Recently passed legislation in Virginia is likely to dramatically change contractual relationships between prime contractors and subcontractors in the Commonwealth. Abrogating well-established common-law principles set forth by the Supreme Court of Virginia, on April 27, 2022, the Virginia General Assembly, after receiving input from Virginia Governor Glenn Youngkin, passed Senate Bill 550 banning “pay-if-paid” clauses in public and private construction contracts. Contractors performing work in Virginia should take note of the new law, which goes into effect next year and will apply to any contracts executed after January 1, 2023.
The History Of Pay-if-Paid Clauses In Virginia
Broadly speaking, “pay-if-paid” clauses are a commonly used tool by prime contractors on construction projects to shift the risk to subcontractors in the event that the owner does not pay the prime contractor for work. Such clauses usually include language creating an express condition precedent to the subcontractor’s right to be paid for work under a subcontract, stating that the prime contractor shall be under no obligation to pay the subcontractor for work unless and until the prime contractor first receives payment for that work by the project owner. The “pay-if-paid” clause also has a less extreme cousin, the “pay-when-paid” clause, which merely delays the time in which the prime contractor is obligated to pay the subcontractor to the time in which the prime contractor is paid by the owner. It does not, however, extinguish the prime contractor’s ultimate obligation to pay the subcontractor.
Prior to 2022, Virginia found itself in the majority of the states that upheld the enforceability of such “pay-if-paid” clauses. Indeed, in 1995, the Supreme Court of Virginia made clear in Galloway Corp. v. S.B. Ballard Const. Co., 250 Va. 493, 501 (1995), that “[i]f . . . the parties clearly intend there to be a condition precedent fulfilled before payment comes due, the contract will be construed as written and will not be reformed by the court . . . .” Since then, courts consistently cited Galloway in upholding the enforceability of pay-if-paid clauses in Virginia. See, e.g., Universal Concrete Prods. Corp. v. Turner Const. Co., No. 2:08-cv-298, 2009 WL 10701538, at *3 (E.D.Va. Feb. 20, 2009).
Senate Bill 550 – A Sea Change
Senate Bill 550 was introduced in the Virginia Senate on January 12, 2022 and initially passed by both Houses of the General Assembly in March 2022. SB550 amends Virginia Code §§ 2.2-4354 and 11-4.6, which govern both public and private sector contracts. Specifically, the amendments require that any construction contract between a general contractor and subcontractor include a provision obligating the “higher-tier contractor” to pay the “lower-tier contractor” within the earlier of 45 days of satisfactory completion of the subcontract work, or seven days after the higher tier contractor’s receipt of payment for the subcontract work from the owner.
Some questions persisted following the passage of SB550. The bill did not indicate whether the new timely payment requirements would apply retroactively – that is, to contracts entered into before the bill’s passage. Nor did the bill address whether a higher-tier contractor was still entitled to withhold retainage amounts from the subcontractor – a common practice by prime contractors to ensure proper performance of the work.
In Virginia, however, the governor is permitted to propose amendments to legislation passed by the General Assembly. Newly elected Governor Glenn Youngkin did just that with SB550, proposing certain amendments to add more certainty to the new code section. Governor Youngkin’s proposed amendments explicitly permitted retainage and added an additional clarifier that the new requirements will not apply retroactively, instead only applying to construction contracts entered into after January 1, 2023. Finally, the Governor’s amended version extended the time for payment in the new § 11-4.6, with the statutory language now stating that “[a]ny contract in which there is at least one general contractor and one subcontractor . . . shall require such higher-tier contractor to pay such lower-tier subcontractor within the earlier of (i) 60 days of the satisfactory completion of the portion of the work for which the subcontractor has invoiced, or (ii) seven days after receipt of amounts paid by the owner to the general contractor or by the higher-tier contractor to the lower-tier contractor for work performed by a subcontractor pursuant to the terms of the contract.”
Pursuant to Virginia law, the Virginia General Assembly passed Governor Youngkin’s proposed amendments to SB550 on April 27, 2022, meaning that the Governor’s version is the final one enacted into law.
Enforceability Of Pay-If-Paid Clauses In Other States
In light of the General Assembly’s acceptance of Governor Youngkin’s proposed amendments, Virginia now joins a minority of ten other states, including California and New York, that preclude the usage of “pay-if-paid” clauses. The majority outlook accepting the validity of “pay-if-paid” clauses, however, remains dominant in more than 30 states, including Florida, Michigan, and Pennsylvania. Contractors in the majority view states should still be mindful of limitations imposed on “pay-if-paid” clauses in these states.
Almost all courts in the majority view states require that the condition precedent to the subcontractor’s payment be clearly and unambiguously expressed. A 1990 Florida Supreme Court decision is instructive on this point. In DEC Elec., Inc. v. Raphael Constr. Corp., the court explained “[i]f a [pay-if-paid] provision is clear and unambiguous, it is interpreted as setting a condition precedent to the general contractor’s obligation to pay . . . . In purported risk-shifting provisions between a contractor and subcontractor, the burden of clear expression is on the general contractor.” 558 So. 2d 427, 429 (Fla. 1990). Notably, the burden to ensure that the “pay-if-paid” clause is clear and unambiguous rests with the prime contractor.
Compare this relatively permissive formulation to a handful of states, including Arizona, Illinois, and Maryland, which protect the rights of subcontractors by expressly limiting the use of “pay-if-paid” clauses in certain contexts. Illinois and Maryland, among other states, have enacted statutes preventing prime contractors from relying on “pay-if-paid” clauses to defeat subcontractor claims relying on mechanics’ liens.
Arizona, on the other hand, is unique in that it has identified specific exceptions to the enforcement of conditions precedent that limit subcontractor recovery. For example, in L. Harvey Concrete, Inc. v. Agro Constr. & Supply Co., the Arizona Court of Appeals reversed a summary judgment decision that had enforced a “pay-when-paid” clause. 939 P.2d 811, 815 (Ariz. Ct. App. 1997). The court explained that such conditions precedent will not be enforced in the case of gross mistake, fraud, or error leading to a lack of honest judgment, and found that the subcontractor had potentially demonstrated that the owner made a gross mistake of fact.
Thus, even in states that permit “pay-if-paid” clauses, courts are cognizant of the risk that prime contractors hold an advantage over subcontractors in contract drafting and have taken steps to protect the subcontractors.
In light of Virginia’s new law precluding “pay-if-paid” clauses, prime contractors must carefully consider their options in ensuring that prime contract funds will be available to satisfy subcontractor payment applications. Virginia’s new law potentially places prime contractors at risk for financing subcontractor pay applications during the pendency of owner payments for subcontractor work, including payment delays arising from contractor claims. Moreover, prudent prime contractors will closely monitor the legality of “pay-if-paid” clauses in the remaining majority-view states which enforce “pay-if-paid” clauses in most circumstances. Further changes to the current landscape regarding “pay-if-paid” clauses may have significant effects on construction subcontracts.
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