Shared Risk of Owner Non-payment

Several months ago we addressed the risk of owner nonpayment. Should the risk be borne solely by the prime contractor who, of course, elected to contract with the project owner? Or should subcontractors share this risk?

The question arises in the context of “pay-if-paid” clauses in subcontracts. The subcontractor gets paid for its work only if the prime contractor receives payment from the project owner for the sub’s work. These clauses are controversial. And their enforceability is increasingly subject to challenge.

The controversy was evident in the large volume of comments we received. The breakdown was predictable. Subcontractors react to pay-if-paid clauses with indignation. Prime contractors feel shared payment risk is an appropriate business arrangement.

I again invite you your opinion on this topic, particularly with regard to the relative abilities of the parties to determine the creditworthiness of the project owner. And is it fair to utilize a contract clause which effectively negates a subcontractor’s public works payment bond rights or private works mechanic’s lien rights?

Bruce Jervis, Editor
Construction Claims Advisor

Comments

[Derek J.]

This is a very interesting topic, and I don't think you can make a generic rule governing all cases. I think each case needs to be looked at individually with regards to how contracts are structured.

However, looking at it from a standpoint of being a consultant for project owners, I take a little different take. Typically I advise project owners to withhold payment to a GC until proof is provided that all subconstractors for the work being paid for have been paid. This comes as a result of subcontractors placing lien's on an owners project, when the GC was fully paid for everything. For whatever reason, the GC withheld payment from the subcontractor, and the sub placed a lien on the project. That lien went against the project owner

Especially in these trying economic times, payment on any project is a very serious issue. You never know when a company is going to go bankrupt, loose financing or just fall behind on their ability to pay. Who shares in that risk needs to be a conversation up front between the parties prior to the finalization of any contract.

[Rob the Lawyer]

If issues with the creditworthiness of the owner/its lender are shared up front with subcontractors, then a conditional payment arrangement makes sense. If not, subcontractors should get paid.

[Chris Thompson]

If payment bonds were legislated, the responsibility could then rightly be shouldered by the correct party: The One Ordering the Wor.

It is undeniably unethical and should be made illegal for anyone to set about doing a project without the funds in place preferably in 3rd party escrow to complete that project.

[Chris Thompson]

"Credit worthiness?" Let the lenders shoulder this burden alone.
There is not a correct "chain of finance" in place to handle unscrupulous Developers, GCs, and Lenders.

As a subcontractor, I have done the work of the projects, handled the mis-management of the projects, financed the projects, and then gone to lawyers to attempt to collect for these projects too often. It is a ridiculous situation and unnecessary.

[Chris Thompson]

"And is it fair to utilize a contract clause which effectively negates a subcontractor’s public works payment bond rights or private works mechanic’s lien rights?"

NO. The pay-if-paid clause comes from an unholy and dark hearted place.

[Julian]

Paid - if -paid conditons within the contract is not acceptable. The subcontractor should not be faced with this risk of non payment for his work.

However if this condition is to be introdcued, then, the subcontractor should be made well aware of its existence before he signs up. This already indicates that the main contractor is passing this risk down. The subcontractor should avoid entering into this contract without adequate protection for his due payments. This clause is just not justifiable anyway you look at it.

[Anthony D. Paglia]

The 'Paid when Paid" has become more of a burden in these times then ever before. Contractually it makes sense to the parties
by sharing the risk and makes no sense to the parties that will not sign the agreement. Sometimes the best contract is the one you refused to sign especially if it contained a "Paid when Paid' clause. To each his own.

[Frank B.]

Well i agree with chris, why is there a difference between someone who knowingly writes bad checks for goods, and an owner who has work done and knows they dont have money or does work without proper funds and contingency reserve? The person who writes bad checks is charged with fraud and arrested right?
Second i think the burden of bonds unfairly discriminates against small business subs. If you are a small business, but by nature of the work you contracts are generally over $100K-$250K, It can cost a company over $5K to have its financials audited to make the bonding company happy, and the bonding company & banks want to see the subcontractor making money and collecting it on time. But in this economy how many people show that? If all you work for is Gc's and only have 1 or 2 crews and each month you only work on 1 or 2 jobs because they are that large, then the Gc's stretch the payment out for 45 and 60+ days and people wonder why you cant pay bills on time and make good money? Well the owner and GC's hold up the payment way too long and do their best to NOT let the subs make money and then hold the retention for 6 months to a year after the job is done which is usually all profit? Its a ridiculous self feeding cycle of BS.
I think that ALL states should mandate that the owner CANNOT get hooked up to public utilities OR get a certificate of occupancy and be able to start using the building UNTIL they have lien waivers and proof from all subs on the job that they are paid in full. Then maybe some owners would get off their ass and care about getting the subs paid in a timely fashion.
I think as an owner you either have the $$ to do a job or you dont, so why wait 30+ days to pay, wouldnt your whole job go smoother if you cut checks in 10-15 days? As a sub if i was busy and had to choose to work on 2 jobs who were in a rush, whose project would you work on that week?the person who pays in 45-60 days or the person who paid in 20?

[Dennis Kane]

An interesting concept was made related to requiring proof of subcontractor payment before issuance of C of O. As a GC, I am not sure I would fight that legislation because it sounds good - and it would insure that I was also paid from the sound of it. But to be certain, that is not the way the real estate finance industry or any large funded type project could work. When capital dries up - we all die on the vine because our projects dry up. Gee, like right now maybe? Largely our business - at least commercial renovations - is an outflow from inexpensive capital to fund developer projects. However, this idea would throw projects with significant - if only one temporary GC/Owner/Sub problems into limbo. Say you had a large site claim that was not resolved. Now nobody can get paid and nobody can occupy the building because the site sub is holding out for what he thinks he is entitled to and has not yet had his day in arbitration/mediation or court. To me, this means everybody takes a hair cut for the sake of expediency and a new dark strategy. Sometimes, the good fight is worth waiting and the entity with time on their side can wait out a situation and ultimately preserve their position. We have done this several times to our own benefit as the GC and our subcontractors when there is no dispute over the actual work. Long money is better than no money. So really what we are talking about is having enough money to fund the risk you engage in for the reward you will reap. IF the GC didnt exist and you were working direct for the owner - would any of this change? Both the risk and reward are a function of time (waiting). Some clients pay faster or have more repeat work than others - so figure out whom you want to work for and get on the site like any other business/ industry. As it stands, everybody knows that life in the material and labor heavy trades is not a "cash flow machine" so stop dreaming that it should be. Lot's of things in life "should be". Don't ask Big Government to solve problems with regulation of disputes that have not even occured yet - a new victim class will be developed from that approach just as well. Good GC's will listen to a heavy material oriented subcontractor and work with them to create a legitimate schedule of values for materials and deposits (when made part of the initial proposal - we cant negotiate for that with the client at award when we dont know) and even the billing of stored materials or retention release for certain trades at the 50% complete mark. There are ways to accomplish this rather than just holding the job up because you didnt want to tell the GC you didnt have the cash to fund the job as you knew was expected as an industry standard. Or, maybe you did before the problem on some other job ate into your operating cash. The LLC entities are set up for just that reason - to avoid spreading of problems from one project to another. You would be surprised at how many of your GC's are actually paying you on "good" client projects that stay "good" because some meltdown elsewhere hasn't forced them to make "dark" decisions accross a portfolio. Meaning the fire wall protected your projects and the financing integrity of it. However, you should also be prepared to NOT get everything you want every time you ask - because you are still competing for the next job as are we the GC. But you have to constructively try and communicate beforehand - not just when the materials need to be on site. The risk lies in the proper schedule of values, communication, performance, and knowing how and when to "warn" if payment slip beyond a one month exposure. Billing on time is a huge help as well - thank you very much.....

It really isn't rocket science - it's just that the construction business is different from the business of construction.