Fear the Form! — Developments in Construction Contracts

Buckingham attorney John Swansinger presents the following article on construction contracts:

One of the greatest days for any contractor, at any level, is when the words “WE WON THE BID…..WE WON THE BID!” are cast over the weary war room.  Can you hear the cracking of high fives and beers opening?

Then, a day, a week, a month later, over some antiquated fax machine or in some email or, heaven forbid, in an envelope, the contract arrives.   The excited  team immediately drills into what to do and when to do it.  Pages of fine print with customary industry covenants barely merit a glance.  Often overlooked in the excitement is the perhaps the most important language:

WHEN DO WE GET PAID???

It’s easy to simply say “it’s a standard form” and “it works for everyone”.  Not true.   All parties at every level must FEAR THE FORM!!!

The “pay if paid” and “pay when paid” concepts sound very similar but are two dramatically different payment terms under construction contracts.  Unfortunately, these terms have caused a great deal of pain in the construction industry as Ohio courts and arbitration panels are teeming with financial disputes after a project owner fails.

The Ohio Supreme Court is poised to clarify the distinction between “pay if paid” and “pay when paid”  in Transtar Electric v A.E.M. Services Corp.  Case No. 2013-0148 (Oral Arguments were November 5, 2013).

As a refresher, “pay if paid” means the general contractor pays the subcontractor if, and only if, the owner pays the general contractor.  Every other payment clause is “pay when paid,” which means the general contractor must pay the subcontractor in a reasonable time after the work is completed.

When a general contractor incorporates “pay if paid” language in the contract, it’s a garden variety attempt to shift risk.  Courts have historically frowned on this shift in risk primarily because the general contractor, who is in privity of contract with the owner, is much better suited than the subcontractor to assess creditworthiness.   It is not surprising that some general contractors like to add, (some might say “slip in”), “pay if paid” clauses in their form agreements with the subcontractors.  When the owner tanks, the subcontractor, already out of pocket, is left to litigate.

In an effort to protect the innocent, disinterested and ignorant, Ohio cases have held that the general contractor is presumed to assume the risk of owner’s default unless a contrary intention is “…clearly and expressly stated in unequivocal terms…” Thos. A. Dyer. Co. v Bishop Internatl. Eng. Co. 303 F. 2d. 655 (6^th Cir. 1962).   The courts have widely accepted that a clause is “pay if paid” if it expressly states:

1. Payment to the contractor is a condition precedent to payment to the subcontractor;
2. subcontractor is to bear the risk of owner’s non-payment, or
3. subcontractor  is to be paid out of a fund the sole source of which is the owner’s payment to the subcontractor. See, e.g., Evans, Mechwart, Hamilton & Tilton, Inc. v Triad Architects, 2011 Ohio 4979.

Too often when the parties try to understand what the boiler plate means they turn their hands up and cry “huh?”  Consequently, the Ohio construction world is watching closely for the Supreme Court’s ruling in Transtar.

Nothing factually novel here.  Transtar  was A.E.M’s subcontractor for certain electrical work.  The owner tanked. Neither the owner nor A.E.M. paid Transtar in full.  Of course, Transtar asked, “Why?”  A.E.M. showed them the following boiler plate “pay if paid” language (they might have added “Sorry for your loss”):

“RECEIPT OF PAYMENT BY CONTRACTOR FROM THE OWNER FOR WORK PERFORMED BY SUBCONTRACTOR IS A CONDITION PRECEDENT TO PAYMENT BY CONTRACTOR TO SUBCONTRACTOR FOR THAT WORK” (emphasis supplied)

The trial court found the foregoing to be a “pay if paid” clause.  The Court of Appeals reversed the decision finding that the language “condition precedent” insufficient to charge both parties with the understanding that a transfer of risk was intended and that it, instead, must be stated in “plain language”. Transtar Electric, Inc. v A.E.M. Electric Services Corp., 983 N.E. 2d 399 (Ohio Ct. App. 2012)

The Supreme Court is considering whether the magic words “condition precedent” are enough  or should the parties intent be determined by more extensive “plain language”.  The case begs the question: Is it reasonable to charge non-attorneys with an understanding of legal concepts like “condition precedent”? A ground swell of amicus support from subcontractor groups seeks to expand the elements necessary for a valid “pay if paid” provision.  Legal knowledge among the parties in a construction project widely varies and, thus, it would be no surprise if a more expansive rule will evolve from the Transtar case.

Meanwhile, celebrate the winning bid, only after you ask “How do I get paid?”  Perform due diligence on the owner.  Teach your team to incorporate best document management practices. Seek clarity and knowledge through counsel. Finally, FEAR THE FORM, and the form will take good care of you.

Contact attorney John Swansinger for more information.