Limitations of Liability – Scenario 3: Pay if Paid and Flow Through Clauses

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I suppose that it is apropos that I have been delayed in writing this  final piece in the four-part Limitations of Liability series, relating to subcontract pay if paid and flow through clauses.  Being more than one step removed from a project’s funding source, subcontractors are used to being dealt with last, and only after a lag in the schedule, whether foreseeable or not.  Subcontractors will tell you that “it” tends to flow downhill, and financial issues and project glitches tend not to improve by the time they make their way to the subcontractor, whether the issues or glitches are tied to the subcontractor or not.

Their concerns regarding delays in payment appear to be justified.  In a recent ENR survey, thirty percent (30%) of payments from contractors to subcontractors were late, by an average of 36.4 days.  Eighty-Three of the subcontractors surveyed reported that more than 6 in 10 payments were past due.  Although most states now have prompt pay laws, with varying degrees of penalties, the survey reflects that these laws seem to have minimal impact on the timing of payments.  Perhaps these timing issues relate to project owners holding funds as long as possible to earn additional interest, but with interest rates so low, that seems unlikely.  Maybe project owners are being cautious and remain as far ahead of their contractors and subcontractors as possible in the funding of the project.  More likely, subcontractors are reluctant to harm their business relationship with contractors, or simply don’t wish to incur added costs in pushing the timing of payments.

Nonetheless, contractors rightfully wish to avoid being “squeezed” between a non-performing owner and the subcontractor.  There are contractual mechanisms to do so fairly, but often times subcontractors are asked to take on even greater risk than the contractor itself.  Subcontractors not surprisingly attempt to avoid these clauses.

Pay if Paid Clauses

These days, most sophisticated contractors include “pay if paid” clauses in all their subcontracts.  An enforceable “pay if paid” clause makes payment by the owner a “condition precedent” to payment to the subcontractor.  If the condition precedent language is not included, the clause becomes nothing more than an obligation to pay within a reasonable time, so  precision in the language is key.  The enforceability of these “pay if paid” clauses can vary by jurisdiction, and if the project owner is unable to pay at all (due to bankruptcy or other reasons), it remains questionable as to whether a court will construe such clauses as a permanent bar, excusing payment from contractor to the subcontractor.  As a result, contractors are now expanding such clauses to require that the subcontractor share in the risk of the financial viability of the owner, and if the owner is unable to pay, the contractor is not required to pay either.

From a subcontractor perspective, being at least one tier removed from the owner and with less opportunity to assess the owner’s credit-worthiness, these provisions may seem unfair.  At the very least, a savvy subcontractor will require financial information regarding the owner’s financing for the project before undertaking the work.  If change orders exceed a certain percentage, perhaps 10%, then the subcontractor may consider requesting further evidence of funding as to those changes.  The subcontractor’s long term relationship is usually with the contractor, so such requests may be awkward, but fair.  When faced with such clauses, subcontractors will want to be mindful of their rights under payment bonds and mechanic’s lien statutes, and not allow such rights to expire before attempting to secure payments.  Pay if paid and flow through clauses may provide defenses for the owner, contractor or surety, but while those defenses are being asserted, the subcontractor’s rights will be better secured by making demand on a bond or filing a lien; these actions may also attract the required attention to bring the matter to closure.

Flow Through Provisions

Finally, though strict flow through provisions serve a legitimate purpose, subcontractors grow weary of provisions limiting their recovery for additional time or cost to such costs or extensions which the contractor can recover from the owner.  There are circumstances on any project in which the contractor rather than the owner is the cause of a delay or added cost.  A subcontractor may seek to except from any flow through provision any delays or added costs caused directly by the contractor that may not be recoverable from the owner.

Take Away

Subcontract flow through and “pay if paid” provisions can be fairly drafted to protect the interests of both contractor and subcontractor.  Subcontractors, however, must be vigilant of more onerous changes that purport to shift all of the risk to the subcontractor.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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