J D HERBERGER & ASSOCIATES, PC

Beginning September 1, 2007, new legislation became effective which has potential to drastically alter the traditional relationship between general contractors and subcontractors – the new contingent payment law. Traditionally, contractors have included in their contracts with subcontractors, contingent payment clauses designed to shift the risk of non-payment by an owner downstream to the subcontractor. If the owner doesn’t pay, then the contractor and the subcontractor both don’t collect on their contracts. This new statute, located in §35.521 of the Texas Business & Commerce Code, will directly affect the way construction and supply based companies will collect for their goods and services in Texas.

A contingent payment clause is a contractual clause designed to effectively re-allocate risk so as to place risk equally upon the contractor and the subcontractors in the event an owner does not pay. Contingent payment clauses generally take two forms – the “pay if paid” clause and the “pay when paid” clause.  A “pay if paid” clause usually says “subcontractor will be paid if and only if contractor gets paid by owner.” The result of this clause being that if an owner, for whatever reason, fails to pay the contractor, the contractor will have a defense to paying the subcontractor.  Effectively, the contractor and subcontractor equally bear the risk of nonpayment by the owner – if the owner does not pay, then both the contractor and subcontractor lose out. A “pay when paid” clause usually says “subcontractor will be paid within 15 days after receipt by contractor of payment from owner.” The new statute, by its terms, will not affect “pay when paid” clauses, leaving to the courts the issue of enforceability and effect. Courts have generally read this type of provision to merely state a reasonable time in which to pay and most courts have held that payment by the owner is not a condition precedent to the obligation of payment by the contractor. The subcontractor will still get paid after a “reasonable” time.

The statute creates situations which will render some “pay if paid” clauses unenforceable. However, the statute only applies to a limited number of contracts.  First, it only applies to contracts entered into on or after September 1, 2007.  Second, the statute only applies to contracts involving improvement to real property, the furnishing of materials for the improvement to real property, or construction management. The term “improvement” includes construction, remodeling, and repair, however, the statutory definition of “improvement” is non-exhaustive, so it may include other things. Lastly, the statute does not apply to design/architect services, public utility type construction, and typical residential construction.

There are four different statutorily created situations where a contingent payment clause will not be effective against the subcontractor – meaning that the contingent payment clause will be unenforceable and the contractor will be unable to rely on a defense using that section of its contract.

Situation One – The Contractor in Default. The contingent payment clause is unenforceable if the reason the contractor is not getting paid is because the contractor is not fulfilling his contractual obligations with the owner. The contractor cannot enforce the contingent payment clause if the reason for non-payment is his own fault. However, if the result of the non-payment by the owner is due to the subcontractor not fulfilling his obligations under his subcontract then the contingent payment clause may be fully enforced by the contractor.

Situation Two – The Sham Relationship. The contingent payment clause is unenforceable if the owner and the contractor are essentially the same person.  This is the traditional “sham relationship.” Logically this makes perfect sense. A contractor cannot use the contingent pay defense if the person who has not paid is himself.

Situation Three – Unconscionability.  The contingent payment clause is unenforceable if enforcement of the clause would be unconscionable. There are few circumstances in the legal world where one could define with certainty the meaning of “unconscionable.” Lawyers frequently use anecdotes to say what does and what doesn’t fall under the rather large umbrella of unconscionability. The new statute helps little as it defines unconscionability by stating what it is not. Essentially, the enforcement of a contingent pay clause will not be unconscionable if the contractor does three things; (1) exercises due diligence in ascertaining that adequate financial arrangements exist to pay for the improvements (2) contractor has communicated this in writing to the subcontractor before the contract is entered into and (3) contractor makes reasonable efforts to collect the amount owed to the contractor OR makes an assignment to the subcontractor of contractor’s cause of action for payment. It is likely that contractors will use this provision frequently to ensure that the contingent payment clause will not be rendered unconscionable. However, the unconscionability of a contingent payment clause where the contractor doesn’t comply with this section is a question for the courts to decide.

Situation Four – Notice by the Subcontractor. The contingent payment clause is unenforceable if, essentially, the subcontractor sends notice that it doesn’t want the clause to be enforceable anymore. This is likely to become the most important part of the statute – at least for subcontractors. The statute creates a way in which the subcontractor may, at its own option, decline to be bound by a contingent payment clause. For subcontractors and suppliers who already spend countless hours drafting and sending demand letters, lien notices, and lien affidavits, get ready to add one more item to the list. For easy reading, I will break down the statute and its most likely application in bullet point form.

1)         Subcontractor submits a pay application to contractor in a form substantially in accordance with the contractor’s requirements.

2)         Subcontractor is not paid within 45 days after subcontractor submits the pay application.

3)         Subcontractor sends (by certified mail, return receipt requested) the contractor written notice objecting to the further enforceability of the contingent payment clause.

4)         The notice usually becomes effective on the 10th day after the date the contractor receives the notice, thereby rendering the contingent payment clause unenforceable.

5)         HOWEVER, the contractor may thereafter submit a written notice back to the subcontractor within 5 days of the contractor’s receipt of the notice from the subcontractor which basically objects to the notice of the subcontractor and states that the reason for non-payment is the failure of the subcontractor to perform its obligations under the subcontract.

6)         After the contingent payment clause becomes unenforceable, there is a still a chance of its revival. If the contractor fully pays the unpaid indebtedness giving rise to the written notice of the Subcontractor, the contingent payment clause is thereafter reinstated as to work performed or materials furnished after the receipt of the payment by the Subcontractor.

This notice provision is one which will likely be often utilized by subcontractors and suppliers. If you do choose to utilize your notice protections under this statute, it is important that you send a notice for each pay application over 45 days late, so as to avoid the “reinstatement” of the contingent payment clause in the event the contractor pays.  In conclusion, I would suggest that specific questions should be directed to your legal counsel. The above is meant only as an overview of the statute as there are numerous caveats to the rules stated.  However, this is a good background to get you started and to protect your interests as a subcontractor or supplier in the State of Texas.