As many in the construction industry likely know, there are two common types of contract clauses that will determine when–and sometimes if–a general contractor must pay a subcontractor. A “pay-if-paid” clause requires a general contractor to pay the subcontractor only if the general contractor is paid by the owner. Thus, if the owner fails to pay, the general contractor owes the subcontractor nothing. The risk of loss is on the subcontractor. A “pay-when-paid” clause requires a general contractor to pay the subcontractor no matter what the owner does. Such a clause calls for payment to a subcontractor within a reasonable time after the owner pays (10 days under Ohio law, unless modified by contract), but if this never happens, the general contractor is still contractually required to pay its subcontractor for the work.
Sometimes the language of the payment terms in a contract make it unclear which category the pay clause falls into. A recent Ohio Supreme Court decision, Transtar Elec. v. A.E.M. Elec. Servs. Corp., 140 Ohio St. 3d 193 (2014), provides some guidance on this point. In rendering a decision, the Ohio Supreme Court noted the following language would constitute a “pay-when-paid” clause, requiring the subcontractor to be paid regardless of when or whether the owner paid the general contractor:
The total price to be paid to Subcontractor shall be . . . $115,000.00 . . . no part of which shall be due until five (5) days after Owner shall have paid Contractor therefor. . . .
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Payments to the Consultant shall be made promptly after the Architect is paid by the Owner. . . . The Architect shall pay the Consultant in proportion to amounts received from the Owner which are attributable to the Consultant's services rendered. * * * The Consultant shall be paid . . . within ten (10) working days after receipt by the Architect from the Owner of payment for the services performed by the Consultant. . . .
Id. at 198. Further, the Court found this contract language would constitute a “pay-if-paid” clause:
Final payment shall be made within thirty (30) days after the last of the following [events, including final payment by the owner] . . . occur, the occurrence of all of which shall be conditions precedent to such final payment. . . .
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RECEIPT OF PAYMENT BY CONTRACTOR FROM THE OWNER FOR WORK PERFORMED BY SUBCONTRACTOR IS A CONDITION PRECEDENT TO PAYMENT BY CONTRACTOR TO SUBCONTRACTOR FOR THAT WORK.
(Emphasis and capitalization in original) Id. at 199.
The key difference between the two sets of terms is that the latter terms clearly indicate the general contractor’s obligation to pay its subcontractor is conditioned upon the general contractor’s receipt of payment from the owner. In other words, the language makes it clear that the general contractor’s obligation to pay its subcontractor is not triggered until and unless the owner pays for the work. The Court did not explicitly require the use of the term “condition precedent” to create a pay-if-paid situation, but if this is the desired arrangement, the term should be included. The Court also noted that, although not necessary, a term indicating that the subcontractor has “assumed the risk” of non-payment from the owner makes a contract even more likely to be construed as creating a pay-if-paid arrangement. Naturally, incorporating the term “pay-if-paid” would have a similar effect.
Contractors and subcontractors should use the above information to assess their contractual rights and responsibilities regarding payment. Looking forward, this information should also be used to determine what kind of payment arrangement a proposed contract calls for. Clearly, subcontractors should be reluctant to accept a “pay-if-paid” clause while a general contractor would prefer such a clause, shifting the risk of loss to the subcontractor if the owner does not pay.
If you have any specific questions or would like to speak generally with one of our experienced attorneys, please do not hesitate to contact Nick Nykulak, Alan Ross or Colleen Koehler at 216-447-1551.