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What to Know If and When You Encounter Contingent Payment Clauses

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Halfway through a project and the owner can’t pay the next pay application. Are you getting paid? Are you still having to pay downstream contractors? Contingent payment clauses that answer these questions provide key protections, and risks, depending on what side of the contract you are on. There are two types of contingent payment clauses: pay-when-paid and pay-if-paid.

Pay-when-paid clauses deal with the timing of an obligation to pay a subcontractor.  Essentially, a subcontractor is paid within a certain time after the general contractor getting paid.  The general contractor’s obligation of when to pay the subcontractor is contingent upon it itself receiving payment.  An example pay-when-paid clause might read:

“General Contractor shall pay Subcontractor within seven days of General Contractor’s receipt of payment from the Owner.”

Unlike pay-if-paid clauses, the general contractor’s obligation to pay the subcontractor is only focused on timing, and will not preclude a subcontractor from eventually getting paid, despite an owner’s failure to pay a general contractor.

Pay-if-paid clauses, on the other hand, makes receipt of payment from the owner a condition precedent to the obligation to pay a subcontractor. Thus, properly drafted pay-if-paid clauses have quite a bit more bite than pay-when-paid clauses. An example pay-if-paid clause might read:

“General Contractor’s receipt of payment from the Owner is a condition precedent to General Contractor’s obligation to make payment to Subcontractor.”

If an owner does not pay the general contractor, the general contractor has no obligation to pay the subcontractor. As a general contractor, pay-if-paid clauses are a very powerful tool.  As a subcontractor, pay-if-paid clauses are extremely risky.

To account for the large ramifications of a pay-if-paid clauses, Texas Business & Commerce Code § 56.001 limits the enforceability of such clauses. Section 56.003, however, provides that the protections are inapplicable to pay-when-paid only when payment is to be made within a “reasonable period”.  Thus, these protections do not apply to pay-when-pay clauses unless the clause provides such a lengthy delay, it effectively turns itself into a pay-if-paid.

  1. Contracts not subject to pay-if-paid.

While Texas generally permits pay-if-paid clauses in construction contracts, it is prohibited in contracts for:

  • design services;
  • the construction or maintenance of a road, highway, street, bridge, utility, water supply project, water plant, wastewater plant, water and wastewater distribution or conveyance facility, wharf, dock, airport runway or taxiway, drainage project, or related type of project associated with civil engineering construction; or

            (3)    improvements to or the construction of a structure that is a:

  • detached single-family residence;
  • duplex;
  • triplex; or

(D)  quadruplex.

  • General Contractor’s fault.

A general contractor cannot rely upon a pay-if-pay clause to withhold payment from a subcontractor if the general contractor is not getting paid due to some fault of its own.  If an owner is withholding payment due to the general contractor’s own mistakes, the pay-if-paid provision with the subcontractor is unenforceable.

  • Notice from Subcontractor

A subcontractor may be able to avoid the enforcement of a pay-if-paid clause if it follows the procedure set forth in §56.052.  To do so, the subcontractor must send a written notice objecting to the enforceability of the pay-if-paid clause 45 days after requesting payment, i.e. invoicing.  Such notice becomes effective based on the latest of several different deadlines—calculated from either the date general contractor received notice, or based on the deadlines provided by the Prompt Pay Act.  Chapter 56.052 of the Prompt Pay Act provides the deadlines:

(b)  For purposes of Subsection (a), the written notice becomes effective on the latest of:

            (1)  the 10th day after the date the contingent payor receives the notice;

            (2)  the eighth day after the date interest begins to accrue against the obligor       under:

                        (A)  Section 28.004, Property Code, under a contract for a private                         project governed by Chapter 28, Property Code; or

                              (B)  31 U.S.C. Section 3903(a)(6), under a contract for a public project               governed by 40 U.S.C. Section 3131; or

                          (3)  the 11th day after the date interest begins to accrue against the obligor             under Section 2251.025, Government Code, under a contract for a public    project governed by Chapter 2251, Government Code.

However, such notice does not prevent enforcement of the pay-if-paid clause where the general contractor contends the subcontractor has not met its contractual requirements, and the general contractor notifies the subcontractor that its notice does not prevent enforcement of the pay-if-paid clause.  

  • Sham relationship

If a general contractor is essentially one in the same as the owner, a “sham contract” exists and  pay-if-paid clauses are unenforceable. This prevents a general contractor who may have control over the owner from not paying itself to avoid paying a subcontractor.

  • Unconscionable

A pay-if-paid clause is also unenforceable if it is “unconscionable.” Proving unconsionability, however, is a high hurdle under Texas law. Section 56.054 provides the clause is not unenforceable where the general contractor has exercised diligence in communicating the owner’s financial ability to pay, in writing, to the subcontractor before the contract is signed, and made reasonable efforts to collect or offered to assign its claims for payment to the subcontractor, and cooperate in collection efforts.

  • Lien Purposes

Importantly, a pay-if-paid clause cannot be used to invalidate a Mechanic’s and Materialmen’s lien. As a subcontractor, if you cannot avoid a pay-if-paid clause, it is essential to pursue lien rights.

Finally, as a general contractor, remember an owner cannot prohibit you from including a contingent payment clause in contracts with subcontractors.

No matter what side of the contract you are on, it’s advisable to work with an experienced construction law attorney and refer to Chapter 56 of the Texas Property Code. Properly drafted clauses and accurately timed notices can make all the difference when it comes to getting paid.

ABOUT THE AUHOR

An active member of ABC Houston and Vice-Chair of ELITE’s Leadership Committee, Julia Edwards joined Gray Reed’s litigation section in 2018 after participating in the firm’s summer associate program. She is often called upon by the firm’s litigators who are going to trial to offer her expertise on voir dire and jury selection. While attending The University of Texas School of Law, Julia received the Dean’s Achievement Award for “Outstanding Student in Construction Litigation” and served as articles editor for The Review of Litigation. She can be reached at jedwards@grayreed.com.

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