In traditional subcontracts, the subcontractor agrees to perform a specified scope of work for a fixed price. If the subcontractor performs the work, the general contractor is obligated to pay the sub even if the owner does not pay the general. In this arrangement, the general contractor bears the risk of owner non-payment.
In most states, general contractors can shift this risk to their subcontractors by inserting “pay-if-paid” language into the subcontract agreement. To be enforceable in Colorado, a pay-if-paid clause must expressly state: (1) the general contractor is only obligated to pay a subcontractor if the owner first pays the general for the sub’s work; and (2) the subcontractor is accepting the risk of owner non-payment. If the owner becomes insolvent or otherwise defaults on its payments to the general, the general has no obligation to pay the subcontractor.
As with many burden-shifting contract provisions, courts strictly construe pay-if-paid clauses. Colorado courts will interpret them as “pay-when-paid” clauses if they do not contain language clearly indicating the subcontractor understood and intended to accept the risk of owner non-payment. General contractors looking to ensure the enforceability of a pay-if-paid clause should make certain it says payment by the owner is a “condition precedent” to paying its subcontractor and affirmatively shifts risk of owner non-payment to the subcontractor. Without the “condition precedent” and risk-shifting language, the clause is likely to be interpreted as a “pay-when-paid” provision. This means the general can delay payment to the subcontractor for a reasonable amount of time if the owner hasn’t paid, but eventually the general will have to pay even if the owner does not.
Most states will enforce a properly crafted pay-if-paid clause. Courts in a few states, notably California and New York, have refused to enforce pay-if-paid clauses on public policy grounds. They reason such clauses violate public policy is because they constitute a waiver of the subcontractor’s mechanic’s lien rights. These rulings, however, are based on unique provisions in those states’ mechanic’s lien laws that don’t necessarily translate to Colorado or other jurisdictions.
The California mechanic’s lien statutes, for instance, provide that mechanic's lien claims are valid for "only such amount as may be due [the subcontractor] according to the terms of his contract." The lien, therefore, is against amounts owed under the subcontract, and if the subcontractor is not due money under its contract because of a pay-if-paid clause, it has no right to a lien. California courts have held that this amounts to a waiver of lien rights in contravention of both California’s anti-lien waiver statute and public policy.
New York law allows a lien claimant to enforce its lien rights against both the subject property and any person liable for the debt upon which the lien is founded. Thus, a subcontractor can enforce its lien against either the owner or the general contractor since both are liable for payment to the subs under New York law. However, if the owner is insolvent and the general is protected by a pay-if-paid clause, the subcontractor has no recourse to enforce its lien. The debt is uncollectible and remains uncollectible until the owner pays the general, and an insolvent owner is unlikely to ever pay. New York courts have found, therefore, a pay-if-paid clause effectively amounts to a waiver of the subcontractor’s lien rights because the lien is unenforceable under these conditions.
So what does all this mean for general contractors? First, you should review your subcontracts and talk to your legal counsel to ensure your pay-if-paid clauses contain the language necessary to make them enforceable in the jurisdiction where the project is located. Otherwise, you may find yourself on the hook to subcontractors even if the owner does not pay. Second, make sure you know whether the states in which you operate will enforce pay-if-paid clauses, even if they are carefully crafted. General contractors doing business in states where pay-if-paid clauses have been invalidated on public policy grounds should be aware of their unenforceability and take that into account when negotiating subcontracts.