The pay-if-paid Clause

Know what you're dealing with

In recent years, increasing numbers of owner bankruptcies and insolvencies have brought pay-if-paid (PIP) clauses into the spotlight. These clauses - which shift the risk of owner nonpayment from general contractors to subcontractors - are controversial.

Some say it's unfair to require subs to bear this risk because they aren't in a position to evaluate the owner's creditworthiness or to protect themselves against owner default. Others assert that the parties to a construction contract should be free to allocate risk as they see fit. So long as the sub understands the significance of a PIP clause, they argue, it can weigh the risk and build a "risk premium" into its price.

Whatever your opinion of PIP clauses, they're common in construction contracts, so you need to understand their impact.

Say the magic words
A PIP clause provides that the general contractor isn't obligated to pay the subcontractor unless and until the owner pays the general contractor. In most states, courts enforce PIP clauses if they explicitly provide that receipt of payment from the owner is a condition precedent to the general contractor's obligation to pay the sub. One reason for this is the view that shifting the risk of nonpayment to a subcontractor is a harsh result that should be imposed only if the language of the contract is clear and unambiguous.

To help ensure that PIP clauses are enforceable, general contractors should use the term "condition precedent" in their contracts. It's also a good idea to include language to the effect that the subcontractor expressly assumes the risk of nonpayment by the owner.

Be aware, however, that even properly drafted PIP clauses may be unenforceable. In some states, such as New York and California, courts have held that PIP clauses violate public policy by forcing subs to waive their statutory mechanics' lien rights. In others, state legislatures have passed laws banning or limiting the use of PIP provisions.

Even in states where PIP clauses are enforceable, they can be invalidated if the general contractor improperly causes the owner to withhold payment (for example, by breaching its contract with the owner).

Impact on surety bonds
If an enforceable PIP clause prevents a subcontractor from collecting from the general contractor, can the sub still make a claim against the general contractor's payment bond? Here, again, the outcome varies from state to state.

In some states, the courts allow sureties to assert a PIP clause as a defense against a subcontractor claim. These courts follow the general rule that a surety "stands in the shoes" of the general contractor and may avail itself of the general contractor's contractual defenses.

In other states, the courts have held that extending the protection of a PIP clause to a surety would defeat the purpose of a payment bond, which is to ensure payment of subs and suppliers in the event the general contractor doesn't pay.

Protect yourself
If you're a general contractor and wish to secure the protection of a PIP clause, review the applicable law for each state in which you do business. For contracts governed by states that permit PIP clauses, make sure the clauses are drafted carefully to make your intentions crystal clear.

If you're a subcontractor being asked to sign a contract that contains a PIP clause, understand and evaluate the risks involved, and then price your services accordingly. Also, consider including similar provisions in your contracts with sub-subcontractors and suppliers, so you're not obligated to pay them unless and until the general contractor pays you.

Whether you're a general contractor or a sub, because laws regarding the enforceability of PIP clauses vary from state to state, it's important to be familiar with the law in the states in which you work and have your lawyers review these provisions carefully.