Even Federal Contractors and Subcontractors Should Pay Heed to State Law on Conditional Payment Clauses

6 min

The Virginia legislature recently took a broad step toward limiting the use of certain common clauses in construction subcontracts. This new legislation, effective January 1, 2023, amends the state's Prompt Payment Act (Va. Code § 2.2-4354) and wage theft statute (Va. Code § 11-4.6) to effectively prohibit the use of clauses, found in most construction subcontracts, which make payment to subcontractors contingent upon the prime contractor's receipt of funds. These "pay-if-paid" and "pay-when-paid" clauses are often the subject of dispute between contractors across the country. However, is Virginia's expansive approach one that is being adopted by other states, as some commentators have suggested? Legislation across the nation is far from uniform, and while some states have taken an approach similar to Virginia's, others have decidedly refrained from doing so. Regardless, all parties to a prime-sub relationship should be aware of this patchwork landscape regarding "pay-if-paid" clauses and their enforceability state by state.

A pay-if-paid ("PIP") clause in a subcontract makes payment by the owner to the prime contractor a condition precedent to payment to any subcontractors in the agreement. Under PIP clauses, payment to subcontractors is triggered only if and after payment is received, in full, from a higher-tiered contractor. Essentially, if the prime contractor doesn't get paid, neither does the subcontractor. These PIP clauses can be disfavored by lawmaking bodies because they can shift the risk of nonpayment by the owner down the line to subcontractors, which are often smaller entities or even individuals who are less capable of bearing the brunt of the loss.

In contrast, pay-when-paid ("PWP") clauses establish timelines for a prime contractor's payment to any lower-tiered subcontractors after the prime contractor is paid.1 While both PIP and PWP clauses can delay payment to subcontractors, PWP clauses are generally not viewed as negatively as PIP clauses. This is because courts typically see PWP clauses as a timing tool rather than a risk-transfer device that allows prime contractors to bypass responsibility for payment.2 Courts in some jurisdictions may still void PWP clauses where they indefinitely delay payment to subcontractors, though overall the clauses are not viewed as unfavorably. PIP clauses, on the other hand, are often not regarded favorably, and courts may strike down a PIP clause if it is not clear from the contract's language that the parties intended to make payment by the owner a condition precedent. However, in some states, such as Virginia under its new statutes, even where the clause's language is clear, the PIP provision will not be enforceable.

Virginia Senate Bill 50 amended its prompt payment and wage theft statutes to contain the following provision:

Payment by the party contracting with the contractor shall not be a condition precedent to payment to any lower-tier subcontractor, regardless of that contractor receiving payment for amounts owed to that contractor. Any provision in a contract contrary to this section shall be unenforceable.3

By amending both its prompt payment and wage theft statutes, Virginia allowed the new provision to be applied to both private and public construction contracts in the Commonwealth, thereby prohibiting PIP clauses in both types of contracting relationships. However, Virginia's new legislation still leaves room for PWP clauses, requiring such PWP clauses to set a reasonable period not to exceed 60 days for payment to any subcontractors.

By amending its Code, Virginia joins several other states that prohibit PIP clauses, including California, Illinois, Massachusetts, North Carolina, New York, South Carolina, and Wisconsin. Most of these states have prohibited PIP clauses statutorily, though California and New York courts created the rule by striking down PIP clauses in contracts that were litigated.4 Additionally, while some states, such as Massachusetts and Virginia, prohibit PIP clauses through prompt payment statutes, not all states have approached the prohibition in this manner — Illinois prohibits PIP clauses through its Mechanic's Lien Act, and Wisconsin utilizes its construction lien laws. Even in the states that prohibit PIP clauses, the prohibitions or limitations are not the same for every contracting relationship. For example, Virginia's new legislation prohibits PIP clauses for both private and public construction contracts, while Massachusetts's legislation seemingly only prohibits PIP clauses in private contracts, leaving the applicability of PIP clauses in the state's public contracts unknown.5

Though some states have acted to prohibit PIP clauses, that is not the case across the country. The treatment of PIP clauses in legislatures and courts across the country is best described as a patchwork, with treatment of these clauses variable and dependent on specific state law. Some states, such as Nevada, acknowledge that PIP clauses are generally disfavored, but will enforce them.6 Some states enforce PIP clauses but have other statutory provisions that mitigate the negative effects of the clauses for subcontractors. For example, Maryland will enforce PIP clauses, but the state's Mechanic's Lien Statute provides that any provision that "conditions payment to the subcontractor on receipt by the contractor of payment from the owner" does not "waive the right of the subcontractor" to claim a mechanic's lien or to sue on a contractor's bond.7 Still other states, including Connecticut and Kentucky, are more unequivocal in their approach to PIP clauses and are more likely to abide by and enforce them.8 These discrepancies between states are notable and represent the jurisdiction-dependent nature of PIP clauses even under federal contracts where the prime may be subject to federal regulation and contract terms.

The treatment and enforceability of PIP clauses can have big impacts on the liability and exposure to risk of prime contractors and subcontractors alike. Thus, it is crucial for all parties to remain mindful of the varying laws and treatment of payment clauses under the applicable state law and thoughtfully contract with that law in mind. When contracting, including certain payment protections, such as "adequate assurances of the owner's financial arrangements to pay," may help protect prime contractors from exposure to liability in the event of nonpayment by the customer.9 Additionally, while some parties may choose to punt on setting out the applicable law to an agreement, including choice of law provisions within the contract may be advisable because it can create clarity on the enforceability of payment clauses and prevent prime and subcontractors from the uncertainty that might arise from a contract devoid of such terms.

[1] Craig L. McCloud, Pay-if-Paid vs. Pay-When-Paid Clauses, A.B.A. (Dec. 11, 2020), https://www.americanbar.org/groups/construction_industry/publications/under_construction/2020/winter2020/pay-if-paid-vs-pay-when-paid/.

[2] Michael C. Loulakis & Lauren P. McLaughlin, Are pay-if-paid clauses fair?, Am. Soc'y Civ. Eng'r (June 15, 2022), https://www.asce.org/publications-and-news/civil-engineering-source/civil-engineering-magazine/article/2022/06/are-pay-if-paid-clauses-fair.

[3] Act of April 27, 2022, ch. 727, 2022 Va. Acts (to be codified as amended at Va. Code Ann. §§ 2.2-4354, 11-4.6) (emphasis added).

[4] Wm. R. Clarke Corp. v. Safeco Ins. Co., 15 Cal. 4th 882, 886 (Cal. 1997); West-Fair Elec. Contrs. V. Aetna Cas. & Sur. Co., 87 N.Y.2d 148, 158 (N.Y. 1995).

[5] Compare Mass. Gen. Laws ch. 149, § 29E(e) to Mass. Gen. Laws ch. 30, §§ 39K–F.

[6] APCO Constr., Inc. v. Zitting Bros. Constr., Inc., 473 P.3d 1021, 1023 (Nev. 2020).

[7] Md. Code Ann., Real Property § 9-113(b).

[8] Elec. Contrs., Inc. v. 50 Morgan Hosp. Grp., LLC, 211 Conn. App. 724, 736 (Conn. App. Ct. 2022); Superior Steel, Inc. v. Ascent at Roebling's Bridge, LLC, No. 2015-SC-000204-DG, 2017 Ky. LEXIS 570, at *34 (Ky. Dec. 14, 2017).

[9] Amy Elizabeth Garber & Robert J. Symon, Virginia is for Lovers… of Strict Contract Language: New Law Prohibits Pay-if-Paid Clauses in Construction Contracts, Nat. L. Rev. (June 13, 2022), https://www.natlawreview.com/article/virginia-lovers-strict-contract-language-new-law-prohibits-pay-if-paid-clauses#:~:text=Virginia%20has%20joined%20the%20growing,)%20wage%20theft%20statute%20.