Think “pay if paid” clauses are unenforceable in Wisconsin? Not always, and if you read the statute too quickly, you may be misled.

Often, construction contracts include conditional payment clauses, such as “pay if paid” or “pay when paid,” as a means to protect upstream (often general) contractors from the potentially crushing risk of having to pay its subcontractors out of its own pocket when the owner has not yet – and may never – pay the upstream contractor.

Clauses and Variations: 'Pay When Paid' versus 'Pay If Paid'

First, let’s make sure we are speaking the same language.

When we refer to a “pay if paid” provision, we mean language in a contract between a contractor and a subcontractor that makes payment to the upstream contractor by its customer (usually the owner) an absolute condition precedent to the contractor’s obligation to pay its downstream subcontractor. That is, the upstream contractor has no legal obligation to pay its subcontractor unless and until the upstream contractor is paid by its customer for the subcontractor’s work. The credit risk is passed entirely to the subcontractor.

On the other hand, “pay when paid” does not contain language creating an absolute condition precedent to payment. Rather, it states that the upstream contractor’s obligation to pay the subcontractor is delayed until the upstream contractor is paid. In most jurisdictions, whether the contract says so or not, payment may be delayed only for a “reasonable period of time” when such a clause is present.

Pay When Paid: A 'Reasonable Period of Time'

Wis. Stat. section 779.135(3) expressly does not prohibit contract provisions that allow a prime contractor to delay payment to a subcontractor until the prime contractor receives payment from its customer. While there is no case authority in Wisconsin on this point, most jurisdictions hold that, in a pay when paid scenario, the upstream contractor has a “reasonable period of time” to make payment to the subcontractor, but may not withhold payment forever regardless of whether the contractor has been paid. Practically speaking, by the time litigation over the construction project has concluded, rest assured that a “reasonable” period of time, whatever that is, will have elapsed.

Pay If Paid: Prohibited in Wisconsin?

Depending on how they do business, many Wisconsin contractors may not use or see pay if paid clauses because there is a general belief that Wisconsin law prohibits them.

Although Wisconsin law prohibits pay if paid clauses in some contexts, the prohibition is not absolute. Section 779.135(3) provides that any provision purporting to make the owner’s payment to a prime contractor a condition precedent to a prime contractor’s payment to a subcontractor, supplier, or service provider is void. But who is a “prime contractor?”

Wis. Stat. section 779.01(2)(d) defines a “prime contractor” as:

1. A person, other than a laborer, but including an architect, professional engineer, construction manager, surveyor, or other service provider, employed by the owner, who enters into a contract with an owner of land who is not personally the prime contractor as defined in subd. 2. to improve the land, or who takes over from a prime contractor the uncompleted contract.

2. An owner of land who acts personally as prime contractor in improving such land.

Again, there is no published case law from Wisconsin’s courts interpreting section 779.135(3).

Appears to Apply Only to ‘Prime Contractor’

However, the statutory language appears to be clear that the prohibition on pay if paid clauses applies only to payment by a “prime contractor.” The legislative history supports this narrow construction. In 2006, the legislature amended section 779.135(3) by replacing the term “general contractor” with the term “prime contractor.” This legislative change strongly suggests that the legislature intended to narrow the prohibition of pay if paid clauses based on the position in the chain of contract (prime versus sub), rather than by the scope of the contract (general versus trade).

Consequently, pay if paid clauses may be enforceable in Wisconsin – even by general contractors – so long as the party seeking to enforce one is not a “prime contractor.” How would that happen? Let’s look at the traditional “design-bid-build” model in contrast with a “design-build” delivery system.

Design-Bid-Build versus Design-Build

In a traditional design-bid-build delivery system, an owner directly contracts separately with a design firm and a construction firm, each of which fits the definition of a prime contractor under section 779.01(2)(d). Any contracts that those “prime contractors” enter into with downstream parties – first-tier subcontractors – are subject to section 779.135(3). Contracts between subcontractors farther downstream, by definition, are not subject to section 779.135(3).

In the design-build delivery system, an owner directly contracts with only one entity that is a single point of responsibility for both design and construction services, the “design-builder.” In this model, the design-builder is the prime contractor. Thus, any contract that the design-builder enters into directly with downstream parties are subject to section 779.135(3). Typically, the design-builder will contract the design services to a separate design entity and the construction services to a general contractor. In this scenario, the general contractor is not a “prime contractor” as defined by the statutes. Accordingly, any contracts that the general (now a sub) contractor enters into with trade contractors downstream do not appear to be subject to the prohibition against pay if paid clauses under section 779.135(3).

Another Scenario

Another possible scenario that is beyond the statute’s prohibition is where a general contractor subcontracts with an entity that it wholly or partially owns. It is not uncommon for larger general contractors to own separate companies that perform specific trade work (i.e., carpentry, concrete), and enter into subcontracts with one or more of its subsidiaries that then subcontract with other downstream trade contractors and/or material suppliers.

There are legitimate business reasons for a general contractor to subcontract some of its prime contract to one or more subsidiaries – and nothing prevents a general contractor from subcontracting all of its prime contract to subsidiaries.¹ Under these circumstances, any contract that a subsidiary entity enters into with a downstream party containing a pay if paid clause would fall outside the literal scope of section 779.135(3).

Absent an adjudication that the first-tier subcontract with the subsidiary is some kind of a sham (and maybe even despite one), the pay if paid clause in the second-tier subcontract presumably would be enforceable because the subsidiary is not a prime contractor under section 779.01(2)(d).

Mitigating Risk

Construction involves plenty of risk to all parties involved. The risk that a prime contractor faces – potentially having to pay all of its subcontractors when it has not been paid – is a risk that it understandably would like to allocate to others and, for good reason, one that a subcontractor understandably would prefer not to assume. While Wisconsin has barred pay if paid clauses in some circumstances, it is by no means an absolute bar.

One would be well advised not to assume that all such clauses are unenforceable – and negotiate accordingly.

This article was originally published on the State Bar of Wisconsin’s Construction and Public Contract Law Section Blog. Visit the State Bar sections or the Construction and Public Contract Law Section web pages to learn more about the benefits of section membership.

Endnotes

¹ For example, a larger project on which we are working is joint-ventured among multiple contractors. The joint venture has subcontracts with each of the joint venture partners for legitimate business reasons.