Editor’s Note: Jason Strickland is a member of the Litigation Practice Group of Ward and Smith, P.A.

In the technology arena, it is common to have layers of contractors. The original, or "prime" ("Prime"), contractor has the relationship with the project owner or initiator. The Prime then contracts with subcontractors to undertake specific subparts of the overall project, and those subcontractors, in turn, may subcontract portions of their work.

It also is common for the Prime (or any intermediate contractors above the party actually performing the work), to include in contracts with the lower-tier subcontractors a clause conditioning payment, or the timing of payment, for work delivered upon the Prime’s receipt of payment from the project owner. Such clauses, referred to as "pay-if-paid" or "pay-when-paid" clauses, attempt to pass to the lower-tier subcontractor the risk of nonpayment or delayed payment from the project owner.

Background

Pay-if-paid and pay-when-paid contracts originated in the construction industry. When, for example, an owner ("Owner") hires a general contractor ("General") to build a house, the General, in turn, hires subcontractors ("Subcontractors") such as a carpenter, a roofer, an electrician, or a plumber to actually perform the work. Traditionally, the General agrees to pay the Subcontractors only when the General receives payment from the Owner. Thus, the General’s contracts with the Subcontractors would contain one of the following types of clauses:

• "Pay-if-paid" clause – payment is conditioned upon payment from the Owner. An example of this type of clause is as follows: "Receipt of payment from the owner is an express condition precedent to contractor’s obligation to pay subcontractor."

or

• "Pay-when-paid" clause – payment is due within a specified period after payment is received from the Owner. An example of this type of clause is as follows: "Within ___ days after receipt by contractor of monies owed for subcontractor’s work on the project, contractor shall pay said monies to subcontractor."

A pay-if-paid clause prevents a Subcontractor from being paid unless and until the General is paid by the Owner. This nonpayment can result from inadequate work entirely unrelated to the Subcontractor’s work, or from the Owner’s financial problems.

Technology Industry

There is a similar contractual structure in the technology industry. One example is the "middleman contract" where a placement agency contracts to supply manpower to the equivalent of the General. The placement agency, as the "middleman," then contracts with individuals to supply the labor needed. Another example occurs on projects for the development of large systems. A corporation or government entity contracts with the system developer (the equivalent of the General) to build the system. The system developer then contracts with parties with specialized skills (subcontractors) to develop specific packages to be integrated into the final system.

Enforceability and Effect

Because of the long history of construction industry disputes, many states have statutes and court decisions which prohibit or sharply limit the enforceability of pay-if-paid clauses in the construction context. However, the enforceability of pay-if-paid and pay-when-paid clauses in the technology industry is not as straightforward. In some states, the rules governing pay-if-paid clauses in the construction context apply with equal force in all industries. In other states, the rules, if any, governing pay-if-paid clauses apply only in the construction context. For example, North Carolina’s statute making pay-if-paid clauses unenforceable expressly applies only to situations involving the improvement of real estate. In these latter states, whether or not and to what extent a pay-if-paid clause can be enforced in the technology industry is an unanswered question.

Considerations and Planning

If you are in the position of the Prime or an intermediate contractor, a pay-if-paid or pay-when-paid clause can be a valuable tool. By conditioning the obligation to pay your subcontractors upon receipt of payment from the owner or the subcontractor who employed you, you avoid the potential pitfall of owing money to a lower-tier subcontractor while awaiting your payment. However, the pay-if-paid or pay-when-paid clause may do little to no good if the contract is governed by state laws that prohibit or limit the enforceability of such clauses.

If you are in the position of a lower-tier subcontractor or employee seeking payment from the Prime or the subcontractor who employed you (your "higher-tier subcontractor"), a pay-if-paid or pay-when-paid clause presents an obvious pitfall. You may not be able to obtain payment until your higher-tier subcontractor has been paid. Without a direct relationship with the owner, you must rely on your higher-tier subcontractor for payment. Your higher-tier subcontractor might never be paid, perhaps for non-performance unrelated to your work, and you will not be paid even though your higher-tier subcontractor has the financial ability to pay you. The risk of nonpayment has been partly or fully shifted from your higher-tier subcontractor to you, even if your work is otherwise without defect.

When entering into contracts with a tiered contracting structure, be aware of any pay-if-paid or pay-when-paid clauses, even if they are not explicitly named as such. Further, you should determine what state’s laws will apply to interpretation of the contract and what impact that will have on the enforceability and limits of any pay-if-paid or pay-when-paid clauses.

Conclusion

Pay-if-paid and pay-when-paid clauses are common in both the construction and the technology industries. Such clauses simultaneously present valuable tools to upper-tier contracting parties and potential pitfalls to lower-tier subcontractors. It is important to understand how these clauses potentially operate and whether they are operable in your particular situation. Ultimately, if faced with negative impacts of an enforceable pay-if-paid or pay-when-paid clause or the inability to enforce such a clause, attempt to build into your contract price a risk premium that accounts for the resulting increased risk you are assuming.

© 2008, Ward and Smith, P.A.

Ward and Smith, P.A. provides a multi-specialty approach to the representation of technology companies and their officers, directors, employees, and investors. Jason T. Strickland practices in the Litigation Practice Group and represents clients in a broad range of disputes. Comments or questions may be sent to j_s@wardandsmith.com.

This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.