Although the economic effects of COVID-19 may be felt for many years to come, its effect on payment for ongoing construction may be more immediate.  What is the general contractor’s obligation to pay subcontractors when the project owner’s funds run out? Bluntly, it depends. One important consideration is whether the subcontract agreement contains a pay-if-paid clause.    

1.    What is Pay-If-Paid?

A pay-if-paid clause, more eloquently called a contingent payment clause, requires the owner to pay the general contractor before the general contractor has to pay its subcontractor.  In legal parlance, it makes payment from an owner a condition precedent to the general contractor paying its subcontractor. If the general contractor does not receive payment from the owner, the general contractor is not obligated to pay its subcontractor.

2.    Vive La Difference: “If” and “When”

Pay-if-paid is not the same as pay-when-paid.  Pay-if-paid shifts the risk of the owner’s non-payment from the general contractor to the subcontractor.  Pay-when-paid, in contrast, elongates the payment term until the owner pays the general contractor, but does not shift any risk of non-payment.  The difference is subtle, but extremely important, at least in Texas.

Under Texas law, pay-if-paid clauses are subject to statutory restrictions; pay-when-paid clauses are not. The contingent payment statute, found in Chapter 56 of the Texas Business & Commerce Code, limits the enforcement of pay-if-paid clauses.

3.    The Lawless Ones

The first step in determining whether Chapter 56 applies to a specific pay-if-paid clause is to determine whether the statute even applies to the contract. The contingent payment statute does not apply to contracts that are solely for: 

a.   design services;
b.   the construction or maintenance of a road, highway, street, bridge, utility, water supply project, water plant, wastewater plant, water and wastewater distribution
or conveyance facility, wharf, dock, airport runway or taxiway, drainage project, or related type of project associated with civil engineering construction; or
c.   improvements to or the construction of a structure that is a detached single-family residence, duplex, triplex, or quadruplex. 

Any other type of construction project will be subject to the contingent payment statute

4.    What Does the Word “If” Mean?

To paraphrase a former President, what does the word “if” mean?  The contingent payment statute tells us that even though the contract may say “if”, the effect is quite different.  In general, the contingent payment statute prohibits enforcement of pay-if-paid clauses. 

The statute provides four prohibitions enforcing pay-if-paid clauses under 4 broad categories.

a.  Unconscionability. A general contractor, or its surety, may not enforce a contingent payment clause if the enforcement would be “unconscionable.” The statute defines what is “not unconscionable”, presumably similar to what is considered “conscionable”, that would allow enforcement of a pay-if-paid clause.  The checklist of requirements for a general contractor to overcome an argument that the pay-if-paid clause is unconscionable and therefore unenforceable is long. The list includes the following items.

A general contractor can demonstrate that its “exercises diligence” by: communicating in writing to the subcontractor, before the subcontract agreement is enforceable, the financial viability of the owner and the existence of adequate financial arrangements to pay for the improvements (see below), and; making reasonable efforts to collect the amounts owed the subcontractor or assign or offer to assign at a reasonable time its claims against the owner for the amounts owed to the subcontractor and offer reasonable cooperation in those collection efforts.

For a private (versus public) projects, a general contractor is considered to have “exercised diligence” if it provides written notice to the subcontractor of the following financial arrangements/information:

• • • • • Name, address, and business telephone number of the owner;
        • Legally sufficient description of the property on which the improvements are being constructed;
        • Name and address of the surety on any payment bond provided; 
        • If a loan has been obtained for the construction of improvements:
          • Statement, furnished by the owner and supported by reasonable and credible evidence from all applicable lenders, of the amount of the loan;
          • Summary of the terms of the loan;
          • Statement of whether there is foreseeable default of the owner; 
          • Name, address, and business telephone number of the borrowers and lenders; and
        • If no loan has been obtained or the loan does not cover the full cost for construction of improvements, a statement, furnished by the owner and supported by reasonable and credible evidence from all applicable banks or other depository institutions, of the amount, source, and location of funds available to pay the balance of the contract amount.
          

b.  General Contractor at Fault.  A general contractor may not enforce a pay-if-paid clause to the extent that the owner’s nonpayment is the result of the general contractor not meeting its contractual obligations. If the owner’s nonpayment is the result of the subcontractor’s failure to meet its contractual requirements, the clause may be enforced provided not prohibited by another part of the statute.

c.  45-Day Rule. A general contractor may not enforce a pay-if-paid clause as to work performed or materials delivered after the subcontractor gives written notice to the general contractor objecting to the further enforceability of the clause. The subcontractor may send written notice only after the 45th day after the date the subcontractor submits a written request for payment to the general contractor.

The 45-day rule will not prevent enforcement of a pay-if-paid clause if the owner disputes payment as a result of the subcontractor’s failure to meet its contractual requirements, and the general contractor gives written notice to the subcontractor that the subcontractor’s 45-day notice does not prevent enforcement of the pay-if-paid clause.

d.  The general contractor, or its surety, may not enforce a contingent payment clause if the general contractor is in a “sham relationship” with the owner. Section 53.026 of the Texas Property Code provides the definition of a “sham relationship.

5.    Waving Good-Bye

One final note to the clever contract writers:  A general contractor cannot ask a subcontractor to waive the provisions of the contingent payment statute. Any purported waiver of the statute is void. 

In the aftermath of the pandemic, when payment disputes ripen, determining the enforceability of pay-if-paid clauses may be a critical or determinative factor.  In reviewing any given contract or clause, you should consult with a licensed attorney.

If or when you need assistance evaluating whether your pay-if-paid clause really means what it says, the attorneys at GS are available to answer any questions you may have.  You may contact us at info@gstexlaw.com.

 

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