In New Jersey, the enforceability of contract clauses commonly known as “paid-when-paid” and “paid-if-paid” has not been clear. Despite what appeared to be the intent of certain clauses to condition payment to subcontractors upon the receipt of payment from the owner, the courts have provided little guidance on how those clauses must be drafted in order to be upheld. In the last year, two New Jersey cases clarified when a court will find that receipt by the general contractor of payment from the owner is a condition precedent to liability to pay the subcontractor. In short, a “pay-if-paid” clause will only be enforced if it clearly shifts the risk of nonpayment to the subcontractor.

Pay-When-Paid Clauses

A typical “pay-when-paid” clause might read:

Contractor shall pay subcontractor within ten days of contractor’s receipt of payment from the owner.

In New Jersey, clauses such as this, which provide a time by which payment may reasonably be expected by the subcontractor, will be interpreted to require payment within a reasonable period of time from when the subcontractor’s work was performed and invoiced, even if payment is not received from the owner.

For example, in Seal Tite Corp. v. Ehret, Inc., 589 F. Supp. 701 (D.N.J. 1984), the subcontract in question contained a “pay-when-paid” clause, which provided that the subcontractor would get paid as follows: “ninety percent monthly of work completed, within seven days of receipt of payment by Owner.” The general contractor took the position that since it had not yet received payment from the owner, which was experiencing significant financial difficulties, it had no obligation to pay the subcontractor. The Court disagreed, ruling that the “pay-when-paid” clause should be interpreted as an unconditional promise to pay, with the payment being due within a reasonable time, regardless of whether the general contractor has received payment. The Court reasoned that the solvency of an owner is a credit risk necessarily incurred by a general contractor and that risk should not be shifted to a subcontractor unless the subcontract payment terms clearly identify that possibility.

Pay-If-Paid Clauses

A typical “pay-if-paid” clause might read:

Contractor’s receipt of payment from the owner is a condition precedent to contractor’s obligation to make payment to the subcontractor, the subcontractor expressly assumes the risk of the owner’s nonpayment and the subcontract price includes this risk.

In New Jersey, this type of payment clause will be upheld only if it contains language that expressly and unambiguously shifts the risk of the owner’s nonpayment from the contractor to the subcontractor.

In Titan Stone, Tile & Masonry, Inc. v. Hunt Construction Group, Inc., U.S. District Court 05-3362, 2007 WL 869556 (D.N.J. 2007), the clause in question appeared to be a clear expression of a shift in risk of payment to the subcontractor: “Final Payment by Owner to Hunt shall be an express condition precedent to Hunt’s duty to make Final Payment to Subcontractor.” Notwithstanding what appears to be unequivocal language concerning the intent of the parties, the Court ruled that there was a fact question about whether that clause should be read to relieve Hunt from any obligation to pay retainage to Titan until Hunt recovers the corresponding funds from the owner, or merely provided Hunt with a reasonable time to pay Titan in case of non-payment by the owner.

In contrast to the Titan Stone case, two more recent cases show that our Courts will uphold the intent of a “pay-if-paid” clause if the contract language is carefully drafted. In Fixture Specialists, Inc. v. Global Construction, L.L.C., U.S. District Court, No. 07-5614, 2009 WL 904031 (D.N.J. 2009), the clause at issue provided the following:

Subcontractor agrees that Contractor shall never be obligated to pay Subcontractor under any circumstances, unless and until funds are in hand received by Contractor in full, less any applicable retainage, covering the Work or material for which Subcontractor has submitted an Application for Payment. This is a condition precedent to any obligation of Contractor, and shall not be construed as a time of payment clause.

The Court found that by virtue of the unequivocal language used in the subcontract, the parties clearly intended to shift any and all circumstances of the owner’s nonpayment to the subcontractor. The Opinion noted that it is not the use of “when” or “if” that is dispositive of the enforceability of the clause, but whether there is clear evidence of intent by both parties to shift the risk of collection.

The Fixture Specialist’s Court also found that a surety for a general contractor may raise the defense of a properly drafted “pay-if-paid” clause to defeat a payment bond claim.

The latest case construing “pay-ifpaid” clauses was decided by the New Jersey Appellate Division in O.A. Peterson Construction Co., Inc. v. Englewood Hospital and Medical Center (July 1, 2010). The payment terms at issue provided the following:

It is expressly understood and agreed that the receipt by the Contractor of payment for the Subcontractor’s work shall be a condition precedent to the Contractor’s obligation to pay the Subcontractor. That is, the Contractor shall have no liability or responsibility for any amounts due or claimed to be due the Subcontractor for any reason whatsoever except to the extent that the Contractor has actually received funds from the Owner specifically designated for disbursement to the Subcontractor.

The Appellate Court found that this clause was clearly a “pay-if-paid” clause and even corrected the trial judge’s characterization of the clause as “pay-when-paid.” However, the twist in this case was that the general contractor (“OAP”) had settled with the owner and had received payment of the settlement amount. OAP argued that because the settlement agreement did not designate specific portions of the settlement funds for disbursement to a subcontractor, it could rely upon the “pay-if-paid” clause to defeat that subcontractor’s right to payment. The Court rejected that attempt to “game the system” and found that the subcontractor was entitled to payment in view of the settlement. (The Opinion did not discuss the method of calculating the amount due to the subcontractor. Presumably, in circumstances such as this, each subcontractor must be paid a pro rata share out of the settlement proceeds).

Take-Away

The law of this State is now settled with regard to payments owed to subcontractors. Subcontracts that include a time of payment provision will be interpreted as “pay-whenpaid” clauses and will be enforced only to the extent that they impose upon a general contractor a reasonable time by which subcontractors must be paid. In order for a payment clause to be interpreted as a “pay-if-paid” clause, the language must be abundantly clear that the risk of nonpayment by the owner has been squarely shifted to the subcontractor. Those general contractors who are seeking to impose such terms on their subcontractors should use language similar to that contained in the Fixture Specialists or O.A. Petersen cases. Subcontractors should be aware that if they sign subcontracts which include that language, they are accepting the fact that if the owner becomes insolvent or for some other reason the general contractor does not receive payment, they will not be able to sue for breach of contract against the general contractor or its surety. However, on non-public jobs they will still be able to file a construction lien claim against the subject property.