ConstructionPro Week, Volume: Construction Advisor Today - Issue: 45 - 03/03/2010

Should Subcontractors Share the Risk of Owner Nonpayment?

Is it fair for subcontractors to bear the risk of owner nonpayment for their work? Many prime contractors would argue that it is. The subcontractor is being asked to share the risk. If the project owner hasn’t paid the prime for the sub’s work, why should the prime be required to pay the sub, in effect financing the owner’s project?

 

Subcontractors would respond that the prime contractor elected to do business with the project owner and had the opportunity to evaluate the credit-worthiness of the owner. The sub contracted only with the prime and should be paid by the prime for work performed. The subcontractor has no control over the business relationship between the project owner and the prime contractor.

 

Some states have limited, by statute or case law, the enforceability of subcontract pay-if-paid clauses. But in the majority of jurisdictions, the clauses are enforceable if clearly and unambiguously worded. A recent federal appellate decision, applying Virginia law, illustrated how difficult it can be to avoid the effect of these clauses.


I invite your opinion on this topic. Is it reasonable for prime contractors to expect their subcontractors to share the risk of project owner nonpayment?

Featured in next week's Construction Claims Advisor:

  • Contractor Denied Compensation for Storm Impact on Labor and Materials
  • Subcontracting Did Not Lead to Insurance Exclusion
  • Owner Could Sue Architect Only Under Contract

 

Comments


The problem as I see it is that ALL subcontractors are NOT created equal. Subs in the early phases of construction are more likely to be paid to avoid liens or construction delays than are subs involved at the end stages of a project. This varying status makes a united front difficult to establish regarding payment.

 

The creditworthiness of the owner and the contractor should be demonstrated on a standard form that the AIA or other organization creates (in conjunction with owner, lender, contractor, subcontractor and supplier representatives) that balances the needs of disclosure and privacy. This disclosure would then be available to the subcontractors and suppliers. The risk of non-payment can then be negotiated between the contractor and subcontractors and suppliers. Of course, this issue begs the question of whether pay-when-paid should be legally enforceable. That will require legislation, it seems to me, after all the constituent groups chime in.

 

It seems like an unfair practice, but drill down a few levels and it is more equitable than it appears. First, a sub has the same obligation to decide whether or not they want to do business with a GC based on reputation or capabilities fro the subject project. Suns shouldn't be a protected class of business people. So - it goes both ways. Second, it should be noted that why the owner doesnt pay the GC is very important. If it is a simply "no pay due to no money" that's a bad deal all the way around and the GC is out his own cash as well. The two should be members of a team the whole way through and the GC should NOT be burdened with an outsized risk for the reward. How would the sub get the work without the GC conduit anyway? Third, if the issue is simply a dispute over work and an equitable settlement made off the top of funds owed - GC's may try to "share the pain" across the entire project team. That's an economic decision for the sub and GC to attempt or agree to with alternate outcomes based on the relationship and facts. Lastly, if an owner direct work under the contract, the sub should suffer the same fate as the GC so long as the GC properly administered the general contractor should a non-payment occur. Good GC's are clear about these risks up front in their documentation. Simply put - at a 5-10% gross profit on the whole project while managing subs that sometimes disappear or fail for their own reasons, the GC model doesnt work without laying off the risk proportionate to the trades involved. That is not to say that subs or GC's havent made mistakes or errors in judgement in all of this. But there should be an overriding statute - and when there isnt - you have a clear subcontract that spells out how the rules of the game as played by that GC. If the sub doesnt agree he can walk up front. If the sub agrees and gambles that nothing harmful will come about (as did the GC), then is goes bad on both of them. Unless there is fraud, it's just business.

 

I strongly agree with the above comment. We are a landscape contractor and are usually the last sub or one of the last subs on site. We regularly deal with paid when paid issues in trying to collect our monies.

 

I am a precast subcontractor that often is some 40% of a total job cost. We see a lot of pay-if-paid clauses and the issue then is reviewing the credit of the owner. I find that most GCs do not want me to discuss credit with the owner and if we are able to the owner does not understand the issue. Second to that the owner has positioned an LLC to reduce libility so "on paper" the owner has just the minimum in assets to obtain a bank loan. To me having the owners credit available via the GC is the real difficult part.

 

Yes, the sub should be paid by the person they are contracted with regardless of other issues between other parties. If you go to a grocery store will they let you skip paying if you haven't gotten your paycheck yet? If the GC wants the subs to help bear the risk then the GC also needs to share the profits with the subs which is usually not the case.

 

As a small subcontractor I would find it onerous to to have a GC fail to pay for work contracted even while acting as agent for a owner who failed to honor the contract. I would not hesitate to place a lien or notice of contract if after starting the job there seemed the chance of default. 
The two responses above that seemed to think that it was OK were of course GC's. The negative were sub's,the line of demarcation seems fairly clear. If some one make a promises they should keep it.
I know that is out of fashion these days .

 


In Maryland the effectiveness of the pay-if-paid clause is limited. For example, this defense has no effect in mechanis'lien claims, or in payment bond claims against a surety. I wrote an article on this subject, entitled "Effect of Pay-If-Paid Clauses Has Been Eroded in Maryland," which can be accessed at www.constructionlaw.com

 

We are a custom millwork fabricator. Typically one of the last trades in but we are unique in that we are typically treated like a site trade that has material delivered to site and it is assembled there. Our product is manufactured in a plant and delivered to the site for installation - not unlike furnishings and fixutres - but 95% custom. Its a tough spot for us as our material and labor expense is 80-85% offiste often and well in advance (months) of billing and payment (reimbursement) of expenses. FF&E is paid upon deliver and/or within a specified term and willnot abide by a "paid when paid" structure. There is often no room to negotiate this clause nor is consideration provided for supplier/manufacturing subs under the GCs contract. Tough spot but one has to be super aggressive about negotiatoin,collections and willing to take the risk. Mitigate it by being selective about your clients and strengthen the "team" relationship so you can avoid surprises. The reality of business, particularly in today's climate.

 

Progress payments, progress payments, progress payments! As a sub one has to create a method to ensure one gets paid for the work performed. And that has to be in the contract. And we should have the guts to stop work if the previous invoice has not been paid in the appropriate timeframe set out in the contract. Typically if this is all agreed to ahead of time, and MONITORED, the GC and owner see that you're serious, and there is no problems. This means that the sub's PM has to give forewarning when payments are slow and not hesitate to have documented conversations with the GC. When there is a Pay when paid clause, there should also be a method of sign off, ie the owner should be monitoring that all subs have been paid prior to releasing the next payment to the GC. The sub may still be out if the owner (or the GC) goes bankrupt, but by a lesser amount. It's a risk we take - I hate the clause, but what can you do. I can also see the GC's point of view, that if the owner is slow in making payments, it can cause serious cash flow problems if they have to pay the sub, especially for big-ticket items.

 

If a subcontractor enters the relationship (project) with full knowledge of the "pay when paid" provision, then it is fair and should be enforceable. A good subcontractor should insist on a written contract and should carefully review, involving an attorney if needed to fully understand the implications of the contract. Our contract specifically ties the subcontractor to all provisions of the owner contract. Copies of the owner contract are provided to subs upon request. Full disclosure is the key in my opinion.

 

This is definitely a tuff question to answer and will take litigation to be decided. I have been in the construction industry for years and feel strongly that if the GC does not get paid because of financial difficulties of the owner then the burden of payment to the sub should not fall on the GC. Provided there is a paid when paid clause. Progress payments or monthly draws are the best way to monitor and in many cases contractors continue to work even though payment is late and or not made at all. On a 14 million dollar project non payment by the owner not only puts the GC at risk for maybe 5% but also the subs. I am involved in a case right now where there were promises for payment made by the owner via refinance and the GC and subs continued to work. As the refi didn’t take place the owner left the GC with a 4 million dollar balance owed to subs of which several hundred thousand were owed to the GC. The owner got the benefit for the work so why should the GC be on the hook. With risk there is reward it should be shared. It’s all about risk management if you don’t like the paid when paid then don’t sign the contract find different work. If you sign it then you should be bound.

 

The "pay when paid" provision is reasonable and enforceable. The subcontractor has much more leverage under the lien law than does the GC in many occasions to ensure payment, assuming performance under the contract is maintained. A good lien law results is a balance of any risks associated with the "pay when paid" clause. Notice of Commencements filing by the Owner is verification of funding and who can be liable if the exact steps of proper payment under the lien law are not followed. GC's should be diligent in their duties to provide necessary data for a subcontractor to mitigate risks of non payment by the funding source. Subs have the same opportunity under the Notice of Commencement to investigate any party and or its financial position.

 

In my direct experience, having a sub discuss anything with my client is tortious interference. A contract between A & B does not impact on a contract between B and C. For me, I create and require performance approval clauses for payments to my subs and even with that, the actuality of enforcement versus interpersonal calamity, guns and threats in this business of ours often outweighs any legal direction for resolution.

 

In the past two years, I have had subs arrested, my life threatened, incredible job site theft and vandalism and often have become the brunt of frustration for prior shortfalls with other GCs or owner's reps.

Finally, when a client doesn't pay for whatever reason and coupled with that has fraudulantly insured or undewr-insured the project, everyone loses. We all know the GC or owner's rep often is asecondary funding source for these "LLCs" created with too little knowledge and way too much greed and imagination. There is no definitive IRS or national rulings for LLCs and I also write contracts with owners individually only and with the LLC as an "aka" to insure there is a well from which to draw the water "just in case..."

This being said, there are some terrific clients and some awesome subs but these are the exceptions in my past few years' experience.

It's interesting that while primes seldom hesitate to stiff subs if they are themselves stiffed by the owner, those very same primes also rarely share bonuses with their subs even though the performance the prime is being bonused for may very well be due to the performance of the sub. No, the prime hired the sub and the sub performed the job he was hired for and should be paid regardless of whether or not the prime got paid. Put another way, my employees are owed their paycheck whether my clients pay or not.

 

Subs should never agree to a pay when paid clause.If GCs want to have such control over the work, they should do the work in house and not pass the risk to a sub who should have NO business relationship with the owner.The sub has a relationship with the GC similar to a supplier...he provides a product which just happens to be thought of differently than materials. Do all these GCs not pay their employees if things go bad in payments? sub-consultants have the same problem with primes who want all of the reward and want you to take the un-known risks when they control the shots.

 

I think the Gc's today need to stop being so scared of the Owners and Architects. Gc's need to tell owners "if you want us to do the job and this good price as the low bidder than we are to be paid in 10 days. I dont understand why the GC's let the owners get away with so much stuff. Either owners have the project funded or they dont. If they have the money then progress checks should be able to be cut immediately, so the money can get to the subs and suppliers. There are so many out of state GC's and owners that do multi state work and they dont care about not paying the subs and suppliers. But us as sub's have to work with these suppliers all the time or we are out of business if we cant buy stuff from them so we have to make sure our suppliers get paid. 
Also as the first sub on the job for sitework and excavation we have to wait longer than anybody for our retainage so there really needs to be legislation in MD that the owners cannot under any circumstances get the U&O and open the place up without ALL subs and major suppliers being paid first. They are too much in a hurry these days to get the job done and then open and not in a hurry enough to pay people. Meanwhile the subs are left to argue with the GC or GC and owner for months about final payments, change orders,a nd retention. The GC's i see are too scared to tell the owner like it is, and they dont care enough about the subs to help them, 99% of the subs are small businesses with small offices and most of us are just one bad GC away from being out of business. Meaning that if a GC gets you for alot of money then you are done.

 

All good points, but the GC's "fee" usually represents only 3%-7% profit. Tipically, the construction costs are 80%-85% subs...do the math.

 

As a GC, I agree that a "pay when paid" agreement with my sub's is only fair. In a "perfect" world, I can guarentee my clients "credit". But tell me, when do those conditions arise. I work with the same sub's alway's, I do not shop there bid's. We are a "team" and as a team, we play fair, and share the risk.

 

I am an electrical sub-contractor. So long as you build your schedule of value correctly, order your materials at the start of the job and bill for stored materials you should never be upside down. It is reasonable for the subs to share the risk and we do share in the reward. I do think Frank makes one good point. GC's should work more closely with thier subs so that more of the risk is back on the owners and architects.

 

I do have one situation where a GC signed a change order with out the owners knowledge. Then the owner refused to pay and the GC went back to he paid when paid. Is that enforcable?

As a GC it would be a big red flag to me if a sub started complaining about a pay when paid clause.

 

This usually means that their company has serious cash flow problems and should not be bidding work of this magnitude. If they choose not to sign the contract because of the boiler plate pay when paid clause, then I would contract it the next lowest bidder and blacklist the contractor who refused to sign the contract.

Frank's comment is the most logical of them all. GC's are not financially capable of taking this risk all on their own.

 

In response to the subs comments above, look at it this way:
*If you were able to sign the contract with the owner directly, would you? (If you answer yes, you still run the same risk of non-payment as with a GC!)
*If you are able to make more money on the job than your original estimate, do you give money back to the GC? (My guess would be no.)
*Why do we GC's have to deal with so many mechanic's liens from your vendors even though we have paid you? (Could it be that you don't treat your subs/vendors as you say you should be treated?)
*Why do you keep bidding to the GC's who treat you badly?
*Risk of payment by an owner is something we all must evaluate on our own. As was said above, if you don't like the structure of the deal...walk away.

If I do the work, I should be paid promptly. The prime's relationship and issues with the end customer is not my concern or problem.

 

Progress payments typically are 30 to 45 days after some portion of the work is already in-place. Therefore, the GC and Subs are both at risk for the on-going work being installed during this duration.

 

The GC often has to deal not only with the Owner but also the Architect and the Bank, whereas the subs are happy to not be involved with the bank. The Owner, Bank and Architect also have rights to comment on the progress portion of the work being completed. In a perfect world subs would not over-bill and Architects would not typically deny percentage complete. But it happens. A smart GC wants the bank to be involved- so they know the funds are committed to the project; then the issue is to minimize the change orders- to avoid exceeding the funds allotted. 
The GC will typically work with key subs and keep them happy, whereas the GC will be far more careful with a sub that seems to overbill or invoice for goods that have been produced off-site and are not yet installed in the buildings. This is not playing favorites- but knowing the risk involved and making logical decisions- when the payments are not being made as promised.

Another key consideration in stopping work or continuing- at risk- is the safety and integrity of the building. It is very unwise to simply stop a project- without thought to liability while the project is in limbo. Therefore, a GC may need to proceed to at least minimize the risk to all parties (in case of some safety or structural stability issue).

The issue of pay when paid is not a simple black and white issue. The input of the Architect, Owner and Financial Institution, versus risk of liens and stop notices, also have to be kept in balance.

I've been on the end of paid when paid and non-payment. Even so that checks are bounced by homeowners. Dealing with the homeowner is a very contractual relationship, no matter what stage or who you are. I find if a sub, after supplying the endless bookwork to get the job, has to go to the property owner for payment would only raise costs. The GC makes money on his financial skills, so would the GC want to see a decrease in income due to clauses protecting him if non-payment is an issue? I know I would not. The potential for a massive delay is possible, and with more players in the game the resolution means more time.

 

I would like to keep my relationships of quality GCs, while striving to keep my costs minimal for the GCs. No homeowner will get the price negotiated from a sub-contractor like a GC would get.

I have three observations in response to the comments.
There is no question that trades who perform in the latter stages of a project are at greater risk from a pay-if-paid clause.
Disclosure of owner creditworthiness to subcontractors would be ideal, but is unlikely to become the norm.
The interrelationship between pay-if-paid clauses and subcontractor lien rights is an interesting one. In some jurisdictions, these clauses cannot be used to negate lien rights. But in many states, if there is no payment right under the subcontract, there can be no mechanic's lien.

 

no sub should have to accept a "pay when paid" clause. If general contractors had any integrity left at all, we subs wouldn't have to argue about it because they wouldn't exist. if the GC is unable to guarantee payment he has no business contracting with the sub in the first place. I have seen this 'ripoff' clause misused many times. subs should say, "we will accept your 'pay when paid' clause, but its only good for 90 days and oh, by the way, that's going to cost you an additional 15% on the contract." I bet that clause would disappear pretty darn quick then. Subs need to unite and put the pukes out of business that will say they question the financial stability of a sub that has a problem with that clause. Don't let the GC talk down to you! He is the one admitting he isn't sure he can pay his bill! You are just being responsible to your employees and your families by refusing to sign a contract that says you may not get paid. All you GC's that think your subs should be your backup plan to save you when you mismanage a job and the owner doesn't pay you- go ahead and go out of business! we don't need you around. And to the arrogance that asks how would subs exist without the GC 'conduit'? -- oh please!! get rid of the GC and the sub will do just fine! there are hundreds of reasons the owner may not pay the general contractor. most of them have to do with the GC's performance. why should we subs guarantee the performance of those we do not control. generals should place their efforts in securing the construction funds in a force account to guarantee their subs payment instead of wasting time trying to get a subcontractor to sign an immoral contract.

 

As a specialty contractor in the security sector, we are also one of the last on site when working as a sub. All my proposals clearly state, this agreement is between my company and the company/individual hiring us and nothing will hold up payment once our SOW is complete. So far this has kept us paid. However, many times we act as the prime and have to bring on subs. In every case, I have always paid every subs invoice in full once work is complete regardless if I have been paid or not. Why, because I treat people the way I want to be treated. Some call this the Golden Rule.

 

I've been in the millwork industry over thirty years and I think I've seen and heard it all. If I could go back and make a different career choice I would, because construction, although a noble profession, is full of pitfalls - much more so than most businesses. We've had a lot of good experiences over the years, and a few really bad ones. The bad ones can kill a whole careeer, steal a lifetime of savings, and ruin a good business. We are still here, even through this economy, but my business has been stiffed for hundreds of thousands of dollars on single projects. We've hired lawyers who've changed their billing from a fee basis to a contingency due to the fact that they agreed, after getting into the meat and potatoes of our claim, that we were being taken advantage of and knew we could not afford the six figures of legal fees over the two and a half years it took to get the case into court. The contractor said it was about pay when paid, but it turned out that the contractor negotiated settlements and payouts with the bigger subs (mechanical, steel) and let the guys who could not afford to fight flap in the breeze. (this was addressed in a previous post by someone else) This sounds like sour grapes and it is, but the system of payment in the indstry is the problem. This GC took a project for 2/3 of the value, got all the money it was going to get from the owner, and didn't pay the subs who could not afford to fight. We were the only one to get them to the courthouse, thanks to principled attorneys. That's not speculation. I was told that personally by one of the superintendants at the courthouse. Now, that's one story about an incompetent, unscrupulous general contractor, but it's illustrative of the problem that subs face and there needs to be protection in the law from people who lie, cheat and steal. There is just about everywhere else, and having done some lobbying for this type of thing I've found that the GC lobby is much stronger than the sub's lobby. On the flip side, I have been an owner's rep and treated the payment process very seriously when approving contractor draws. The contractor received payment on or before the 10th of the month following billing, retainage amounts were reduced to 5% after completion and approval of the individual sub's work, and once proof of downstream payments was received all retainage was released to each sub individually during the progress of the project. Guess which project was fully manned, had excellent workmanship, no arguments or even heated discussions, and was ahead of schedule in a busy market. I used that opportunity to prove a point, and prove it I did.
Subs - know your customer, set your terms, and walk away if you don't get them. We learned this the hard way and we are slower today than we otherwise would be for doing just that, walking away from any project that will not schedule payments to our satisfaction. I've discussed this with my banker and he tells me that the less risk I take, even in a slow market, the better the board of directors at the bank views my business. By the way, for the project I went on about above, the court directed us to settle out of court. It seems that even though you have a case, you might not get to present it without a judge willing to invest the time to hear the evidence. The end result to my business was far less than satisfying, and a sub going up against a GC with deeper pockets has little chance of being treated fairly. My attorney called it "gaming the legal system for profit". Seller beware. I end this by saying thanks and kudos to all the contractors who treat their subs fairly. That does happen more often than not.

 

To say a Sub shouldn't sign a pay when paid contract is not realistic. Every contract we see has this clause, usually along with some really onerous liability, too. Anything but a direct contract with a homeowner or a very small business will have a PWP. 
Our only protection is to lein, Oh wait, the contract says we can't do that either. 

 

What all you GC's seem to forget is that you dont have any real our-of-pocket costs. What real costs do you have? maybe some rentals on forklifts or something, and then the onsite foreman time and expected profit? Big deal. You try getting tens of thousands of dollars in bills from your suppliers and then not get paid from the GC and see how you like it. Also most all vendors and suplliers want personal guarantees from the business owner to grant credit to the business. So why in the world should i put my family and home at risk because so many of all you GC's nowadays are scum. I've heard GC's who brag about how many people they put out of business.Being a sub in todays commercial construction market sucks, if i had any sense i would have gone to college and gotten a real job.
Another problem that happens way to much is the architects and engineers are terrible, they get worse by the year. What does an architect know about anything outside liek sitework, dirtwork or utilities? NOTHING, and they never involve the civil engineer for hiw own work. A & E's have way to much to say sometimes on the job and they have WAY to much input about GC's or subs payments and chaneg orders. "oh well you should have included that in the bid, the owner shouldnt have to pay for that" SOUND familiar? Oh sure, you as the A/E dont care about anybody else getting paid you got all your money up front already. Not only that you A/E drag for feet for months or years getting the proper plans and permits and when it finally gets to construction you put all of us under the gun because the owner wants it done NOW. To work in the commercial construction market today sucks. I like the actual work and what i do, but just trying to get paid and always be ont he defense against not getting screwed from the GC's gets old. It seems liek every price or change order or bid yo always want lower, or back up and justification about the cost. The prices are what they are, if i give you a good price for the bid, then change orders are a bit higher? well DUH! i have to make some money somewhere, and dont worry you will be diligence in your efforts to screw me later, make me do work thats not in contract, or hold my retainage for a year and hope i go away to make up for it, and by the way we bid the job over a year ago, prices have gone up and fuel costs have gone up, so get off my back about prices, you have no idea what the H*!! you are talking about.

 

One would assume we are talking about a GC At Risk...hence they have assume the position in the food chain.
As a design professional or tradesman, we have not enrolled to be a "at risk" participant...hence we can choice to not participate or we can be compensated appropriately with a appropriate contingency line item.
The GC "At Risk" is delivering a product as is Ford, GE, Lockheed, etc. I have not seen Ford, GE, Lockheed, etc. turn to their subcontractors/suppliers and tell them they will be paid when they get paid.
The GC "At Risk" should not expect the subs/suppliers to assume their risk and role.

 

I opine that to receive the business loans from creditors you must have a good motivation. However, once I've received a collateral loan, because I was willing to buy a bike.

 

 

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