Shifting the Risk of Owner Insolvency to Subcontractors

Written construction contracts are tools used to define relationships, clarify scope of work, establish time lines and performance standards, and allocate risk. One risk that general contractors may wish to shift to their subcontractors is the potential for owner insolvency or inability to pay. Many contracts contain a generic “Pay-When-Paid” clause, which attempts to relieve the general contractor of the obligation to pay its subcontractors for their completed work until, and unless, the general contractor receives payment from the owner. General contractors, however, need to understand that not all Pay-When-Paid clauses effectively shift the risk of owner insolvency to the subcontractor.

In construction projects, the general contractor bears the risk of an owner’s insolvency, inability to pay, or skipping town. In an attempt to shift this risk to subcontractors, general contractors insert a Pay-When-Paid clause in the subcontract agreement to make payment by the general contractor to the subcontractor conditional. The Minnesota Court of Appeals interpreted a typical Pay-When-Paid clause in Mrozik Construction, Inc. v. Lovering Associates, Inc., 461 N.W.2d 49 (Minn.App. 1990). The language of the Pay-When-Paid clause in Mrozik was:

THE CONTRACTOR AGREES AS FOLLOWS: D. Final payment including all retention becomes due and payable within 30 days after Architects’ certification of final payment. At all times the Subcontractor shall be paid to the extent that the Contractor has been paid on the Subcontractor’s account. (Emphasis added.)

The Court in Mrozik interpreted this clause to merely outline the timing of payments to the subcontractor, and not to effectively create a condition precedent to the general contractor’s obligation to make any payments to the subcontractor. In making this interpretation, the Court recognized that general contractors normally assume the credit risk of the owner, and in order to alter this common understanding, the language in the subcontract must be express and unequivocal.

In response to Mrozik, the Association of General Contractors (AGC) attempted to create a “Pay-If-Paid” clause to make the owner’s payment to the general contractor a condition precedent to the general contractor’s obligation to pay the subcontractor. This was accomplished by the drafting of Rider B-55 to the AGC’s Labor and Materials Standard Subcontract Agreement. The critical language in Rider B-55 provides:

1. Irrespective of any term or inference to the contrary in the Subcontract, Contractor and Subcontractor expressly agree that the Owner’s payment to Contractor on the Subcontractor’s account is an absolute condition precedent to Contractor’s obligation to pay Subcontractor any progress or final payment pursuant to the Subcontract, except to the extent Subcontractor establishes that the Owner’s failure to make payment to Contractor was caused by the fault of the Contractor.

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3. Subcontractor expressly agrees that it retains the risk of the Owner’s insolvency or inability to pay for Subcontractor’s Work, and such risk is not transferred to Contractor under the Subcontract.

While Minnesota Appellate Courts have not yet interpreted this Rider B-55, it appears to address the Mrozik Court’s concerns regarding creating a valid condition precedent to the general contractor’s obligation to pay a subcontractor.

If a general contractor truly wants to shift the risk of owner insolvency or inability to pay, it must incorporate explicit language, exemplified by the AGC’s Rider B-55, into its Subcontract Agreements. In any case, if a subcontract has language similar to the generic Pay-When-Paid clause at issue in the Mrozik case, the general contractor must be aware that it will likely need to pay a subcontractor for its work irregardless of the ability of the owner to pay.

Ryan J. Hatton is an associate with Rinke-Noonan and practices in areas of construction law and litigation, mechanic's liens, bond claims, and land use litigation.