Pay When Paid, Limits and Limitations

By Adam Leitman Bailey and Dov Treiman
October 10, 2018

Adam Leitman Bailey and Dov Treiman discuss “Pay-if-Paid” clauses in construction contracts and write: “Like many jurisdictions across the United States, New York outlaws Pay-If-Paid clauses, but, in New York’s case, only indirectly.”


Construction projects entail financial risk—risks for the owners of the property, risks for the banks financing them, risks for the general contractor, subcontractors, even the construction workers. Naturally, all of these risk takers seek to push off the risk to someone else. Many of these push-offs the law allows; others are legally intolerable. Where the risk imperils the viability of the construction industry itself, one highly favored by all who seek “progress,” legislatures select whom they will protect. Across the United States, legislators have spent a century considering the particular form of protection known alternately as “pay if paid” and “pay when paid.”

Pay-If-Paid Defined

The idea behind “Pay-If-Paid” is that a general contractor will often wish to lower its financial risk by entering into deals with its subcontractors under which the subcontractor is only paid if, as, and when the general contractor receives payment. Such a provision greatly reduces the up-front expenditures of the general contractor and generally forces the subcontractor to advance funds to its employees for which it has not yet received any reimbursement. If there is no such advance to the workers (of whom some may well be self-employed), then the risk of nonpayment is fully shifted to those least likely able to afford nonpayment, the actual manual laborers.

A moment’s thought about the “pay-when-paid” variation leads to the conclusion that if the “when” is “never” then the payment never occurs which means that under those circumstances, “pay-when-paid” boils down to “pay-if-paid.” Thus, many courts and practitioners use the phrases interchangeably (Welsbach Electric Corp. v. Mastec North America, Inc., 7 N.Y.3d 624, 859 N.E.2d 498, 825 N.Y.S.2d 692 (2006), footnote 2).

Illegality of Pay-If-Paid

Like many jurisdictions across the United States, New York outlaws Pay-If-Paid clauses, but, in New York’s case, only indirectly.

Generally speaking, prohibitions on contractual clauses in New York reside in Article 5 of the General Obligations Law. However, the cases questioning the enforceability of Pay-If-Paid clauses do not point to any provision of the General Obligations Law, but rather to the Lien Law, even though in nearly none of those cases has anyone filed a lien. Rather, the cases construe the right to collect on the debt and whether the debt has actually arisen, which thus would hypothetically impact the right to file a lien.

The core concept in these cases is the so-called “mechanic’s lien,” taking its name from an obsolete meaning of the word “mechanic”, being “one who is employed in a manual occupation; a handicraftsman.” (Oxford English Dictionary, Oxford University Press, 1971.) These are governed by Article 2 of New York’s Lien Law. Specifically, Lien Law §3 states, “A contractor, subcontractor, laborer, materialman… who performs labor or furnishes materials for the improvement of real property with the consent or at the request of the owner thereof… shall have a lien for the principal and interest, of the value, or the agreed price, of such labor…” The law of these liens, first enacted in New York in 1830,[1] has evolved through the years to increase the protections accorded to these “mechanics.”

Lien Law §34, a later development, makes contracts to waive the ability to assert the lien unenforceable, stating, “Notwithstanding the provisions of any other law, any contract, agreement or understanding whereby the right to file or enforce any lien created under article two is waived,[2] shall be void as against public policy and wholly unenforceable.” It was based on this provision, as amended through the decades, that the Court of Appeals in West-Fair Elec. Contractors v. Aetna Cas. & Sur. Co., 87 N.Y.2d 148 (1995) ruled,

We hold that a pay-when-paid 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 set forth in the Lien Law §34. By contrast, a pay-when-paid provision which merely fixes a time for payment does not indefinitely suspend a subcontractor’s right to payment upon the failure of an owner to pay the general contractor, and does not violate public policy as stated in the Lien Law. (87 N.Y.2d at 158)

While the first sentence is the settled law of New York State, the second sentence of this holding has given rise to severe controversy, giving rise to the kinds of clouds on title these authors frequently encounter in their practice with a noticeable lack of clear cut answers.

In arriving at its conclusions, West-Fair expressly distinguished Schuler-Haas Elec. Co. v. Aetna Cas. & Sur. Co., 40 N.Y.2d 883 (1976), affirming 49 A.D.2d 60, 371 N.Y.S.2d 207 (4th Dept. 1975) in which the Court of Appeals had permitted enforceability of a pay-when-paid clause because the Appellate Division had found that the clause, in its factual context had only delayed payment and not made it contingent on the owner paying the general contractor.

The Appellate Division had pointed to a substantial body of law from sister states that found that such clauses only delayed the payment until a “reasonable time” after the general contractor became entitled to the payment and not made it contingent upon the general contractor’s actual receipt of payment. Yet, it is this very interpretation where the clause determines a “when” and not a “whether” that to this day potentially saves the clause. However, for such a savings to take place, the facts of the case have to support such a reading. That level of fact finding, however, is unlikely to be available in an ordinary title search.

Since the easy interpretation of the clarity of a property’s title is a vital component to the smooth transfer of real property, itself an important public policy fostering a number of legal rules, the policy in favor of supporting the construction trades finds a counterbalancing policy in favor of supporting the easy, safe, and reliable conveyance of interests in real property.

Choice of Law

We noted above that the protections accorded to “mechanics” have evolved since their first statutory enactment in 1830. That evolution has given rise to a split in analysis inside the Court of Appeals in which a crucial factor becomes not where the construction is taking place or where the contract is signed, but what the contract itself has to say about which jurisdiction’s laws shall govern it.

Normally, one would expect a clause in a contract that determines what body of law will govern the contract will select the body of law of the location where the contract is to be performed. Thus, normally, one would expect a construction contract in New York to be governed by New York law. However, in the business world, there are expectations about who is going to draft a contract. In real estate matters, certain traditions are clearly evident. Usually in transactional work, the seller drafts the sales contract, the landlord drafts the lease, the communications company drafts the cellular tower lease, and the general contractor drafts the construction contract.

Depending on how well heeled the other side is, they may have increasing or diminishing input into the contract, but these norms of authorship tend to persist. Naturally, the drafter proposes terms most greatly to the favor of the drafter, terms that the recipient of the draft may not recognize as having such a bias. The law compensates for this only limitedly in the doctrine that ambiguities in contracts are resolved against the drafter. “In cases of doubt or ambiguity, a contract must be construed most strongly against the party who prepared it, and favorably to a party who had no voice in the selection of its language.” Jacobson v. Sassower, 66 N.Y.2d 991, 489 N.E.2d 1283, 499 N.Y.S.2d 381 (1985).

However, where the contract is clear, the mere fact that it favors one side does not, standing by itself require a construction against that side. “Thus, if the agreement on its face is reasonably susceptible of only one meaning, a court is not free to alter the contract to reflect its personal notions of fairness and equity.” Greenfield v. Philles Records, 98 N.Y.2d 562, 569-570, 780 N.E.2d 166, 750 N.Y.S.2d 565 (2002); Welsbach Electric Corp. v. Mastec North America, Inc., 7 N.Y.3d 624, 859 N.E.2d 498, 825 N.Y.S.2d 692 (2006).

So, where there is a choice of law provision in a construction contract, setting that choice so as to favor the drafter, if there is a reasonable connection to the jurisdiction where the selected law originates, it will be sustained. That connection includes, for example, where the General Contractor is a Florida corporation. Welsbach Electric Corp. v. Mastec North America, Inc., 7 N.Y.3d 624, 859 N.E.2d 498, 825 N.Y.S.2d 692 (2006). However, even choice of law contracted by the parties must yield when the chosen law is at fundamental conflict with New York’s interpretation of public policy.

The mere fact that a New York statute outlaws certain behavior as “void as against public policy” is not sufficient to answer the question. New York courts will still examine whether the public policy in question is so “fundamental” that New York will adhere to its own position (where it is fundamental) or yield to the foreign jurisdiction’s position (when New York’s public policy is not fundamental).

In writing about Lien Law §34, the Court of Appeals in Welsbach Electric, supra at 627, quotes the principle, “Indeed, if New York statutes or court opinions were routinely read to express fundamental policy, choice of law principles would be meaningless,” while failing to note that Lien Law §34 unlike the great bulk of New York statutes specifically mentions public policy. Thus, sub silentio, the court is holding that such unusual mention in the statute is not part of the calculus as to whether the New York law is fundamental public policy. Finding because the lien law had evolved in New York over the course of a century, it was not fundamental New York public policy, the Court of Appeals sustained the application of the Florida law and allowed pay-if-paid under those circumstances.

In construing Welsbach, supra’s teaching on choice of law, in Madden v. Midland Funding, 237 F.Supp. 3d 130 (S.D.N.Y. 2017), the Federal District Court in a case involving a loan wrote, “In addressing that issue, courts have looked to the location of the following factors: the parties’ negotiation of the agreement; performance under the agreement, including where loan payments were received; the parties’ places of incorporation; the parties’ principal places of business; and the property that is the subject of the transaction.” In order to understand the impact of these factors, however, one must note that Welsbach found one of the factors referencing Florida. So clearly, one is enough.

When Pay-If-Paid Clauses Can Be Enforced

Leading up to West Fair, supra, there were several cases holding that clauses that merely delay the payment to the subcontractor are enforceable. West Fair did not seek to overrule those cases, but rather to distinguish them. Thus, in cases like Maines Paper & Food Service v. Losco Group, 36 A.D.3d 1047, 827 N.Y.S.2d 345 (3d Dept. 2007), courts continue to allow clauses that delay payment to a subcontractor until the landowner has approved the construction.

While not speaking to the subject, it would appear that the clause would remain unenforceable if the landowner’s nonpayment arises from insolvency or simply the decision not to honor the debt. Presumably, where the reason for the nonpayment is merely that the contractor has not obtained approval for the job and either there has been insufficient time to obtain such approval or the withheld approval is reasonable and requiring a cure, the general contractor can ultimately expect payment and therefore so can the subcontractors.

Title Issues

However, none of the above creates a title issue unless and until someone attempts to file a mechanic’s lien and the owner seeks to vacate it. While the nuance of the exact contract language will not appear in a title report, if there is a lien, a prospective purchaser is already in touch with the owner. Such contact allows both the owner to make representations as to the clarity of the title and the purchaser to demand resolution of the cloud, potentially by examining the construction contract and proofs of payment on it.

That being the case, where the owner is aware of recent construction on the building (often a public record thanks to the records of building permits), and the time for filing liens has not expired, even without a filed lien, the purchaser may wish to examine the construction contracts during the due diligence period and receive clarification about any potential problems.

Conclusion

Pay-if-paid clauses are generally but not always illegal in New York. Those wishing to protect the title to their own buildings undergoing construction and those contracting to purchase such a building will both be motivated to examine if the construction contracts contain such clauses and what the state of payments for construction currently are.

 

Endnotes:

[1] Welsbach Electric Corp. v. Mastec North America, Inc., 7 N.Y.3d 624, 859 N.E.2d 498, 825 N.Y.S.2d 692 (2006). West-Fair Elec. Contractors v. Aetna Cas. & Sur. Co., 87 N.Y.2d 148 (1995) notes that forbidding the waiver of mechanics’ liens first hails from 1897, but according to Welsbach § 34 first came into being in 1929.

[2] §34 and everything else involving mechanics’ liens are contained in Lien Law Article 2.

Original article