The top and bottom of the contracting chain have been in a tug-of-war over who controls payment logistics and financial risk on a construction project for more than 200 years.
The risk itself is a zero-sum game. On every construction project, some party will shoulder the risk burden. The consequences of this burden are familiar to any industry participant—waiting for late payments while continuing to work the job or suffering enormous margin hits when unexpected conditions, change orders, contractor defaults or delays rear their ugly heads.
This financial risk is unlike the risk of a safety accident, for example, where investments in safety equipment and training can lower the risk for everyone. Every construction engagement presents the risk of financial loss, and that risk gets passed around the jobsite. In fact, the status quo in this area is nicely summed up by ENR.com’s article on the 2013 Risk & Compliance Summit: “The perception of risk depends on where you live on the payment chain.”
The perception of risk is really the perception of who should shoulder the risk. Top-of-the-chain parties want risk down the chain to protect them from unknown liens, subcontractor default and scope or delay problems. Bottom-of-the-chain parties need cash flow and worry about payment abuses.
Understanding the root of financial risk in the construction industry is relatively simple. One party contractually agrees to furnish labor and/or materials to another. The furnishing party wants payment before furnishing, and the receiving party wants performance before paying.
In America, this friction is resolved by agreement. The parties engaged in a transaction can agree with one another on when payment will be made. This seems simple enough, but there is just one issue: fairness. Is it always fair to leave such things to agreement? Or are there inequalities between contracting parties that allow better positioned parties to take advantage of others?
For years, industry players have brainstormed, lobbied and used strong-arm tactics to ensure they avoid financial losses and get paid for their work. The history of this battle began more than 200 years ago when Thomas Jefferson prepared Maryland for the construction of Washington D.C., and it ultimately reveals the United States’ overall perception. Can history offer any relevant insight to the industry today, and to construction business owners? The answer may be surprising.
Protecting Builders, Tradesmen and Suppliers
In the 1790s, the nation was new and it had an enormous inventory of empty land. What it lacked, however, was a stable banking or credit market enabling property owners to invest in developing the land.
Jefferson introduced the first mechanics lien legislation in Maryland in 1791 to promote the construction and development of modern-day Washington, D.C. The legislation’s purpose was to protect those furnishing materials and laborers against the risks of the sketchy banking and credit markets. The financial risk burden, in other words, would be borne by the top-of-the-chain parties.
Since then, every state has adopted a mechanics lien law. Written into each law is a promise by the state to the tradespeople and suppliers that payment is assured and financial risk is not theirs.
Circumventing Mechanics Lien Laws
Once Jefferson’s mechanics lien concept took hold, top-of-the-chain parties began a long campaign to offset the legal protections granted to bottom-of-the-chain parties.
The shortest distance between two points is a straight line, and accordingly, the first effort to offset mechanics lien protections was the no-lien clause. This is a contractual provision whereby a party signs away their right to use the lien rights.
This practice set up a battle between America’s policy interest in promoting the “freedom to contract” with the policy interests of protecting payment rights for tradespeople, builders and suppliers. Overall, the protection of payment rights prevailed, as only three states currently allow these no-lien clauses.
Unable to circumvent mechanics lien protections entirely, top-of-the-chain parties devised methods to mitigate those rights. One approach, the pay-when-paid clause, started becoming more prevalent in the 1980’s.
Most industry participants have encountered pay-when-paid clauses. These clauses have a variety of forms and styles, but typically control the timing of when payment will be due for furnishing labor or materials to a project. Through these clauses, the parties agree that payment due to one party (i.e. a subcontractor) will be due when payment is received by another party (i.e. the general contractor).
Since American policy protects tradespeople, builders and suppliers against nonpayment, most courts have refused to interpret these clauses to circumvent lien rights or the right to get paid overall. Instead, they are interpreted as a timing provision. If the when-paid part never occurs, the payment down the chain must still occur within some reasonable time. And lien rights, of course, are still intact.
Undeterred, top-of-the-chain parties made their payment provisions more clear. Now, contracts state that payment is only due to a subcontractor or supplier if (not when) payment is received up the chain. Or, the provision will be more explicit and say that “payment from the owner is a condition precedent” for payment to be due down the chain, or expressly state that “the subcontractor is assuming the financial risk.”
These provisions are fairly new and still working their way through the courts. Thus far many courts are invalidating these provisions as being against public policy. The courts enforcing these provisions associate a number of limitations including: (i) That the language must be clear; and (ii) That mechanics lien rights remain available despite the provision.
Payment Management Systems
Most recently, top-of-the-chain companies are utilizing technology offerings to offset or mitigate their financial risk. “Construction payment management” systems assist top-of-chain parties in organizing and monitoring the subcontractors and suppliers on a project.
While these systems can track which sub-tier parties send a preliminary notice and which do not, giving top-of-chain parties insight into their lien exposure, the ultimate effect on lien rights and bottom-of-chain party rights remains to be seen. Are these tools creating honest transparency and processes, or are they simply another stab at shifting risk back down the chain? Time will tell.
The Struggle to Get Paid Then and Now
The struggle to get paid has always been an industry problem, but there was a certain clarity in the past about payment rights. Today, unfortunately, the construction industry slugs through ambiguity, legal grey matter,
conflicting decisions and more.
This leaves contracting parties to battle one another for position, all the while, avoiding, ignoring or staying ignorant to the public policy set by Jefferson more than 200 years ago. Still, the laws are nearly everywhere: Financial risk is borne by the top.