed.  Under New York law, pay-if-paid clauses are unenforceable as contrary to New York’s public policy.  Florida allows pay-if-paid clauses when the clause is clear and unambiguous.  The issue before the court was whether New York’s public policy against pay-if-paid clauses should override the parties’ choice of law.  In other words, which should prevail— New York’s public policy against pay-if-paid clauses or the parties’ freedom of contract?

Court’s Analysis

            New York’s highest court unanimously held that the parties’ choice of law controls because a pay-if-paid clause is not so “truly obnoxious” as to violate  that state’s fundamental public policy.  In other words, New York’s public policy against pay-if-paid clauses in construction contracts was not so fundamental that it overrode the parties’ choice of Florida law to govern their construction subcontract. 

            The court reasoned that New York’s current Lien Law § 34, passed in 1975, outlawed pay-if-paid clauses to “protect New York subcontractors from the oppressive use of bargaining power” by general contractors.  The court found that neither MasTec nor Welsbach was a New York corporation and that both were sophisticated commercial entities that knowingly and voluntarily entered into the subcontract.  In sum, the court held that Welsbach had not met its heavy burden of proving that Florida law would be offensive to New York’s fundamental public policy, and the pay-if-paid clause was therefore enforceable.

Choice of Law Statutes

            Today, however, the result in a New York construction contract case with similar facts would most likely be different due to the passage of New York’s Prompt Payment Act of 2002.  This prompt payment statute renders void any provision that makes a private construction contract subject to the laws of another state.  N.Y. Gen. Bus. Law § 757.    In the Welsbach Electric  decision, the subcontract was signed in 2000, and, as explained above, the court upheld a choice-of-law provision (application of Florida law to a New York construction project) even though this meant enforcing a pay-if-paid clause in the subcontract.  Under the new statute, a subcontract’s pay-if-paid clause may not be enforceable in New York if the subcontract agreement is signed on or after the effective date of the prompt payment statute, January 14, 2003.

Comment

             Conditional payment clauses are very controversial.  Under the majority view, subject to the use of clear and unequivocal express language, a conditional payment clause in  a construction subcontract stating that the subcontractor will be paid when the general contractor is paid will  be construed as establishing true condition precedent (i.e., pay-if-paid).  If the language is not sufficiently clear, the clause is likely to be treated as merely fixing a reasonable time for payment to the subcontractor. 

            A pay-if-paid clause in a construction subcontract must be clear and unambiguous.  The clause must be drafted with precision and should contain the term “condition precedent.”  Sample subcontract language could include: “Payment from the Owner is a condition precedent to the Contractor’s obligation to pay the Subcontractor, and the Owner’s funds will be the sole source from which payment will be made to the Subcontractor.”  The parties’ intention to shift the risk of the owner’s nonpayment from the general contractor to the subcontractor must be clearly articulated.

            Even an iron-clad pay-if-paid clause will not be enforced in a jurisdiction that prohibits these clauses by statute or where they are deemed to violate fundamental public policy.  Parties are not always free to contract in any way they please.

Finally, all parties (general contractor and subcontractors at all tiers) should consider the financial viability of the other entities associated with the project as well as all available information on the project’s financing.  Consider this as a “financial site investigation”.   Public policy and the careful negotiation of contract terms cannot avoid the litigation and losses associated with a financially distressed project and possible bankruptcy of one or more entities in the chain of contracts.

John M. Mastin, Jr.
(404) 582-8057
jmmastin@smithcurrie.com
Member of the State Bar of Georgia