Payment clauses in California construction contracts are often complex and multi-layered. This is especially true in contracts between general contractors and their subcontractors. The general does not want to pay the subs until it receives funding from the owners. The subs, of course, want their progress and final payments as soon as possible.
Up until 1997, two different payment provisions were used in California contracts to manage payments by a general to its subcontractors. The first was called a “pay if paid” clause, and provided a contractor did not have to pay its subcontractors for work performed unless the subcontractor was first paid by the owner of the project. The second was the “pay when paid clause.” It required subcontractors to be paid for their work after the general was paid by the owner, or within “a reasonable time” after the subcontractors finished their work if the owner did not pay the general.
While the two clauses were frequently viewed as interchangeable, they are in fact quite different - in the “pay if paid” clause, a subcontractor is not entitled to payment unless the general contractor receives payment from the owner. In a “pay when paid” clause, the subcontractor must be paid, even if the general does not receive payment from the owner.
A typical “pay if paid” clause provides: “Receipt of payment by the Contractor from the Owner for the Subcontract Work is a condition precedent to payment by the Contractor to the Subcontractor. The Subcontractor hereby acknowledges that it relies on the credit of the Owner, not the Contractor, for payment of Subcontract Work.” (ConsensusDocs Standard Agreement 655 [now retired].)
A “pay if paid” clause creates a condition precedent for payment to the subcontractor. Unless the general contractor is paid by the owner, the general contractor has no obligation to pay a subcontractor for its work. As such, the clause essentially transfers the risk of non-payment by the owner from the general contractor to the subcontractor.
By contrast, a “pay when paid” clause is a “timing mechanism” as to when payment will be made. A typical “pay when paid” clause provides: “Progress payments to the Subcontractor for satisfactory performance of the Subcontract Work shall be made no later than seven (7) Days after receipt by the Contractor of payment from the Owner for the Subcontract Work. If payment from the Owner for such Subcontract Work is not received by the Contractor, through no fault of the Subcontractor, the Contractor will make payment to the Subcontractor within a reasonable time for the Subcontract Work satisfactorily performed.” (ConsensusDocs Standard Agreement 750.)
A “pay when paid” clause creates an unconditional promise that subcontractors will eventually be paid, and does not shift the risk of non-payment.
While both clauses are currently in use in contracts in many states, “pay if paid” clauses are unenforceable in the State of California.
In Wm. R. Clarke Corp. v. Safeco Ins. Co. (1997) 15 Cal.4th 882 the California Supreme Court held pay if paid clauses were against public policy. The Court held “pay if paid” clauses act as an indirect waiver of a subcontractor’s mechanic’s liens rights in violation of former Civil Code section 3262 (now Civil Code section 8122). Section 3262 held that contracts which “waive, affect, or impair” a claimant’s right to a mechanic’s lien are “null, void and unenforceable.” The court reasoned the “pay if paid” clause was “in substance a waiver of mechanic's lien rights because it has the same practical effect as an express waiver of those rights.” Since nothing was “due” a subcontractor unless the owner paid the general contractor, the subcontractor had no right to file a lien to protect its right to payment.
By contrast, “pay when paid” clauses are enforceable if the subcontractor is paid within a reasonable period of time after its work is completed. Yamanishi v. Bailey & Collishaw, Inc. (1972) 29 Cal.App.3d 457. Under Yamanishi, a general contractor may avoid paying subcontractors for a period of time while it seeks payment from the owner. The key is that payment from the owner to the general contractor is not a condition precedent to the subcontractor. The general contractor must pay the subcontractor whether or not it receives payment from the owner. (cf Capital Steel Fabricators, Inc. v. Mega Construction Co. (1997) 58 Cal.App.4th 1052 holding a pay when paid clause that acted as a condition precedent to payment as unenforceable.)
Unfortunately, there are no reported California cases identifying what constitutes a “reasonable” time period for payment by the general contractor to the subcontractor. This is true as well for the few unpublished cases which have considered the issue. See, i.e., Sampson v. Richardson Group 2013 Cal.App. Unpub. LEXIS 751: “The Civil Code bars the parties to construction contracts from limiting a contractor or subcontractor’s right to payment through the use of a “pay if paid” clause. (Citations omitted.) However, this rule does not apply where a contract provision limiting a subcontractor’s right to payment is construed ‘as merely fixing the usual time for payment to the subcontractor, with the implied understanding that the subcontractor in any event has an unconditional right to payment within a reasonable time.’ [Citations].” See also, Interior Partitions, Inc. v. Bay Commerc. Constr., Inc. 2003 Cal.App. Unpub. LEXIS 10240: “A ‘pay when paid’ provision posits that the subcontractor will get paid when the general contractor is paid by the owner for the subcontractor’s work, so long as payment to the subcontractor will occur within a reasonable period. . . .” (Emphasis added.)
The unanswered question, therefore, for both general contractors and subcontractors is “what is a reasonable period of time” for payment, and when does the time period become so long that the pay when paid clause is rendered unenforceable as against public policy? Because there is a lack of court guidance, it is up to the contracting parties to agree on what is reasonable.
To avoid ambiguity, and the potential for litigation, drafters of a subcontract containing a pay when paid clause, should consider including a firm deadline for the release of payments. A court is likely to uphold that deadline, if it was bargained for and agreed to by the parties.