Understanding Conditional Payment Clauses in Construction Contracts

 If you are in the construction industry, you’ve undoubtedly heard the terms “pay-if-paid” (“PIP”) and “pay-when-paid” (“PWP”). Although these conditional payment clauses have become standard, there is still some confusion concerning how they function. Understanding the legal distinctions between the two terms can be important in the event of a payment dispute.

What Is a conditional payment clause?

A conditional payment clause is a clause that conditions payment on some other event. For example, contractors often include a clause in their subcontracts that conditions payment to the subcontractor on the contractor first receiving payment from the owner. The terms PIP and PWP are sometimes used interchangeably but, in fact, they have important and distinct legal consequences that affect whether a contractor is ultimately responsible for paying a subcontractor when the owner does not pay the contractor.

PIP clause: A risk-transferring provision

A PIP clause creates a condition precedent to payment from the contractor to its subcontractor. The condition of payment to the subcontractor is payment by the owner to the contractor for the subcontractor’s work. If the owner fails to pay the contractor, then under a PIP clause, the contractor has no obligation to pay its subcontractor. If enforced, the financial risk for the owner’s nonpayment is shifted to the subcontractor.

The following is an example of a typical PIP provision:

“The obligation of the contractor to make any payment under the subcontract is subject to the express and absolute condition precedent of payment by owner. It is expressly agreed that contractor shall have no obligation to pay for any work until contractor has received payment for such work from owner. Subcontractor expressly assumes the risk of nonpayment of owner.”

PWP clause: a timing provision

In contrast, a PWP provision establishes a reasonable time frame for the contractor to make payment to the subcontractor in the event of owner nonpayment. A PWP clause governs the timing for payment, a “when” term, and does not set an express condition precedent, an “if” term, which controls whether there is the right to recover payment at all.

The following is an example of a typical PWP provision:

“The subcontractor shall be paid within seven (7) days after receipt by the general contractor of payment from the owner for subcontract work.”

PWP clauses, such as the one above, are interpreted as requiring the contractor to pay the subcontractor within a reasonable time frame even if the owner never pays.¹

Are PIP clauses enforceable?

Whether a PIP clause in a subcontract is enforceable is determined by the precise language used in the subcontract and the jurisdiction in which the project is located.

Because of the harsh financial consequences to the subcontractor, courts are reluctant to enforce PIP provisions. Instead, to protect the subcontractor and allow them to recover payment from the contractor for work performed, many courts tend to construe PIP clauses as a timing provision.

Delaying payment for a PWP provision: How long is too long?

If the conditional payment clause is construed as a timing provision, and if the owner does not pay, the question becomes how long is a “reasonable period of time” before the payment then becomes due?

Unfortunately, the law is unclear on what constitutes a “reasonable period of time” after which a contractor becomes obligated to pay its subcontractor from its own funds despite owner nonpayment. Generally, what constitutes a “reasonable period of time” will vary from case to case and be fact-specific.²

A general contractor recently learned the hard way that a PWP clause does not always work as intended in the event of owner nonpayment.³

Clark, a general contractor, entered into a contract with a Southern California public water district for the construction of a water treatment plant. Clark retained Crosno as a subcontractor to perform work on the project. After Crosno completed most of its work, a dispute arose between the owner and Clark that resulted in Clark’s termination from the project. Clark immediately sued the owner to recover payment due under the prime contract.

The subcontract between Crosno and Clark contained a PWP provision that in the event of owner nonpayment, Clark and its surety:

“Shall have a reasonable time to make payment to Subcontractor. Reasonable time shall be determined according to the relevant circumstances, but in no event shall be less than the time Contractor and Subcontractor require to pursue to conclusion their legal remedies against Owner… .” ⁴

Crosno claimed it was entitled to payment despite the PWP provision. Clark, on the other hand, claimed the clause was enforceable because Clark was actively pursuing its remedies against the owner to recover payment, not just for Clark’s work but for Crosno’s work as well. Clark’s intention was to satisfy the outstanding amount owed to Crosno from the proceeds recovered from the owner. After three years of litigation, Clark was victorious against the owner.

However, a court determined that the three years Crosno had been waiting for payment while Clark sued the owner was unreasonable, notwithstanding the PWP provision in the subcontract. Clark was required to pay Crosno before recovering the corresponding payment from the owner, contrary to the intent of the PWP clause.

Conclusion

Given the potential consequences to subcontractors, courts are reluctant to enforce clauses conditioning payment to subcontractors on the contractor’s receipt of funds from the owner. Because a PIP clause in effect limits the recourse of the subcontractor to a single source, i.e., the owner, courts require the language of the PIP clause to be clear. If there is any opportunity to read the language another way, a court will likely construe the language as merely governing the timing of payment and not as a forfeiture of the right to payment. In addition, courts have imposed limits on what constitutes a reasonable period for the subcontractor to wait for payment from the contractor in the event of owner nonpayment. As such, contractors should review their subcontracts to ensure the payment language clearly captures their intent and is enforceable in the jurisdiction where the work takes place.

If you would like additional information on specific jurisdictional statutes, Travelers has a “State-by-State Survey on Conditional Payment Clauses” for your reference. Feel free to reach out to a member of the Travelers Surety Underwriting or Claim teams to obtain a copy of the survey.

Sources
¹ See Thos. J. Dyer Co. v. Bishop Int’l Eng’g Co., 303 F.2d 655 (6th Cir. 1962).

² See Avon Bros. v. Tom Martin Const. Co., 2000 WL 34241102, (N.J. Super. Ct. App. Div. Aug. 30, 2000) (three years was more than reasonable time for subcontractor to await payment from general contractor); John F. Sanchez Plumbing Co. v. Aetna Cas. & Sur. Co., 564 So. 2d 1302 (La. Ct. App. 1990) (held a 22 month delay was too long); Havens Steel Co. v. Randolph Eng’g Co., 613 F. Supp. 514 (W.D. Mo. 1985) (contractor reasonably could only delay payment to subcontractor for three months); Moore v. Continental Cas. Co., 366 F. Supp. 954 (W.D. Okla. 1973) (two years was more than reasonable period of time to wait for payment).

³ Crosno Constr., Inc. v. Travelers Cas. & Sur. Co. of Am., 47 Cal. App. 5th 940, 261 Cal. Rptr . 3d 317, (2020) (finding the pay when paid clause was too indefinite a time period and therefore impermissibly impaired Crosno’s bond rights).

⁴ Northern California trial courts had frequently enforced this provision.