Contractors, and their sureties, regularly rely upon what are called ‘‘pay-if-paid’’ provisions to mitigate financial risk and defend against payment claims.  However, in doing so, they could find themselves enjoying a false sense of security in the effectiveness of such provisions.  Proper use of a contractual ‘pay-if-paid’ provision must consider the jurisdiction in which it will be used, and its ability to withstand challenges to the provision’s validity, including challenges from what is called the “prevention doctrine.”

A ‘pay-if-paid’ provision is what is called a contractual “condition precedent.”   This type of language makes a contractual obligation to perform some act, here payment to a downstream party, conditioned upon the occurrence of another event taking place first, here, the receipt of payment from an upstream party. In summary, there is only an obligation to pay a subcontractor “if” the contractor is paid first.

In some jurisdictions, ‘pay-if-paid’ provisions are illegal.   Even where permitted, these provisions can be disfavored and narrowly interpreted.  Therefore, to be used effectively, these provisions must clearly and unambiguously show that the contractual parties intended to shift the risk of non-payment by using this provision. 

The “prevention doctrine” should also be considered when drafting a “pay if paid” provision.  The prevention doctrine is a contractual principal that can, in essence, void the use of a pay if paid defense. The “prevention doctrine” simply means, in this context, a contractor cannot use, as a defense to a payment claim, non-payment from an upstream party when that contractor itself has caused the reasons for the upstream party’s non-payment. In this context, the contractor has ‘prevented’ the payment condition precedent from occurring.   For example, in Connolly Construction Corp  v. Travelers Casualty & Surety[1], the following  provision: “if, and only if,… owner pays contractor …which is an express condition precedent to [contractor’s] duty to pay [subcontractor], progress payments shall be due to [subcontractor]” was held to be a valid ‘pay if paid’ “condition precedent” to the Contractor’s payment obligation.  However, this provision was not strong enough to overcome the “prevention doctrine” because the Contractor’s own project failures were the reason the owner refused to release the payment that would have triggered the Contractor’s obligation to pay the subcontractors.

This prevention doctrine issue is critical because many payment claims involve disputes over the reasons, or cause, of non-payment.  Therefore, contractors and sureties, who previously believed they had a solid defense to any payment claims may now find themselves litigating this payment issue. 

Consideration, therefore, should be given to using “condition precedent” language that shows the parties unequivocally intended to shift all the risk of non-payment for any reason, which, in essence, would neutralize the prevention doctrine where legally permissible.   For example, language such as “Subcontractor agrees that Contractor shall never be obligated to pay Subcontractor under any circumstances, …including those caused by the Contractor, until the Contractor has received payment for subcontractor’s work from the Owner” may show the contractual parties intended to completely and fully shift all risk of non-payment downstream.   In Fixture Specialist v. Global Construction[2], the Court considered substantially similar language.  The Court recognized the parties had the freedom to contract and chose to use this “all encompassing” provision to shift the risk of “any and all circumstances of owner non-payment” to the subcontractor. Id.  Fixture Specialist is an important decision because it also upheld the Surety’s use of this provision as a defense, even against arguments that such a harsh payment provision violated New Jersey’s public policy. The use of this language should be evaluated from both a business and a legal perspective with legal counsel.

In closing, ‘pay-if-paid’ provisions can be an effective risk mitigation tool.  However, as a growing number of states contemplate proscribing their use, contractors and sureties should regularly evaluate the strength of their contractual payment language.  These payment provisions should be adjusted accordingly, with the advice of counsel, to avoid lengthy and expensive disputes over whether or not payment is due.

[1] Connolly Construction Corp. v. Travelers Casualty & Surety, 2018 WL 3549281 (July 24, 2018)

[2] Fixture Specialists, Inc. v. Global Const., LLC, No. 07-CV-5614, 2009 WL 904031,  (D.N.J. Mar. 30, 2009) ).