Industry Watch – Pay-When-Paid – A Common but Illegal Term that Exists In Most Construction Contracts.

For several years I have been beating the drum of removing “Pay-when-Paid” and “Trickle-down” terms in construction contracts.

I’ve written several articles on the matter, but righting the wrongs of the construction industry is a slow process.

Pay-when-paid

For the un-initiated, “Pay-when-paid” clauses are contract terms that allow General Contractors to withhold payment from sub-contractors until the General Contractor receives payment from the Owner.

At first glance, this (very common provision) may seem reasonable, but in practice, these clauses expose Owner’s to several risks.

Pay-when-paid Risks

As we learned from the fall of Carillion, it is common for General Contractors to co-mingled the various payments they receive (from all projects) into one operating account.  This makes distinguishing funds from any single project impossible.

As long as the General Contractor operates prudently and does not go out of business, this practice is not a problem. 

However, if the General Contractor becomes insolvent (or simply doesn’t pay his sub-contractors), it can be very difficult to discern which payments have been made and which payments have not. 

Should a General Contractor become insolvent and not pay his sub-contractors, the only recourse for the sub-contractors is to turn to the Owner for payment.  Laws vary widely, so check with Legal, but this can happen even if the Owner paid the General Contractor.

Trickle-Down Terms

Similarly, the use of a “trickle-down” clause ties the contract terms in the agreement between the General Contractor and his Sub-contractors with the terms from the General Contractor and the Owner. 

General Contractors typically include a “trickle-down” clause as a blanket provision to transfer the provisions of their agreement with the Owner down to their sub-contractors. 

This practice has a similar effect to the “Pay-when-paid” clause except that a “trickle-down” clause is far more inclusive.

I generally seek to strike any clauses in the Owner’s agreement that allows for these practices and I add language to require the Contractor to secure written agreements with his subcontractors. 

My argument is that the General Contractor should not rely on the Owner’s contract to define the terms and obligations between the Contractor and his subcontractors.  Rather, the GC should specifically state any and all of their sub-contractor terms (including payment obligations) independently of the Owner’s obligations to the GC.  The Contractor should adhere to those terms independent of what may or may not be happening between the Contractor and the Owner.

Trickle-Down Risks

One of the most common clauses impacted by trickle down clauses is retainage provisions. 

Retaining a portion of each payment is a practice used by Owners to keep General Contractors from abandoning the project before they have completed all tasks.

It is common for General Contractors to trickle down retainage provisions from the Owner’s agreement to sub-contractors.  General Contractors claim this practice is used to ensure their sub-contractors complete their work.

This is somewhat true and General Contractors are certainly free to use this practice.  However, allowing the General Contractor to use this practice simply because the Owner has applied retainage on the General Contractor negates the whole point of the Owner’s retainage clause. 

If the amount retained by the Owner is simply deducted from the payment the General Contractor makes to the subcontractor, the net effect is that the Owner’s retainage provision is nullified. 

Sample Payment Scenario with Trickle Down Retainage

Assume a GC has quoted a fee of 10% and the Owner’s contract allows for a 10% retainage from each payment. 

Let’s also assume that a subcontractor has completed their scope and submitted an invoice of $10,000 to the General Contractor.  The GC then adds his 10% fee and submits an invoice to the Owner for $11,000 ($10,000 x 0.1 = $1,000.00). 

When the Owner pays the invoice, he retains 10% which means the Owner pays the GC only $9,900 ($11,000 x 0.9).  The GC then retains 10% from the subcontractor paying them only $8,910 ($9,900 x 0.9).

The subcontractor (who has completed all of their work) gets shorted $1,090 ($10,000 – $8,910).  The GC however not only receives his fee which was supposed to be $1000, he retains an additional $90 from the sub-contractor.

The act of withholding retainage from a sub-contractor who has completed his work exposes the Owner because the sub-contractor could file a Lien on the property for the with-held amount.  Further, the retainage provision in the Owner’s contract is rendered completely meaningless. 

No Silver Bullet

In the end, modifying these clauses alone cannot protect an Owner from a GC’s default or from a subcontractor’s lien.

There are a dozen other provisions and processes that must also be in place, but recent court rulings further emphasize the importance of paying attention to these clauses.

Indefinite Payment Illegal

In May of 2020 the Fourth District Court of California (reinforced by an appellate court ruling) found that Contractors cannot delay payments to their sub-contractors indefinitely

According to the ruling, delaying payment to a subcontractor until some “undefined, unspecified point in time” violates the standards of “reasonableness”. 

The court also ruled that payments legally due to a subcontractor need to be made whether the prime Contractor is paid or not paid.

Pay-If-Paid Illegal

This ruling echoes a 1997 California ruling where the courts found  “Pay-if-paid” clauses unenforceable.

Together these two California cases (and several dozen similar cases in other states) reaffirm sub-contractor rights to be paid in a timely manner regardless of whether the Owner pays the General Contractor.

This is a great result for the sub-contractor market and another reason why Owner’s need to be even more careful about how their contracts address payment.

I also hope this result will get the AIA to begin reconsidering language in their Standard forms of Agreement that tie sub-contractor payments to the Contractor’s receipt of payment from the Owner.

Closing

These rulings are another sign that we need to pay close attention to payment terms in construction contracts.

The terms of agreement between a GC and an Owner should stand independent of the GC’s contract with his subcontractors.  Allowing the GC to “trickle down” any of the terms of their agreement with the Owner to his subcontractors creates unnecessary risks that should be avoided.

What about you?  What provisions do you use to mitigate risks?  Tell me your stories.

Thanks for reading.  If you enjoyed this content, please feel free to browse my previous articles and please like, share, comment, and subscribe.  This helps promote my content and is greatly appreciated.

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