Pay-if-paid clauses in general contracts commonly appear in the construction industry. But while these agreements protect the general contractor, they leave subcontractors and material suppliers at risk of not getting paid for their share of the work. These clauses state that "the general contractor on a project does not need to pay the subcontractor unless and until it has been paid by the project owner for the subcontractor's work, including any retention the owner withholds until the job is complete," per American Subcontractors Association (ASA).
Additionally, flow down or incorporated by reference clauses in subcontracts and purchase orders can bind subcontractors and material suppliers to a pay-if-paid clause that may appear in a general contract.
Several states have acknowledged the disconnect and passed laws to ban pay-if-paid clauses in efforts to protect subcontractors. These states include California, Delaware, New York, North Carolina, South Carolina and Wisconsin. Virginia will be the latest to join this list effective Jan. 1, 2023, according to the ASA.
Chris Ring of NACM's Secured Transaction Services expects other states to follow suit as the ban gains widespread support. "Some states have already said that pay-if-paid clauses are harmful and provided legislative protection that even if there is pay-if-paid language embedded in the general contract, that language is unenforceable," he said. "Legislators have already come on board with help and now other legislators in other states should be willing to join the fight as well."
The ban signed into law by Virginia Governor Glenn Youngkin in April, SB 550, shifts the risk of owner nonpayment back to the contractor. Pay-if-paid language is expressly prohibited under the new law, and public contracts must include a payment clause that makes the contractor responsible for the entire amount owed to any subcontractor with which it contracts.
"Our primary customers working on a construction project want to preserve their right to have a mechanic's claim on a piece of property to ensure the property owner pays them," Ring said. "With the pay-if-paid clauses embedded in either the general contract, subcontract or purchase holder, it limits their ability to force their lien rights."
In SB 550, general contractors are still entitled to withhold payments, as long as there is a good faith dispute over the subcontractor's compliance with the contract. According to the ASA, in order to take advantage of this exception, "private owners and both public and private contractors must notify lower-tier subcontractors in writing of their intent to withhold payment and their reasoning." The law also requires private contractors of any tier to pay subcontractors by 60 days of satisfactory completion of their work, or seven days after the receipt of payment from the owner or contractor—whichever comes first.
Despite support for the ban, some states have ruled pay-if-paid clauses as valid. Those states are Arizona, Colorado, Georgia, Florida, Illinois, Maryland and Michigan.
-Jamilex Gotay, editorial associate