The Enforceability of “Pay if Paid” Clauses by Contractors Against Subcontractors

A June 30, 2010 case decided by the Appellate Division of the Superior Court of New Jersey, O.A. Peterson Construction Co., Inc. v. Englewood Hospital And Medical Center, 2010 WL 2696758 (N.J.Super., App.Div. 2010) dealt with the issue of whether a contractor can withhold payment to its subcontractor under a “pay if paid” clause.

   

    The Underlying Facts

    Plaintiff O.A. Peterson Construction Co., Inc. (“OAP”) was the general contractor on a construction project for Englewood Hospital (“Hospital” or “owner”). On Par Contracting Co., Inc. (“On Par”) was one of the subcontractors on the project. The contract between OAP and On Par contained the following provision concerning OAP's obligation to pay On Par:

It is expressly understood and agreed that the receipt by the Contractor of payment for the Subcontractor's work shall be a condition precedent to the Contractor's obligation to pay the Subcontractor. That is, the Contractor shall have no liability or responsibility for any amounts due or claimed to be due the Subcontractor for any reason whatsoever except to the extent that the Contractor has actually received funds from the Owner specifically designated for disbursement to the Subcontractor.

[Emphasis added.]

    The Pay if Paid Clause  

    OAP contended that this language constituted an unambiguous “pay if paid” clause, which shifted to On Par the risk of the owner's nonpayment for the work. The Court agreed, stating, “[W]e find that the “pay if paid” clause unambiguously shifted the risk of non-payment to the subcontractor. That is, the clause clearly anticipated that as the contract progressed, the owner would make periodic payments to the general contractor, with portions being designated as payment for work performed by each specific subcontractor on the job. If the owner refused to pay for a particular subcontractor's work, the general contractor was not obligated to pay that subcontractor until the dispute was resolved and the owner made payment.” Id. at 2

    The Covenant of Good Faith and Fair Dealing

    One interesting note is that the Court also decided that OAP was wrong to enter into a settlement with the owner that did not designate a portion of the settlement funds for disbursement to the subcontractor, and then rely on the “pay if paid” clause to defeat that subcontractor's right to payment. It found that this argument would violate the covenant of good faith and fair dealing implicit in every contract.

 

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