United States: "Paid If Paid" Clauses – Who Is Left Holding The Bag When A Project Owner Fails To Pay?

If the owner of a half completed construction project declares bankruptcy or otherwise defaults in making payments, is it the general contractor or a subcontractor(s) that bears the risk of non-payment?  The answer may hinge on whether the subcontract between the general contractor and subcontractor includes a "paid when paid" clause or a "paid if paid" clause.

"Paid When Paid" Clauses versus "Paid If Paid" Clauses

A "paid when paid" clause is a clause that essentially provides the general contractor agrees to pay the subcontractor after receipt of payment by the owner for the subcontractor's work.  If the owner fails to pay the general contractor then there is an express or an implied agreement for the general contractor to pay the subcontractor within a reasonable amount of time.  However, a "paid if paid" clause provides that the general contractor's receipt of payment from the owner for the subcontractor's work is a condition precedent to the general contractor's obligation to make payment to the subcontractor.  Thus, under a "paid if paid" clause, the general contractor has no obligation to make payment to a subcontractor unless a corresponding payment is made by the owner.  In addition to a "paid when paid" clause or a "paid if paid" clause included in the subcontract between a general contractor and its subcontractor, these payment clauses may also be included in further downstream contracts such as subcontracts between a subcontractor and its sub-subcontractor.

Enforceability of "Paid If Paid" Clauses in Indiana

A fairly recent Seventh Circuit Court of Appeals decision highlights the importance of conducting a thorough review and careful negotiation of subcontracts including as to any "paid if paid" clauses. In BMD Contractors v. Fidelity and Deposit Company of Maryland, 679 F.3d 643 (7^th Cir. 2012) (applying Indiana law), a project owner declared bankruptcy resulting in corresponding flow-down payments not being made to the general contractor, subcontractors and sub-subcontractors.  An unpaid sub-subcontractor filed suit against the surety that provided a payment bond for one of the subcontractors.  The subcontract between the sub-subcontractor and subcontractor included a clause that stated "It is expressly agreed that Owner's acceptance of subcontractor's work and payment to the contractor for the subcontractor's work are conditions precedent to the subcontractor's right to payments by the contractor."  The sub-subcontractor argued that this clause was a "paid when paid" clause, but the Seventh Circuit held that the language in the clause was plain and that the clause was an enforceable "paid if paid" clause.  As a result, the sub-subcontractor, per the terms of its subcontract with the subcontractor, assumed the risk of non-payment by the project owner.  Moreover, the Seventh Circuit held that the surety is only liable where the principal itself (in this case the subcontractor) is liable.  Since the principal (the subcontractor) is not liable to the sub-subcontractor as a result of the inclusion of the "paid if paid" clause, the surety is also not liable to the sub-subcontractor.  Accordingly, the sub-subcontractor bore the risk of loss of non-payment by the owner and wasn't entitled to recover from the subcontractor's payment bond, all because the sub-subcontractor agreed to a subcontract that included a valid and enforceable "paid if paid" clause. 

A few additional points should also be mentioned regarding the BMD Contractors decision.  Had the subcontract at issue instead included a "paid when paid" clause, the subcontractor (and not the sub-subcontractor) and its surety would likely have borne the risk of loss and the obligation to pay the sub-subcontractor amounts due for the work performed under the subcontract, despite the subcontractor having not been paid.  In addition to filing suit on the payment bond, the sub-subcontractor in the BMD Contractors case also recorded a mechanic's lien which uncontested ultimately resulted in a partial payment to the sub-subcontractor when the property was sold.  Accordingly, it is important to note that even where a subcontract includes a "paid if paid" clause, it may not preclude a mechanic's lien action being brought by the unpaid subcontractor that agreed to a "paid if paid" clause.  Also, and as noted by the Seventh Circuit federal court in interpreting the subcontract under Indiana law, Indiana courts have not specifically addressed "paid if paid" clauses so it is conceivable that a future Indiana court may hold differently than the Seventh Circuit regarding the enforceability of "paid if paid" clauses.

Know Your Subcontract

For subcontractors and sub-subcontractors that are unwilling to accept the risk of non-payment by the project owner, such subcontractors and sub-subcontractors should review their subcontracts closely in order to determine if there is a "paid if paid" clause within the subcontract and then negotiate the terms of the subcontract so as to remove any "paid if paid" clause before signing the subcontract.  As was the case with the sub-subcontractor in the BMD Contractors case, even if a subcontractor or sub-subcontractor agreed to a subcontract that included a "paid if paid" clause, such subcontractor or sub-subcontractor may still have mechanic's lien rights against the improved property so long as they otherwise comply with the Indiana mechanic's lien statutory requirements.

If the general contractor or a subcontractor wants a "paid if paid" clause to flow down to its subcontractors or sub-subcontractors, as the case may be, it is important for the language in the subcontract to clearly and unambiguously provide that that receipt of payment from the owner or general contractor is a condition precedent to that party's obligation to make payment.  An improperly drafted "paid if paid" clause may result in a court interpreting the clause as a "paid when paid" clause, which may in turn result in the general contractor or subcontractor that thought it was protected by a "paid if paid" clause ending up holding the bag and thus bearing the risk of non-payment by the project owner.

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.