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Are Pay-if-Paid Clauses Really Enforceable?

by: Stormy Mayfield
Stormy Mayfield
Stormy Mayfield
Contingent payment clauses exist in many Texas construction contracts. In 2009, the Legislature passed a bill that has become Chapter 56 of the Texas Business Commerce Code. That bill settled a long-running debate about the enforceability of “Contingent Payment” clauses. The bill was crafted through a grueling eight-session mediated dialogue where titans of the industry met with the sole intention of striking a rare middle ground that would assuage concerns of enforceability.

Contractors and subcontractors/suppliers worried about the unsettled judicial appellate landscape concerning contingent payment clauses. Contractors worried that the Texas Supreme Court would strike contingent payment clauses, following precedent in other states. Subcontractors and suppliers worried that the Texas Supreme Court would apply a “freedom of contract” theory to enforce pay-if-paid language.

The negotiators determined their own statutory compromise. crafted Chapter 56 appropriately titled, “Agreement for Payment of Construction Subcontractor”. Chapter 56 expressly makes contingent payment clauses enforceable. But only when the general contractor fulfills two additional conditions.

I should note that the clause is not available to every kind of construction contract. Section 56.002 identifies types of contracts which are not covered under the Chapter, which includes some maintenance contracts and some residential contracts.

And the statute only applies to pay-if-paid clauses. Pay-when-paid clauses (concerning not if, but when, payment will be made) remain untouched. They don’t absolve a general contractor’s obligation to pay the subcontractor if the owner refuses or is otherwise unable to meet its payment obligations to the contractor. Though what constitutes a “reasonable time” is not clearly defined, parties can typically determine reasonableness by anywhere from 30 to 90 days. The pay-when-paid clauses are not addressed in Chapter 56 of the Texas Business Commerce Code, due in large part to their straight-forward application and low risk to all parties.

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The enforceability of the pay-if-paid clause is not without complexity. The statute presents nuances that require special attention. Considering the general contractor can use this clause as a shield, the negotiated hurdles to securing enforceability are significant. For our purposes we’ll simplify them and point out two significant conditions that a general contractor must meet for enforceability of the contingent pay statute.

The first is that the general contractor must have provided the subcontractor with the information necessary to determine the economic viability of the owner through providing financial and funding information for the contract. The chapter requires this information be provided before the contract is signed. The statute specifies what information must be obtained from the owner and provided to the subcontractor – for both public and private projects. And it requires the owner to provide it.

Public work contractors have a shorter shopping list. If the public project is governed by Chapter 2253 of the Government Code, they have to obtain and pass down (1) the name, address, and primary business telephone number of the primary obligor; (2) the name and address of the surety on the payment bond provided to the primary obligor to which any notice of claim should be sent; and (3) a statement from the primary obligor that funds are available and have been authorized for the full contract amount for the construction of the improvements. If the public contract is governed by 40 U.S.C. Section 3131, they have to obtain and pass down the same information contained in (1) and (2), but instead of the statement from the primary obligor, the contractor must simply provide the name of the contracting officer if known.

Private work contractors will have to obtain more information. The statute specifies that they have to collect and share (1) name, address and business telephone of the primary obligor; (2) a description, legally sufficient for identification, of the property on which the improvements are being constructed; (3) the name and address of the surety on any payment bond provided under Subchapter I, Chapter 53, Property Code, to which any notice of claim should be sent; (4) if a loan has been obtained for the construction of improvements: (A) a statement, furnished by the primary obligor and supported by reasonable and credible evidence from all applicable lenders, of the amount of the loan; (B) a summary of the terms of the loan; (C) a statement of whether there is foreseeable default of the primary obligor; and (D) the name, address, and business telephone number of the borrowers and lenders; and (5) a statement, furnished by the primary obligor and supported by reasonable and credible evidence from all applicable banks or other depository institutions, of the amount, source, and location of funds available to pay the balance of the contract amount If there is no loan or the loan is not sufficient to pay for all of the construction of the improvements.

The second condition is that the general contractor must attempt to collect the funds owed before seeking protection under the clause. But the statute doesn’t specify the level of effort required.

Failure to meet these two requirements can make the pay-if-paid clause unenforceable, which could then obligate a general contractor to make the downstream subcontractors whole. Other potential pitfalls of a contract’s contingent payment clause may be the existence of a sham relationship with the owner, unconscionability concerns, or a subcontractor’s written rejection of the clause for future work.

Another important provision of the statute allows a subcontractor to protest the pay-if-paid clause’s enforceability. Basically, a subcontractor who faced with non-payment due to owner non-payment and the contingent payment clause can send a written notice to the contractor objecting to the further enforcement of the pay-if-paid clause. Timing is everything – the notice cannot be sent until at least 45 days after the subcontractor sends an invoice to the contractor that is unpaid. This notice bars further enforcement of the pay-if-paid clause unless one of two things happens. First, the contractor sends notice to the subcontractor within a specified time that the subcontractor’s notice is ineffective. And there’s a very short period or that contractor communication. Second, the pay-if-paid clause is reinstated if the subcontractor receives the payment giving rise to the subcontractor’s notice.

Chapter 56 may be like all compromises – it may not fully satisfy either side. But contingent payment clauses are commonplace in today’s construction contracts. They can protect parties, insulating them from a volatile market. In order to fully avail yourself of the benefits of these provisions, you must have a full appraisal and understanding of the ins and outs of these provisions.

Stormy Mayfield is an accomplished attorney at Peckar & Abramson, P.C., specializing in complex litigation, resolving disputes in commercial and residential construction, contract claims, employment issues, and more. She takes a proactive approach by assisting clients in contract drafting, corporate governance, and compliance to mitigate litigation risks. Her prior experience includes handling administrative protests in various government bodies.

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