6.2 Payment Contingencies: Pay-When-Paid vs Pay-If-Paid

6.2 Payment Contingencies: Pay-When-Paid vs Pay-If-Paid

In the construction industry, cash flow is the lifeblood of project delivery. When a project owner delays payment or encounters financial insolvency, general contractors face significant financial exposure if they remain unconditionally obligated to pay trade subcontractors. To mitigate this financial risk, general contractors incorporate conditional payment language into subcontract agreements.

Under Tennessee law, payment clauses fall into two distinct legal classifications: Pay-When-Paid clauses and Pay-If-Paid clauses. Tennessee courts enforce strict legal standards when interpreting these provisions, requiring general contractors to understand the exact wording necessary to shift insolvency risk, as well as how these clauses interface with the Tennessee Prompt Pay Act of 1991 (TCA Title 66, Chapter 34) and statutory mechanics' lien rights (TCA Title 66, Chapter 11).

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Pay-When-Paid vs. Pay-If-Paid: Fundamental Legal Distinctions

The fundamental legal difference between Pay-When-Paid and Pay-If-Paid provisions centers on whether owner payment is a temporary timing mechanism or an absolute risk-shifting condition precedent.

Pay-When-Paid Clauses: Timing Mechanisms

A Pay-When-Paid clause states that the general contractor will pay the subcontractor within a specified number of days after receiving payment from the project owner (e.g., "Contractor shall pay Subcontractor within 10 days of receipt of payment from Owner").

Under established Tennessee case law (such as Koch v. Construction Technology, Inc.), courts interpret standard Pay-When-Paid clauses as timing mechanisms rather than risk-shifting mechanisms. The clause merely allows the general contractor a reasonable period of time to secure funds from the owner. If the owner delays payment or goes bankrupt, the general contractor is not relieved of its underlying contractual obligation; after a "reasonable time" elapses (typically 60 to 90 days depending on circumstances), the general contractor must pay the subcontractor out of its own financial reserves.

Pay-If-Paid Clauses: Absolute Conditions Precedent

A Pay-If-Paid clause creates a true condition precedent to payment. If drafted correctly, it establishes that receipt of payment from the project owner is an absolute prerequisite before any legal duty arises for the general contractor to pay the subcontractor. If the owner defaults or becomes insolvent, the subcontractor receives no payment for its completed work.

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Enforceability Standards Under Tennessee Law

Because Pay-If-Paid clauses work a forfeiture by shifting the catastrophic risk of owner default onto trade subcontractors who had no control over owner creditworthiness, Tennessee courts disfavor them. Courts apply a strong legal presumption against conditional payment provisions.

The Explicit Condition Precedent Standard

For a Pay-If-Paid clause to be legally enforceable in Tennessee courts, the contract must contain clear, unequivocal, and explicit language clearly demonstrating that both parties intended to make owner payment a condition precedent. Standard phrasing that legally enforces a Pay-If-Paid obligation includes:

"Receipt of payment from the Owner by the Contractor is an explicit, express condition precedent to any obligation of the Contractor to pay the Subcontractor. Subcontractor expressly assumes the risk of Owner insolvency or nonpayment."

If a clause uses ambiguous terms such as "subject to payment by owner" or "out of funds received from owner" without explicitly stating "condition precedent" and "risk of nonpayment," Tennessee courts will construe the provision as a Pay-When-Paid timing clause, holding the general contractor liable for payment.

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Tennessee Prompt Pay Act of 1991 (TCA Title 66, Chapter 34)

The Tennessee Prompt Pay Act of 1991 establishes strict statutory timelines for pass-through payments on both public and private construction projects across the state. General contractors must align their subcontract payment provisions with these statutory mandates.

Statutory 10-Day Payment Requirement

Under TCA 66-34-301, when a project owner pays a general contractor for work performed by subcontractors, the general contractor must pay each subcontractor for their portion of the work within 10 calendar days of receiving the funds from the owner.

Retainage Cap & Escrow Rules

• 5.0% Retainage Cap (TCA 66-34-103): Retainage withheld by an owner or general contractor cannot exceed 5.0% of the total contract amount.
• Escrow Requirement: For projects with a total contract value of $500,000 or more, retainage withheld must be deposited into a separate, interest-bearing escrow account with a qualified financial institution. Failure to deposit retainage into an escrow account subjects the withholding party to a statutory penalty of $300 per day for each day of noncompliance (TCA 66-34-103(c)).

Statutory Interest and Notice Penalties

If a general contractor fails to make timely payments without a valid legal reason (such as defective work or bona fide dispute):

1. Notice of Nonpayment: The subcontractor must send written notice demanding payment via registered or certified mail.
2. 10-Day Cure Period: The defaulting party has 10 calendar days from receipt of notice to cure the nonpayment.
3. Statutory Interest: Unpaid balances accrue interest at the statutory rate of 1.5% per month (18% per annum) or the contract rate, whichever is higher (TCA 66-34-601).
4. Attorneys' Fees: If litigation ensues and the court finds the nonpaying party acted in bad faith, the prevailing party is entitled to recover reasonable attorney's fees.