Paid-When-Paid Provisions and Effects on Subcontractors

By: Timothy J. Broussard

Posted on October 3, 2016

When a subcontractor is not paid on a project, it usually comes at the worst time. There is payroll and suppliers to be paid. Yet, the builder has failed to pay the subcontractor because the owner is in dispute with the builder, particularly on extra work charges. Or, perhaps the owner has run into cash flow issues that affect timing of funding. The subcontractor should conduct careful investigation to identify and verify these problems with the builder and, if available, the owner's representatives. Sometimes, there are other reasons why there is no funding to the builder.

Before a subcontractor proceeds to protect itself, a review of its subcontract is important. A common clause in a subcontract agreement is called a "Paid-When-Paid" Provision.

Generally, a Paid-When-Paid Provision is designed to protect the builder and prevent an immediate obligation to pay its subcontractors prior to payment from the owner. This Paid-When-Paid Provision is often covered up in other languages in the subcontract agreement and could include the following payment language:

"Contractor will promptly remit to Subcontractor all funds received by Contractor from Owner in compensation for work performed by Subcontractor. Contractor is excused to make progress payments to Subcontractor during any period of time when owner withholds payment from Contractor because . . ."

As you can see from the above clause, it requires payment only upon owner's payment to the builder. The clause does not interfere with the subcontractor's rights to payment entirely and allows the subcontractor to protect its lien rights. When the clause relates to timing of payment as opposed to affecting the subcontractor's right to payment, the clause has a better chance of withstanding enforceability over time.

There are two primary cases that discuss the enforceability of Paid-When-Paid provisions. (See, W.M. Clark Corp. v Safeco Insurance Co. (1997) 15 Cal.4th 882 and Capitol Steel Fabricators, Inc. v. Mega Construction Co. (2010) 58 Cal.App.4th 1029.) California Supreme Court has found "Paid-If" provisions unenforceable and invalid. However, Paid-When-Paid provisions remain valid but arguably disfavored. Case law involving Paid-When-Paid provisions seek to determine if the clause interferes with a subcontractor's right to payment and its constitutional rights to protect its license.

There are five options that a subcontractor should consider when it comes to the above situation of non-payment and a Paid-When-Paid clause in its contract.

1. Preliminary Notice and Mechanic's Lien

A valid Paid-When-Paid Provision cannot interfere with a subcontractor's right to commence action to protect its lien rights or perfect its mechanic's lien rights. If there is language that impedes the subcontractor's right to file a mechanic's lien, it will be deemed invalid.

As a reminder, protection of a subcontractor's lien rights is important and might be the only avenue for a subcontractor to recover later. It is important for a subcontractor to make sure that it has timely served a preliminary notice of a lien within 20 days of commencement of work to all owners and lenders on the project. Failure to timely serve a preliminary lien could jeopardize a subcontractor's right to a mechanic's lien and/or enforceability of stop payment in the future.

A subcontractor must carefully document/record its dates of actual completion of work. The Paid-When-Paid provision would prevent a subcontractor's claim, at least initially, against the builder. A subcontractor's remedies, for early payment may be directly against the owner by way of perfecting its mechanic's liens.

2. Timing

The builder cannot withhold payment forever even when an owner fails to pay because of bankruptcy. The builder remains obligated to reimburse the subcontractor. The Paid-When-Paid Provision simply allows the builder "reasonable time" to resolve the payment issue. What remains unknown is what is "reasonable time."

It is clear that "reasonable time" has accrued when a builder actually receives payment from the owner. Rarely is this the circumstance. A builder could prevent payment until it exhausts its own legal remedies against the owner. A Paid-When-Paid Provision would allow the builder many months to prevent payment to a subcontractor while it tries to resolve its disputes with the owner. Complex construction matters could take years to resolve by way of arbitration or trial, leaving the subcontractor holding the bag.

3. Paid-When-Paid Provision is Unclear

When the Paid-When-Paid Provision is unclear as to whether it jeopardizes a subcontractor's right to payment, the courts will likely find in favor of the subcontractor. The Paid-When-Paid Provision only allows a delay of a reasonable time without the builder being subject to attorneys' fees, costs and violation of prompt payment statutes. The subcontractor is still permitted to file a lawsuit for foreclosure for mechanic's lien, and/or commence action for stop payment notice. Typically, the subcontractor is required to commence action before the reasonable time has elapsed for a builder to resolve its disputes with the owner. Again, this stresses the importance of timely serving preliminary liens and perfecting a subcontractor's mechanic's lien.

If the subcontractor prematurely files suit for breach of contract against the builder and a valid Paid-When-Paid Provision exists, the subcontractor could likewise be subject to breach of its own subcontract or agreement. This puts a subcontractor in a dilemma when the builder is seeking recovery against the owner. A subcontractor may need to perfect its mechanic's lien against the owner first to avoid any breach of contract. Typically, a builder becomes a party by way of the builder's own complaint for non-payment or cross-complaint by the owner on the subcontractor's mechanic's lien.

4. Attorneys' Fees

Typically, attorneys' fees can be recovered by statute or by contract. A careful review of the subcontract agreement will determine if a successful party can recover for its attorneys' fees. When the subcontract agreement has a Paid-When-Paid Provision, we often find the builder has excluded a successful party's ability to recover for attorneys' fees and costs. Although there are exceptions, the subcontractor might be unable to recover its attorneys' fees.

Likewise, a builder would also be unable to recover its attorneys' fees. However, the builder has often weighed these circumstances before and it typically works in its favor when a Paid-When-Paid Provision must be exercised in a subcontract agreement.

When an owner fails to pay a builder, the subcontractor's ability to recover for attorneys' fees by statute becomes remote with a Paid-When-Paid provision. One exception is the scenario when a builder willfully withholds payment or diverts funds that are specifically earmarked for a subcontractor's work. However, the chances of recovery for attorneys' fees are otherwise rare.

In contrast, if the contract has a binding arbitration provision, there are rules set forth in some arbitration guidelines that may allow for recovery for attorneys' fees even when the contract does not permit it. However, a careful review of the contract would be required to rule out any of these options.

5. Prevention of the Effects of Paid-When-Paid Clauses

A subcontractor should carefully avoid the above circumstances, including some of the following:

· Builder & Owner Reputation

A reputable builder who has a long history regarding payment is worth its weight in gold. Typically, we see the scenario where the subcontractor and builder have never worked together in the past.

Likewise, there are owners who equally have a good reputation in the construction industry. It does not resolve all circumstances but does protect the subcontractor from the scenario that we see often in construction. Even when disputes arise, both the builder and owner should work together constructively to resolve the issue.

A subcontractor that has never worked with a builder or owner might proceed with caution, particularly when it comes to change orders.

· Short Progress Payment Schedules

A short progress payment schedule allows both the builder and subcontractor to remain on time and on budget. Likewise, it also allows a subcontractor early notice of non-payment from the builder. If necessary, a subcontractor could exercise its right to stop work before substantial funds are unpaid.

· Prevailing Party Clause

When a party breaches a contract, it seems inherent that a prevailing party would incur unwanted attorneys' fees and costs. This clause increases the risk for both sides and cuts both ways if a subcontractor breaches its agreement. Typically, a builder attempts to reduce its exposure by eliminating the prevailing party clause. Requiring a prevailing party clause may encourage the builder to resolve quickly with the owner because of its own consequences.

· Direct Contractual Relation with Owner

Although rare, sometimes the builder permits extra work to be performed by the subcontractor directly with the owner. Direct contractual relationship with the owner could avoid some of the circumstances noted above. Even small extra work authorized directly by the owner could allow for the subcontractor to seek prompt payment penalties and recover for attorneys' fees against the owner directly. This also allows the subcontractor to receive direct payment from the owner when disputes arise. Regardless, signed charge orders are required to protect a subcontractor.

· Avoid Paid-When-Paid Provisions

The Paid-When-Paid Provision protects the builder and not the subcontractor. Avoiding this clause is best for the subcontractor in negotiating a better deal. In exchange, the subcontractor can negotiate better terms with the builder in exchange of this risk (e.g., more competitive pricing, shorter time frames for progress payments, etc.)

All of the above options do not avoid all problems by the subcontractor when it comes to lack of payment. There are many potential avenues a subcontractor must consider when a builder fails to pay and has disputes with payment with the owner. This situation becomes more complex when the subcontract or agreement has a Paid-When-Paid Provision.

Timothy J. Broussard is a Partner with Kring & Chung, LLP's Irvine, CA office. He can be reached at (949) 345-1621 or tbroussard@kringandchung.com.

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