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Pay-if-paid clauses: Shifting the Risk of Nonpayment to Subcontractors


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By Mary Leigh Pirtle

Background
A general contractor (“contractor”) was hired by a large hotel chain to construct a swimming pool at one of its hotel locations. The contractor entered into a contract with a subcontractor for the electrical work necessary for the installation. After the subcontractor completed the work, it invoiced the contractor for approximately $190,000, but the contractor only paid approximately $140,000 to the subcontractor. Naturally upset, the subcontractor sued the contractor for the deficiency.  In its defense, the contractor argued that the contract contained a pay-if-paid clause, and it was not liable for payment to the subcontractor because it had not yet been paid the full amount by the owner. In response, the subcontractor argued that the contract clause only contained a pay-when-paid requirement.  The trial court agreed with the contractor, and the subcontractor appealed.

Clear and unambiguous language required
The Sixth District Court of Appeals of Ohio began its review by analyzing the usage of pay-if-paid clauses and found that traditionally the risk of insolvency rests with the general contractor. The appellate court noted that general contractors are in the best position to assess an owner’s creditworthiness and the potential for an owner to default on a project.  Thus, the appellate court concluded that pay-if-paid clauses are generally disfavored and normally the owner’s insolvency will not permit a general contractor to defeat a subcontractor’s claim for payment if the general contractor is not paid by the owner.

The appellate court reasoned, however, that despite its disfavored status (and the fact that some states have banned the use of such clauses as void due to public policy), the precedent in Ohio permits the use of such clauses in contracts if the contract clearly and unambiguously states the condition of payment to the subcontractor on the general contractor’s receipt of payment from the owner. The contract between the parties in this case stated “receipt of payment by contractor from owner for work performed by subcontractor is a condition precedent to payment by contractor to subcontractor for that work.” In analyzing this language, the appellate court concluded that the words “condition precedent” were not “sufficiently defined to impart that both parties understand that the provision alters a fundamental custom between a general contractor and a subcontractor.” Therefore, the appellate court concluded that the absence of clear language in the contract specifically manifesting the intent to shift risk of nonpayment to the subcontractor necessarily renders it a pay-when-paid clause.

Practice points
This case clearly highlights the importance for contractors and subcontractors to understand the difference between pay-if-paid and pay-when-paid clauses when entering into a contract.  While the subcontractor was successful in reversing the trial court’s decision, the Ohio Supreme Court has granted the contractor’s petition to review the decision of the Court of Appeals. The American Subcontractors Association, Inc. recently filed an amicus brief before the Ohio Supreme Court arguing that pay-if-paid clauses should either be flatly unenforceable due to the unreasonableness of shifting the risk of nonpayment to a party who has no control or be extraordinarily explicit in the contractual terms.  Undoubtedly, the construction industry in Ohio, as well as in other states, will be closely monitoring the case to determine the outcome and the enforceability of pay-if-paid clauses.


 

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