There are many risks to be managed in conjunction with construction contracts. This is particularly true from the perspective of a subcontractor and the subcontractor’s lender. One of the risks that the parties seek to mitigate is the collection risk in the event of an insolvent property owner. As a result, general contractors frequently try to include in subcontracts what is called a “paid if paid” clause, which requires the general contractor to pay its subcontractors only if it receives payment from the owner. In a recent case, the 7th Circuit Court of Appeals was required to make two determinations. The first was whether or not the contract language was in fact a “paid if paid” clause as distinguished from a “paid when paid”, which merely determines the time for payment, not whether or not payment is due.
While there are no magic words necessary to create either one of these clauses, the particular language in this contract is instructive. The provision read as follows: “It is expressly agreed that Owner’s acceptance of Subcontractor’s work and payment to the Contractor for the Subcontractor’s work are conditions precedent to the Subcontractor’s right to payments by the Contractor.” The Court held that this was clearly a “paid if paid” clause. The next issue it considered was whether or not such a clause was legal under Indiana law. Applying Indiana law, the 7th Circuit held that there was no prohibition against the enforcement of a clearly written “paid if paid” clause. Therefore, the contractor, who was never paid by the owner, was excused from payment to the subcontractor. In addition, the payment bond surety for the general contractor was also discharged because its liability was derivative of the general contractor.
Subcontractors need to be aware of the distinction between the two types of clauses. Subcontractors also need to be aware that a determination of which type of clause contract language is designed to create is not always crystal clear. It is recommended that legal counsel be sought to review this type of clause to make a determination of what the subcontractor’s risk might be. If it is a “paid if paid” clause, the subcontractor should perform credit underwriting not only on the general contractor but also on the owner.
This is not just a problem for subcontractors. It should also be a concern for banks lending to subcontractors when evaluating the collectability of accounts receivable. Jobs performed by subcontractors for strong general contractors but weak owners could easily be misevaluated by a lender if a lender is not aware of this collection risk shifting type of clause.
Author: Terry G. Farmer (bio)