No provision of a construction contract has more significance to the parties than the one governing payments. The amount, frequency and time of payments are the keystone of every construction contract. Yet no contractor or subcontractor wants to finance construction with its own funds, and for that reason almost every contract contains some form of "pay when paid" provision.
The usual provision is one where, for example, the general contractor agrees to pay its subcontractors or suppliers within so many days after receiving payment on account of their particular work or material. A less usual provision, but one that is appearing more frequently, is where the general contractor's agreement to pay is explicitly conditioned on its receiving payment on account of the work or material furnished by its subcontractors or suppliers. The legal distinction between these two types of payment provisions can have enormous consequences.
Courts have interpreted the first type of provision as merely setting the time for payment. Thus, if a general contractor does not receive payment on account of a subcontractor's work for reasons unrelated to the subcontractor's performance, the general must still pay the sub, although the court may postpone the payment for a reasonable time to give the general contractor the opportunity to collect from the owner.
But where the general contractor's obligation to pay a subcontractor is explicitly conditioned on receipt of payment by the general contractor for that subcontractor's work, courts have denied payment to the subcontractor where the general contractor has not been paid. Thus, a subcontractor who performs perfectly, and incurs enormous expense in doing so, could be denied payment because the general contractor is unable to collect from the owner. The existence of security available to the subcontractor, such as a payment bond or mechanic's lien, does not help because under this type of "pay when paid" provision there would be no amount due under the subcontract for which the security could be invoked.
There are two principal circumstances where a general contractor may be unable to collect from the owner. The first is the owner's insolvency which leaves no funds from which payment can be obtained; and the second is where the general contractor has breached the prime contract, which, under Massachusetts law, prevents any recovery by the general contractor as a matter of law.
Who should bear the risk of owner insolvency is the subject of legitimate negotiation between a general contractor and its subcontractors. While the general contractor occupies a better position to assess the owner's financing than more remote subcontractors and suppliers, and is better able to react to early signs of an owner's financial difficulties by ordering a suspension of work and invoking mechanic's lien rights, those opportunities are not fool-proof and no general contractor (or subcontractor) wants to have to pay for work out of its own pocket when the party receiving the benefit of the work cannot pay. A general contractor's insistence on including a conditional "pay when paid" provision in its subcontracts may reflect its early concern about the owner's financial condition.
Of more dubious legitimacy is a "pay when paid" provision which enables a general contractor (or a subcontractor) to escape the obligation to pay its subcontractors and suppliers where the inability to collect for their work is caused by its own breach of contract. Such a provision is the equivalent of indemnifying someone against his own misconduct. Any subcontractor or supplier faced with a conditional "pay when paid" provision in a proposed subcontract needs to carefully assess the legal risk imposed by that provision, and decide whether the contract's potential benefit justifies the contract risk of nonpayment. In many instances the reward may not merit the risk, making further negotiation or rejection of the contract the more prudent course. And where the decision is made to take the risk, consideration should be given to sharing that risk among lower tier subcontractors and suppliers by insisting on the same conditional payment provision in those contracts.
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