Contract Formation and the Impact of Contingent Payment Provisions

By DuPont, Michael J.; Hennessey, William M. | Business Credit, March 2002 | Go to article overview

Contract Formation and the Impact of Contingent Payment Provisions


DuPont, Michael J., Hennessey, William M., Business Credit


Introduction

The construction industry is filled with both performance and payment risks. There are a number of reasons why an owner, construction manager, general contractor or subcontractor refuses to make payment to the party with whom it has a contract. The reasons range from insolvency of the party responsible for payment to the non-performance of any party on the project. Construction managers, general contractors and subcontractors commonly use conditional payment clauses to shift the financial risk, and sometimes performance risk, of a project to lower-- tier subcontractors and suppliers.

By accepting a contingent payment provision, a lower-tier contractor or supplier ("Supplier") assumes increased risk that third parties will fail to meet their financial or performance obligations on the project. Consequently, a Supplier must broaden the scope of its credit analysis from a focus on its customer and statutory lien and bond protection to an analysis that includes an assessment of the viability of the players and the project.

Contingent payment provisions are commonly referred to as "pay-if-paid" or "pay-when-paid" provisions. Historically, the courts have interpreted pay-if-paid clauses as being pay-when-- paid clauses. In other words, contingent payment provisions have been treated as mere timing provisions and not as an absolute bar to a Supplier's claim against its customer. More recently, however, the courts have shifted their focus to concentrate on the intention of the parties. Courts now seem inclined to strictly enforce contingent payment clauses if the contract language clearly shows the parties' intention to transfer the risk of insolvency.

Contingent payment clauses may be present at any level of the contract chain. The language used by contractors to shift the risk is varied. Therefore, it is critical to review each contract to determine if it contains a contingent payment clause.

Statutory and Judicial Interpretation

Advising a Supplier of the implications of contingent payment provisions is difficult. In the absence of a statute addressing the enforceability of contingent payment provisions, there is no uniform rule on the enforceability of such clauses. In fact, treatment of contingent payment provisions by the courts varies from state to state. There are even jurisdictions where the courts have rendered inconsistent opinions. However, courts tend to categorize contingent payment provisions as one of the following: (1) a condition precedent to payment, (2) a timing provision or (3) void and unenforceable as against public policy.

Some state courts have given clear direction on the enforceability of contingent payment clauses. For instance, both California and New York courts clearly hold that contingent payment clauses are void as against public policy and, consequently, refuse to enforce the provisions.i Other states are not as clearly hostile to contingent payment clauses.ii

The majority rule evolving from the more recent cases is that a contingent payment provision will be treated as a timing provision rather than a complete defense to a Supplier's claim for payment, unless the contract language clearly indicates the parties' intention to shift risk of nonpayment to the Supplier. To safely operate in the majority of states, a Supplier must closely review the applicable contract language to determine if it falls within the "clear intent" exception to the majority rule.

The law governing this issue is in a constant state of change. A few states have gone so far as to enact statutes addressing the enforceability of contingent payment clauses. Some declare such provisions void as against public policy.iii Others permit a general contractor or subcontractor to rely on contingent payment provisions as a defense to a Supplier's claim, but expressly protect the Supplier's right to file a statutory mechanic's lien or payment bond claim. …

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