“Pay-if-Paid” vs. “Pay-when-Paid”: Understanding Contractor’s and Subcontractor’s Assumption of Risk of Owner’s Nonpayment Thumbnail

“Pay-if-Paid” vs. “Pay-when-Paid”: Understanding Contractor’s and Subcontractor’s Assumption of Risk of Owner’s Nonpayment

In a typical construction contract, the project owner pays the prime contractor, and the prime contractor in turn pays the subcontractor, and so on down the line. The question then arises, what happens if the owner doesn’t pay the prime contractor? Does the prime contractor have to pay the subcontractor? Can the subcontractor still pursue payment? The answer to this question, as is the case in most construction disputes, depends on the terms of the contract.

Under Ohio law, there are generally two types of payment provisions that govern the manner by which a contractor compensates a subcontractor or lower-tier tradesperson: (i) Pay-when-Paid; and (ii) Pay-if-Paid. The key distinction between these two provisions is the party that assumes the risk of non-payment.

If the contract contains a “pay-when-paid” provision, the contractor, in essence, makes an unconditional promise to pay the subcontractor within a reasonable time after receiving payment from the owner. While the obligation to pay may be delayed, the contractor will ultimately have to pay the subcontractor within a reasonable time. This is true even if the owner never pays the contractor. As such, under a “pay-when-paid” payment agreement, the contractor assumes the risk of the owner’s nonpayment.

Unlike some jurisdictions, Ohio recognizes the enforceability of a “pay-if-paid” provision. See, e.g. Transtar Elec. v. A.E.M. Elec. Servs. Corp., 140 Ohio St.3d 193, 2014-Ohio-3095. Under such a payment structure, the owner’s payment to the contractor is a condition precedent to the contractor’s duty to pay a lower-tier subcontractor or supplier. Stated otherwise, if the contract includes a “pay-if-paid” provisions and the owner fails to pay the contractor, the contractor may have no payment obligation to the subcontractor. Here, the subcontractor, not the contractor, assumes the risk of the owner’s nonpayment. See Chapman Excavating Co., Inc. v. Fortney & Weygandt, Inc., 2004 WL 1631118 (8th Dist.2004). An effective “pay-if-paid” provision will likely resemble the following (though no particular language is required):

Subcontractor understands and agrees Contractor’s receipt of payment from Contractor’s customer on account of Subcontractor’s Work, Merchandise and/or Services is an express and absolute condition precedent to Contractor’s obligation to pay Subcontractor.  Subcontractor hereby assumes the risk of default or nonpayment by Contractor’s customer or the project owner for any reason whatsoever, including the risk(s) associated with creditworthiness of Contractor’s customer or the project owner and the alleged breach by Contractor.

It’s important to note that Ohio courts typically disfavor “pay-if-paid” provisions and may convert the contract to a “pay-when-paid” contract if the language purportedly creating a condition precedent to payment is ambiguous or inexplicit.

These two minor, seemingly similar provisions can result in vastly different liability for the contractor and subcontractor - i.e. delayed payment v. no payment. Failing to understand the distinction prior to signing a contract or poorly drafting a provision may lead to a risk allocation unintended by the parties. There are also avenues to collect money owed, notwithstanding even clearly drafted “pay-if-paid” provisions, and defenses to such allocations of risk. For example, some jurisdictions have permitted a subcontractor to apply the “Prevention Doctrine” to preclude a contractor from withholding payment based on a valid “pay-if-paid” provision when the contractor materially contributed to the owner’s failure to pay. If faced with the possibility of non-payment based upon a “pay-if-paid” provision, subcontractors and suppliers should not assume they are out of luck and give up.

It is crucial for contractors and subcontractors to understand key contract language or have legal professionals draft and/or review project contracts before entering into any agreements. And if they find themselves fighting for compensation thereafter, it is best to seek legal guidance sooner rather than later.

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