The construction industry has unique issues when a party does not pay an obligation that it owes. There are usually a number of parties involved, many of which have an obligation to pay money. Usually, the lender must pay the owner, the owner must pay the contractor and the contractor must pay all subcontractors. In addition, the rights of the non-breaching party usually are greater than a simple claim against the breaching party, and may include claims against third parties.
A. Right To Stop Work
It is not uncommon for the payment process to break down while the work is ongoing. Many contractors or subcontractors think that if they are not paid, they have the right to stop work and to walk off the job. In most situations, it probably is better not to do so. A contractor who walks off the job may find himself liable for delay or other claims that far exceed the original amount that was unpaid to him.
Before stopping work due to a failure of payment, one should consult Section 506 of the Pennsylvania Contractor and Subcontractor Payment Act, 73 P.S. § 506, since this act applies to most construction projects.1 Under this section, "The owner may withhold payment for deficiency items according to the terms of the construction contract. The owner shall pay the contractor according to the provisions of this act for any item which appears on the invoice and has been satisfactorily completed." Section § 502 defines "Deficiency item" as "work performed but which the owner, the contractor or the inspector will not certify as being completed according to the specifications of a construction contract." 73 P.S. § 502. If the owner wishes to withhold payment, "it shall notify the contractor of the deficiency item within seven calendar days of the date the invoice is received." 73 P.S. § 506(b). The owner's right to withhold payment, it would seem, is waived if this provision is not followed. See also discussion of Pennsylvania Contractor and Subcontractor Payment Act, infra.
While it generally is not a good idea to stop work, there are times when it is justified. A party who contemplates stopping work always should speak with his attorney before taking such a drastic step. Whether a party is permitted to stop work usually is determined by the language in the contract. For example, AIA Document A201 Article 9.7.1 (1997) provides:
If the Architect does not issue a certificate for payment through no fault of the Contractor, within seven days after receipt of the Contractor's Application for Payment, or if the Owner does not pay the Contractor within seven days after the date established in the Contract Documents, the amount certified by the Architect or awarded by arbitration, then the Contractor may, upon seven additional days written notice to the Owner and Architect, stop the work until payment of the amount owing has been received. The contract time shall be extended appropriately and the Contract Sum shall be increased by the amount of the Contractor's reasonable costs of shut-down, delay and start-up, plus interest as provided for in the Contract Documents.
If a contract does not have a specific clause permitting a contractor to stop working if he does not get paid, general principles of contract law will apply. If the contract is to provide labor and services only, or if labor and services are a significant part of the contract, the contractor will have the right to stop work for non-payment only if the failure to pay is an uncured material breach of the contract. Whether the breach is material is an issue of fact to be determined by a court or arbitration panel, an outcome that may be difficult to predict. The best course is not to stop work unless the breach is so clearly material that there is no dispute.
If the contract is solely or primarily for the furnishing of goods, the right to stop delivery for non-payment is controlled by the Uniform Commercial Code (UCC), 13 Pa.C.S.A. § 2705. The remedies will depend upon whether the agreement required payment prior to delivery or whether it was an installment contract. See Id.; 13 Pa.C.S.A. § 2612.
If there is no right to stop work, the party can resort to more traditional methods of relief such as mediation, arbitration, litigation or in some circumstances, a mechanics' lien. 2
B. Pennsylvania Contractor And Subcontractor Payment Act, 73 P.S. §§ 501-516.
In 1994, Pennsylvania enacted a law that requires that contractors, subcontractors and suppliers furnishing labor and materials for a construction project be paid promptly. The Act sought to minimize the ability for higher-tier participants (owners and contractors) to hold back funds from lower-tier parties (contractors and subcontractors).
The Act applies to all construction projects except (1) "improvements to real property which consist of six or fewer residential units which are under construction simultaneously" and (2) "contracts for the purchase of materials by a person performing work on his own property." 73 P.S. § 503(a),(b).
Because the Act is relatively new, there have been few cases that have interpreted its provisions. Although much of the Act is clear and straightforward, it is silent on some issues and contains some vague provisions.
1. Payment By The Owner
The Act defines an owner as "A person who has an interest in the real property that is improved and who ordered the improvement to be made. The term includes successors in interest of the owner and agents of the owner acting with their authority." 73 P.S. § 502. While the Act does not establish whether a tenant is an owner (and there has been no caselaw on this), it seems likely that a tenant would be considered an "owner" under the Act because tenants have leasehold interests in the property.
Under the Act, a contractor is "A person authorized or engaged by an owner to improve real property." 73 P.S. § 502. A subcontractor is "A person who has contracted to furnish labor or materials to, or has performed labor for, a contractor or another subcontractor in connection with a contract to improve real property." Id.
The right to payment is described in § 504: "Performance by a contractor or subcontractor in accordance with the provisions of a contract shall entitle the contractor or subcontractor to payment from the party with whom the contractor or subcontractor has contracted." 73 P.S. § 504. Pursuant to Section 505(a), "The owner shall pay the contractor strictly in accordance with terms of the construction contract." 73 P.S. § 505(a). The Act goes on to state that "payment of interim and final invoices shall be due from the owner 20 days after the end of a billing period or 20 days after delivery of the invoice, whichever is later." 73 P.S. § 505(c). Under section 505(d), the owner is given a further grace period of seven days, after which "the owner shall pay the contractor, beginning on the eighth day, interest at the rate of 1% per month or fraction of a month on the balance that is at the time due and owing." 73 P.S. § 505(d). Section (d) begins with "Except as otherwise agreed by the parties. . .," suggesting that the parties can contract around this interest provision. There are no reported cases addressing that issue.
The Act defines "Delivery" as "including, but not limited to, delivery by first class or registered mail, and delivery or transmission by facsimile machine." 73 P.S. § 502. In addition, "Mail, properly addressed, shall be deemed delivered three days from the day it was sent." Id.
If the contract does not contain a payment term, section 505(b) states that "the contractor shall be entitled to invoice the owner for progress payments at the end of the billing period." 73 P.S. § 505(b). Further, "The contractor shall be entitled to submit a final invoice for payment in full upon completion of the agreed-upon work." Id.
As discussed above, an owner may withhold payment to a contractor according to the terms of the contract for any "deficiency items" which a party (owner, contractor, inspector etc.) does not certify as being completed according to the specifications. See 73 P.S. § 502. To withhold payment, the owner must notify the contractor of the deficiency item within seven calendar days of the date that the invoice is received, 73 P.S. § 506(b), and the owner may withhold payment only for the portion of the invoice regarding the deficiency item. If an invoice is incorrect, the party that received the invoice "shall give written notice to the person who sent the invoice within ten working days of receipt of the invoice." 73 P.S. § 508(a). Still, however, the party receiving the invoice cannot refuse to pay if there is an error, but must pay that which is undisputed. 73 P.S. § 508(b).
2. Payment By The Contractor
As stated above, a subcontractor is any party that furnishes labor or materials under a construction contract. 73 P.S. § 502. Section 507(a) states: "Performance by a subcontractor in accordance with the provisions of the contract shall entitle the subcontractor to payment from the party with whom the subcontractor has contracted." 73 P.S. § 507(a).
There are significant differences between this section and section 505, regarding the obligations of an owner to a contractor. Section 507 does not contain the "Except as otherwise agreed by the parties . . ." language that appears in section 505. Thus, a question is raised as to whether subcontractors may waive (or, more likely, may be forced to waive) the requirements of the Act. Further, the absence of this language raises the question of whether a "flow down" clause in a subcontract may be enforced. The purpose of a "flow down" clause is to incorporate the terms of the owner's contract with the contractor.
While there is no "pay-when-paid" provision in the "Entitlement to payment" section (507(a)), there is one in "Time for payment" (507(c)). This section provides that when a subcontractor has performed the provisions of the contract, the contractor shall pay the subcontractor and the subcontractor shall pay each of his subcontractors: "the full or proportional amount received for each such subcontractor's work and materials, based on work completed or services provided under the subcontract, 14 days after receipt of each progress or final payment or 14 days after receipt of the subcontractor's invoice, whichever is later." 73 P.S. § 507(c) (emphasis added).
A potential trap exists in section 507(b). This section states that a contractor or subcontractor shall disclose to a subcontractor the due date for receipt of payments from the owner, before the execution of a subcontract. It also says: "Notwithstanding any other provision of this act, if a contractor or subcontractor fails to accurately disclose the due date to a subcontractor, the contractor or subcontractor shall be obligated to pay the subcontractor as though the due dates established in [§ 505(c)] were met by the owner." 73 P.S. § 507(b). Thus, if a contractor or subcontractor fails to disclose to a lower tier subcontractor or supplier, prior to the signing of a contract, the dates upon which payment is due from the owner, the contractor (or subcontractor) is obligated to make payment as if the owner had complied with its payment obligations, whether or not such payments actually were made. Thus, all contractors or subcontractors should be mindful to make the required disclosures before signing a subcontract or risk waiving the "pay-when-paid" provisions of the Act.
Payment must be made under 507(c) unless the payment is being withheld under section 511. Pursuant to §511(a), a "contractor or subcontractor may withhold payment from any subcontractor responsible for a deficiency item." As discussed above, a "deficiency item" is "work performed but which the owner, the contractor or the inspector will not certify as being completed according to the specifications of a construction contract." 73 P.S. § 502. It is unclear, due to a dearth of reported decisions, if a deficiency item is the only basis for withholding payment to a subcontractor. If there is no deficiency, the "contractor or subcontractor shall pay any subcontractor . . . for any item which appears on the invoice and has been satisfactorily completed." 73 P.S. § 511(a).
Section 511(b) states the procedure that a party must follow when withholding payment due to a deficiency item. This section provides that notice must be given to the subcontractor or supplier and the owner of the reason "within seven calendar days of the date after receipt of the notice of the deficiency item." 73 P.S. § 511(b). The Act is unclear as to what type of notice is to be given and how this notice must be conveyed. Further, the Act is silent regarding the consequences of a failure to provide notice or the providing of insufficient notice.
If payments are subject to retainage, section 509(a) provides that "any amounts which have been retained during the performance of the contract and which are due to be released to the contractor upon final completion shall be paid within 30 days after final acceptance of the work." 73 P.S. § 509(a). The Act is silent as to who has the ultimate say about the "final acceptance of the work." When the retained money has been paid, the contractor or subcontractor has 14 days to pay lower-tier subcontractors the full amount due.
The teeth of the Act are found in Sections 505(d) and 512. Section 505(d) provides that the failure of a party to make payment when due subjects the balance to a 1% interest rate per month. Section 512(a) states:
"if arbitration or litigation is commenced to recover payment due under this act and it is determined that an owner, contractor or subcontractor has failed to comply with the payment terms of this act, the arbitrator or court shall award, in addition to all other damages due, a penalty equal to 1% per month of the amount that was wrongfully withheld."
However, if the owner, contractor or subcontractor's withholding of payment was done in good faith, the penalty provision does not apply. In addition to the interest and penalty, section 512(b) allows the award of attorneys' fees and expenses to "the substantially prevailing party."
To summarize the interest and penalty provisions: failure to pay for any reason (even one in good faith) adds 1% per month in interest; failure to act in good faith adds another 1% per month as a penalty; attorneys' fees and expenses are awarded to the "substantially prevailing party."
Section 514 states that "making a contract subject to the laws of another state or requiring that any litigation, arbitration or other dispute resolution process on the contract occur in another state, shall be unenforceable." 73 P.S. § 514. This provision seeks to prevent parties from contracting around the requirements of the Act, but it may be an unconstitutional restriction on a party's right to contract.
Finally, section 516 terminates a contractor's obligations to others once it has paid the subcontractor. The text of the section states: "Once a contractor has made payment to the subcontractor according to the payment terms of the construction contract or the provisions of this act, future claims for payment against the contractor by parties owed payment from the subcontractor which has been paid shall be barred." 73 P.S. § 516.
C. Public Project Prompt Payment Act, 62 Pa.C.S.A. §§ 3931-3939.
The Public Project Payment Act changed many prevailing payment practices for certain public construction work in Pennsylvania. The purpose of the law "is to establish a uniform and mandatory system governing public contracts." 62 Pa.C.S.A. § 3901(b). The provisions apply only to contracts exceeding $50,000, 62 Pa.C.S.A. § 3902 & 2, and pertain to most government contracts in Pennsylvania.
There are, however, many significant exceptions. Pursuant to 62 Pa.C.S.A. § 3938(a)(2), the Act does not apply "when a local government unit's nonpayment on a particular project is caused by a failure of Federal or State Government to pay funds due and payable to the local government units." Id. In addition, it does not apply to the City of Philadelphia "for so long as any deficit-reducing bonds issued by the authority pursuant to [the Pennsylvania Intergovernmental Cooperation Authority Act for Cities of the First Class, 53 P.S. § 12720.201 et. seq.] are outstanding and payable." 62 Pa.C.S.A. § 3938(b)(3). Further, it does not apply to "a school district [such as the Philadelphia School District] which has been determined to be a distressed school district" under 24 P.S. § 6-691 or "distressed" municipalities. 62 Pa.C.S.A. § 3938(b).
The payment provisions in this Act are similar to those in the Pennsylvania Contractor and Subcontractor Payment Act, 73 P.S. §§ 501-516. First, "the government agency shall pay the contractor or design professional strictly in accordance with the contract." 62 Pa.C.S.A. § 3932(a). A contractor is defined as "a person who enters into a contract with a government agency." 62 Pa.C.S.A. § 3911 & 3. However, "if the contract does not contain a term governing the time for payment, the contractor or design professional shall be entitled to make application for payment from the government agency for progress payments, and the government agency shall make payment less the applicable retainage amount . . . within 45 calendar days of the date of the application for payment is received." 62 Pa.C.S.A. § 3932(b). Under sections (c) and (d), the contracting body is required to pay interest at the rate determined by the Secretary of Revenue for payment of overdue taxes or tax refunds, but interest is not payable if payment is made within 15 days of the due date.
A "subcontractor" is "a person who has contracted to furnish labor or materials to or has performed labor for a contractor or another subcontractor in connection with a contract." 62 Pa.C.S.A. § 3911 & 10. Thus, any lower-tier party is considered a subcontractor, not only the party who has a contract with the general contractor.
This Act contains a "pay-when-paid" clause. Under 62 Pa.C.S.A. § 3933(a), "Performance by a subcontractor in accordance with the provisions of the contract shall entitle the subcontractor to payment from the party with whom the subcontractor has contracted." Section 3933(c) states:
When a subcontractor has performed in accordance with the provisions of the contract, a contractor shall pay to the subcontractor, and each subcontractor shall in turn pay to its subcontractors, the full or proportional amount received for each such subcontractor's work and material, based on work completed or services provided under the subcontract, 14 days after receipt of a progress payment.
62 Pa.C.S.A. § 3934(c). Thus, a contractor need only pay a subcontractor after he has been paid.
Section § 3934(b) requires a contractor to disclose to a subcontractor, prior to the execution of a subcontract, the due date for the receipt of progress payments from the contracting party. This section also states: "if a contractor or subcontractor fails to accurately disclose the due date to a subcontractor, the contractor or subcontractor shall be obligated to pay the subcontractor as though the due dates established in subsection (c) were met by the government agency." Id.
Pursuant to 62 Pa.C.S.A. § 3934(a), "the government may withhold deficiency items according to the terms of the contract. . . The contractor may withhold payment from any subcontractor responsible for a deficiency item." Id. The Act defines "deficiency item" as "Work performed but which the design professional, the contractor or the inspector will not certify as being completed according to the contract." 62 Pa.C.S.A. § 3911 &4. It is unclear, however, whether a deficiency item is the only reason to withhold payment and there is no case law on this issue.
If a higher-tier party withholds payment from a contractor for a deficiency item, "it shall notify the contractor of the deficiency item within the time period specified in the contract or 15 calendar days of the date that the application for payment is received." 62 Pa.C.S.A. § 3934(b). This is a longer period than the 7 days specified under the Pennsylvania Contractor and Subcontractor Payment Act.
Penalties and attorney fees are available under this Act. A payment that has been withheld in bad faith is subject to a penalty of 1% per month for the time that it was withheld. 62 Pa.C.S.A. § 3935(a). A "bad faith withholding" is that which is "arbitrary or vexatious." Id. In addition, reasonable attorney fees are available where the other party acted in bad faith. 62 Pa.C.S.A. § 3935(b).
Finally, section 3939(b) bars a claim against a party who has paid a lower-tier party. This section states: "Once a contractor has made payment to the subcontractor according to the provisions of this subchapter, future claims for payment against the contractor or the contractor's surety by parties owed payment from the subcontractor which has paid shall be barred." 62 Pa.C.S.A. § 3939(b). In other words, if a contractor pays a subcontractor, but the subcontractor does not pay the sub-subcontractor, the sub-subcontractor cannot make a claim against the contractor.
D. Public Works Contractors Bond Act
Although 49 P.S. § 1303(b) (mechanics' liens) states that "no lien shall be allowed for labor or materials furnished for a purely public purpose," subcontractors on public projects can resort to the Public Works Contractors Bond Act. 8 P.S. § 191 et. seq. This Act requires the general contractor to furnish a payment bond at 100% of the contract amount before the award of any contract by the Commonwealth or any local public unit or agency. The contract must be for more than $5,000 for the Act to apply. 8 P.S. § 193(a).
The purpose of the Act is to protect subcontractors on public works projects, but not at the expense of encumbering public property. Section 193(a)(2) provides that the required payment bond "shall be solely for the protection of claimants supplying labor or material to the prime contractor to whom the contract was awarded, or to any of his subcontractors. 8 P.S. § 193(a)(2). It should be noted that this Act is more inclusive than the Mechanics'; Lien Law since it protects those who furnish labor or material to subcontractors and not just the subcontractor himself.
Under the Act, a subcontractor may bring an action on a payment bond only if he first gives written notice setting forth his specific claim within 90 days after the claimant last performed work or furnished materials. 8 P.S. § 194(a). This notice must be by certified or registered mail or by personal service. 8 P.S. § 194(b).
E. The Miller Act
The Miller Act, 40 U.S.C.A. § 270-f is the federal counterpart to the Pennsylvania Public Works Contractors Bond Act, 8 P.S. § 191 et. seq. The Act applies to all federal construction projects that exceed $25,000.00. 40 U.S.C.A § 270a. It requires prime contractors on United States government public building or public works construction, alteration or repair projects to provide to the government a performance bond for the protection of the United States and a payment bond for the protection of parties providing labor or materials for the contract work. 40 U.S.C.A. § 270a.
The Miller Act permits suits in federal court on a payment bond by first-tier subcontractors and by subcontractors and materialmen who have a contractual relationship to the subcontractor. This remedy is in lieu of a construction or mechanics' lien, which cannot be placed on federal property.
There are stringent time limitations in the Miller Act. The most important date is the date the last labor or materials were furnished. From that date, a lawsuit must be brought within one year, but not sooner than 90 days after notice of nonpayment. 40 U.S.C.A. § 270b(b). Before the expiration of the 90 day period, those parties who do not have a contractual relationship with the prime contractor (such as suppliers and subcontractors), must give written notice to the contractor by registered mail of the amount owed and the party to whom the labor or material was furnished. 40 U.S.C.A. § 270b(a).
F. Surety Bonds
The purpose of a surety bond is to make certain that there are sufficient funds to complete the project properly and to assure payment of labor and materials. A surety relationship includes three parties: principal (contractor), obligee (owner) and surety. The principal and the surety have a joint and several relationship, meaning that each party can be sued individually for nonpayment. The surety makes an agreement with the obligee to do certain things if the principal does not do them. If the surety must pay the obligee under the bond, due to the default of the principal, it can demand reimbursement from the principal and others for the obligations paid plus administrative costs. The individual stockholders of the principal can be personally liable if they have personally guaranteed the contract. The liability of the surety cannot be greater than that of the principal. Knecht, Inc. v. United Pacific Ins. Co., 860 F.2d 74 (3d Cir. 1988); Exton Drive-In, Inc. v. Home Ind. Co., 261 A.2d 319 (Pa. 1969); C. Arena & Co. v. St. Paul Fire & Marine Ins. Co., 1993 WL 452184 (E.D.Pa.).
A surety contract differs from an insurance contract in that surety contracts must have three parties, while an insurance contract usually only has two: the insurer and the insured. Pursuant to 33 P.S. § 3 in order to satisfy the statute of frauds, surety agreements and contracts must be in writing and signed by the surety against whom the claim is made.
The most common types of surety bonds are bid bonds, performance bonds and payment bonds. A bid bond guarantees that if a contractor is the lowest bidder on a contract, he will accept the offer to perform in accordance with the contract. The bond states that the surety will pay damages if the contractor does not accept the offer. If the bidder refuses to enter into a contract after its bid has been accepted, the bidder and its surety will be jointy and severally liable. The surety's liability is limited to the amount of the bid bond.
Usually, a surety requires its principal to enter into a general indemnity agreement stating that the principal will indemnify and hold the surety harmless from any and all claims, losses and expenses, including attorney's fees, as a result of the surety having executed the bonds. However, sureties are required to act in good faith and may not be indemnified for expenses that result from their failure to do so. Sureties are subject to the Unfair Insurance Practices Act, 40 P.S. § 1171 et. seq. Under this Act, the Pennsylvania Insurance Commissioner is authorized to investigate any surety and to issue fines or to suspend or revoke a surety's license if it has been found to have violated the law or acted in bad faith.
A performance bond guarantees the availability of the penal sum of the bond to the owner to finish the project if the general contractor defaults. The goal of the surety is to avoid a default and to minimize the costs of completing the project. To avoid default, a surety can provide engineering, accounting, consulting or other technical services. It also may provide financial assistance or pay claims to suppliers of labor or materials.
If there is a default, a surety is not obligated to complete the contract, though it may do so. It may also do nothing and allow the owner to complete the project on its own. After the project is finished, the owner will submit claims to the surety for the costs of completion that exceeded the original contract amount.
Alternatively, the surety can hire another contractor to finish the project. In most cases, this contractor must be approved by the owner. After the completion of the project, the surety must pay the amount that exceeded the original contract price. If a surety contract has a "takeover" agreement, the surety can opt to complete the contract itself.
1The Act applies to all construction contracts except: 1) improvements to real property which consists of six or fewer residential units which are under construction simultaneously, 73 P.S. §503(a); and 2)contracts for the purchase of materials by a person performing work on his or her own real property. 73 P.S. §503(b).
2Due to space constraints, mechanics' liens are not discussed in this article. For information on mechanics' lien, contact the author.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.