HIGHLIGHTS:

  • The Illinois First District Appellate Court recently addressed the longstanding principle of barring payments by general contractors to subcontractors based upon contractual "pay-if-paid" provisions.
  • In Beal Bank Nevada v. Northshore Center, the court ruled that in order for pay-if-paid clauses to result in payment forfeiture, there must be: 1) specific language in the contract that plainly and unambiguously establishes that payment by an owner is a condition precedent to the contractor's obligation to pay downstream subcontractors and 2) clear language indicating that the subcontractor intended to assume the risk of nonpayment.
  • As a result, there are several changes to business practices that will likely occur. These will include the re-examination of standard form contract documents, bid packages and form agreements. There will also be more critical and aggressive claim analysis under weaker payment clauses.

The Illinois First District Appellate Court recently addressed the longstanding principle in A.A. Conte Inc. v. Campbell-Lowrie-Lautermilch Corp., 132 Ill. App. 3d 325 (1st Dist. 1985), of barring payments by general contractors to subcontractors based upon contractual "pay-if-paid" provisions.

The Illinois appellate court in A.A. Conte first held that a pay-if-paid clause can result in a forfeiture of payment by a contractor to a subcontractor. The court in Beal Bank Nevada v. Northshore Center, 2016 IL App 1st 151697 (2016), reviewed A.A. Conte in detail andcreated a strict two-prong standard that must be satisfied before the enforceability of a pay-if-paid provision results in the forfeiture of a payment under a construction contract. A summary of the new standard and the legal principles behind it, as well as ways to address internal business practices afterBeal Bank,are explained in this alert.

A pay-if-paid provision is one of two extremely common contractual provisions that address the payment process and risk in construction project payment obligations. The pay-if-paid clause provides that payments will only be made if the upstream contractor is paid by the owner. This clause ensures that each downstream contracting party bears the risk of loss for payment of its own work when funds from the owner are not made to the general contractor.

In contrast, the second provision, the "pay-when-paid" provision, governs the timing of a contractual payment obligation. The pay-when-paid obligation does not always result in forfeiture, but the pay-if-paid clause can be fatal to a downstream subcontractor's claim for payment.

In both the A.A. Conte and Beal Bank cases, the problems were generally the same. The payment problem stemmed from construction project owners that did not pay general contractors for work performed in due course. In attempting to reduce its project liability, the general contractor in each case sought to enforce a pay-if-paid clause to avoid directly funding the owner's payment requirement. In these cases, the contractors cited clauses in the construction contracts and advised their subcontractors that certain payment clauses represented pay-if-paid provisions, which protected the contractors from incurring the risk of paying downstream subcontractors after the owners failed to make payment.

In analyzing the A.A. Conte case, the court in the Beal Bank case strictly construed the contractor's proposed pay-if-paid contract provision. In doing so, the court cited §227 of the Restatement (Second) of Contracts. The Restatement provides that forfeiture through a pay-if-paid clause is a drastic measure. Furthermore, it requires interpretation of the payment provision that will reduce an obligee's risk of forfeiture, unless the circumstances indicate that the obligee assumed such risk. In Beal Bank, the court denied the contractor's enforcement of the pay-if-paid provision.

In order for pay-if-paid clauses to result in payment forfeiture after Beal Bank, there must be: 1) specific language in the contract that plainly and unambiguously establishes that payment by an owner is a condition precedent to the contractor's obligation to pay downstream subcontractors and 2) clear language indicating that the subcontractor intended to assume the risk of nonpayment. Absent an expression of clear intent to allocate the risk of nonpayment, pay-if-paid requirements should not be deemed to create or shift such risk to the subcontractor.

Potential Changes to Business Practices

As a result of the Beal Bank ruling, there are several changes to business practices that will likely occur. Upstream contractors will re-examine standard form contract documents, bid packages and form agreements to address proper inclusion of clear pay-if-paid risk-shifting language mandated by the court in Beal Bank. Some may even issue nonvalue change orders in an attempt to modify the contract documents already in place to provide for these requirements and ensure that existing pay-if-paid provisions meet this new standard. Other contractors may seek to add this language in other payment documents, payment applications or other contract documents that are required to be executed during the payment process to bring existing clauses up to the current legal standard. Subcontractors will perform more detailed reviews of pay-if-paid provisions. They will also consider proceeding with contract claims against upstream contractors and choose to aggressively litigate weaker contractual payment terms.