Licensed Image from Bulkimport/Photodisc/Thinkstock

Licensed Image from Bulkimport/Photodisc/Thinkstock

Who bears the risk when an owner refuses to pay the general contractor or experiences financial failure?  More than likely, the subcontractors whose agreements include a contingent payment clause.  Two types of payment clauses exist and both are enforceable.  “Pay-when-Paid” clauses and “Pay-if-Paid.”  Pay-when-paid clauses allow the general contractor to wait a reasonable time for the owner to pay before paying the subcontractor.  Pay-if-paid clauses shift the risk of non-payment completely to the subcontractor.  Stated another way, a pay-if-paid clause makes the general contractor’s duty to pay the subcontractor absolutely conditional upon receiving the owner’s payment. Pay-if-paid clauses are also known as contingent payment clauses.

 

The Prevention Doctrine

Federal courts and several state courts have ruled it patently unfair for a contractor to create the very condition that permits it to hide behind a contingent payment clause and refuse payment to subcontractors.  Prohibiting enforcement of a contingent payment clause in that circumstance is known as the “Prevention Doctrine”.  In Texas, the freedom to enforce contingent payment clauses is restricted.  Texas Business and Commerce Code Chapter 56, essentially codifies the prevention doctrine and creates a procedure for subcontractors to render contingent payment clauses unenforceable.

Chapter 56, Subchapter B Texas Business and Commerce Code

Under Texas’ contingent payment statute, a general contractor (and its surety) may not enforce a contingent payment clause to the extent that the owner’s non-payment to the general contractor is the result of the general contractor not meeting its contractual obligations.  However, if non-payment results from the subcontractor’s failure to meet its subcontract obligations, then the clause may be enforced.

In addition to this general restriction, Texas’ Business and Commerce code makes contingent payment clauses unenforceable when:

  1. The general contractor and the owner are in a sham relationship where both are owned or controlled by the owner or where the parties never expected the other person to perform.
  2. The subcontractor gives the contractor timely notice objecting to enforcement of the clause and the general contractor fails to timely advise the subcontractor that its objection is not effective due to the subcontractor’s default; or\
  3. Enforcement of the contingent payment clause would be legally unconscionable.

I’ve yet to encounter the situation where a subcontractor has made a statutory objection to continued enforcement of a contingent payment clause.  This objection, its timing and the response required by the general contractor are beyond the scope of this blog article.  However, you can read the statute here or contact competent legal counsel should you want to avoid enforcement by making an objection.

If Unconscionable – then Unenforceable

A subcontractor can argue that enforcement of a contingent payment clause is unenforceable if enforcement is unconscionable.  The subcontractor must prove that the enforcement of the clause would be so unfair that no reasonable, informed person would agree to it.  However, the statute provides safe harbor provisions for the contractor that takes certain steps before and after entering into a subcontract.  Enforcing a contingent payment clause will not be unconscionable if before entering a subcontract the general contractor investigates the owner’s ability to pay.  After subcontracting, in the event of non-payment, the general contractor must also make reasonable efforts to collect from the owner or enable the subcontractor to pursue the owner directly.

Certain Exemptions Apply

The Texas Business and Commerce Code’s limitations do not apply to contracts that are solely for:

  1. Design services;
  2. Construction or maintenance of roads, highways, streets, bridges, utilities, water plants, wastewater plants, wharfs, docks, sewer distribution, water distribution, airport runway or taxiways, or similar civil engineering construction;
  3. Construction of a detached single-family residence, duplex, triplex or quadruplex.

Best Practices

The inclusion of contingent payment clauses in modern commercial and government subcontracts is nearly universal.  Subcontractors should always seek to delete these provisions.  If deletion proves impossible, obtaining a change from a pay-if-paid clause to a more palatable pay-when-paid clause is best.  That modification still gives the general contractor a reasonable amount of time to pay without completely shifting the risk of owner non-payment to the subcontractor.

In the event that a compromise can’t be obtained, subcontractors should remember that attempts to waive statutory contingent payment protections are void and enforcement may be eluded if non-payment isn’t due to your breach of subcontract, you object to enforcement, the general contractor is in a sham relationship or if enforcement would be unconscionable.

General contractors should exercise due diligence to ensure that their contingent payment clauses are not unconscionable.  In the event an objection to a contingent payment clause is received from a subcontractor, quick contact should be made with your attorney to counter the subcontractor’s written objection.