Virginia Is for Lovers… of Strict Contract Language: New Law Prohibits Pay-if-Paid Clauses in Construction Contracts
Virginia has joined the growing number of states that prohibit “pay-if-paid” clauses. The new law, known as Virginia Senate Bill 550, amends Virginia’s Prompt Payment Act (Va. Code § 2.2-4354) and its relatively new (July 1, 2020) wage theft statute (Va. Code § 11-4.6) and applies to public construction contracts and private construction contracts that involve at least one general contractor and one subcontractor. These changes will have significant practical effects for contractors and subcontractors alike.
For background: “Pay-if-paid” means that the contractor has no obligation to pay a subcontractor unless and until the owner pays the contractor for the subcontractor’s portion of the work (same with higher-tiered subcontractors who pay lower-tiers). In short, pay-if-paid clauses shift the risk of owner nonpayment, up to and including owner insolvency, from the contractor to the subcontractor. Thus, payment by the owner is a “condition precedent” to the contractor’s payment obligation to the subcontractor. Taken literally, this clause creates potential for a contractor to put off payment indefinitely, or at the very least, defend against nonpayment for as long as it takes the owner to pay. Thus, courts that permit these clauses require crystal clear pay-if-paid language to demonstrate that both parties intended to include it. Per its new law, Virginia will no longer enforce this language at all.
In prohibiting pay-if-paid, Virginia’s new law shifts much of the risk of owner nonpayment back to the contractor. The law requires all public contracts to include a payment clause that makes the contractor “liable for the entire amount owed to any subcontractor with which it contracts” unless the subcontractor did not comply with the contract. Then, it expressly prohibits “pay-if-paid” clauses:
Payment by the party contracting with the contractor shall not be a condition precedent to payment to any lower-tier subcontractor, regardless of that contractor receiving payment for amounts owed to that contractor.
Likewise, the new law deems any private contract involving a general contractor and subcontractor to include a provision that any higher-tier contractor is liable to any lower-tier subcontractor for satisfactory performance, and expressly prohibits pay-if-paid language unless the paying party is insolvent or a bankruptcy debtor. This exception provides some relief to contractors, in that they will not be indefinitely on the hook for payment when the paying party is truly insolvent. Note the ramifications for bankruptcy proceedings have yet to be seen, and those situations can quickly become complex. One other ray of light is that the new law does not apply to retainage withholdings by the owner.
Notably, the new law contemplates that contractors are still entitled to withhold payments, presumably where there is a good faith dispute over the subcontractor’s compliance with the contract. However, to take advantage of the “good faith dispute” exception, private owners and both public and private contractors must notify lower tiers in writing of their intent to withhold payment and the reason(s).
Virginia’s new law does not stop at pay-if-paid, but also sets a distinct, limiting deadline for “pay-when-paid” provisions, albeit the new law does not expressly address these clauses. Pay-when-paid means that the contractor’s payment obligations arise when the contractor gets paid, but receipt of payment is not a condition precedent to the obligation to make payment downstream. Essentially, a pay-when-paid clause provides a reasonable amount of time for the contractor to avoid payment liability if it has not yet received payment from the owner for the amounts the subcontractor seeks.
Here, as it relates to pay-when-paid provisions, the new Virginia law requires private contractors (at any tier) to pay subcontractors by the earlier of (i) 60 days of satisfactory completion of the work, or (ii) seven days after receipt of payment from the owner or contractor. This means that if the owner (or higher-tier contractor) fails to pay within 60 days, the contractor is still on the hook for payment. In that respect, the new law provides for a 60-day time period as the reasonable payment period for a pay-when-paid clause. In summary, a Virginia court would likely enforce a 60-day time period for an open-ended pay-when-pay clause.
The impact of Virginia’s new law has the potential to change the climate of subcontract payment disputes. While the law provides added protection to subcontractors, it effectively limits contractor defenses to payment and exposes contractors (and higher-tiered subcontractors) to much more risk if the owner or higher-tier contractor does not pay. Accordingly, contractors (and higher-tiered subcontractors) should negotiate general contracts that include payment protections such as adequate assurances of the owner’s financial arrangements to pay and the right to suspend and/or stop work if the owner fails to pay.
The law applies to construction contracts entered on or after January 1, 2023.