Cash-flow from lender to owner to construction manager to subcontractors is the lifeblood of any construction project. And maintaining a sufficient flow of funds is essential to every construction manager’s ability to manage the job. Contract provisions requiring a contractor or subcontractor to continue to work, even if the right to payment is disputed, mean little to the fate of the project if subcontractors cannot meet payroll.

As a consequence, who will bear the risk of non-payment has becomes a frequent negotiation point, particularly so during periods of economic uncertainty. Imagine that two sophisticated corporations spend thousands of dollars and hundreds of hours of the best legal talent available to negotiate a contract for the construction of a large project to be located in the United States. The negotiations are lengthy and contentious; they are the very definition of ‘arms-length’.

As with all negotiations, the give and take often involves an adjustment to the contract price in exchange for amendment of a certain risk allocation or other material term. At the end of the long process a final deal is struck and the contract is executed. Imagine further that as part of the negotiations, the contract price was increased in exchange for a “pay-if-paid” clause, i.e., a clause that says the construction manager has no obligation to pay the subcontractor for work, unless the owner first pays the construction manager for that work. Under these circumstances, where there is no reason to question the validity of the contract, it would be natural under general principles of U.S. contract law, where “freedom of contract” supposedly reigns, to expect that all of these contract provisions would be enforced as written.

But the aforementioned negotiations involved a third-party. A party that was silent during all of the negotiations, but who gets the final say regarding every provision she wants to influence: public policy. And in some states, public policy will invalidate a provision to share the risk of non-payment through a ‘pay-if-paid’ clause.

In New York, for example, the Court of Appeals (New York’s highest court) has held that a “provision which forces the subcontractor to assume the risk that the owner will fail to pay the general contractor is void and unenforceable as contrary to public policy.” West-Fair Electric Contr. v. AETNA, 87 N.Y.2d 148 (1995). The basis of the Court of Appeals decision was New York State’s mechanics’ lien law, which provides that subcontractors have the right to file a lien against real property to which they have contributed manpower or material to improve. Because a pay-if-paid clause threatened that right, such clauses were found to be contrary to public policy. So much for freedom of contract!

By Jeffrey Gans

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