Oral Argument Preview: Pay-if-Paid or Pay-When Paid?Transtar Electric, Inc. v. A.E.M. Electrical Services Corp.

Update: On July 17, 2014, the Supreme Court of Ohio handed down a merit decision in this case.  Read the analysis of the decision here.

Read the analysis of the oral argument here.

On November 5, 2013, the Supreme Court of Ohio will hear oral argument in the case of Transtar Electric, Inc. v. A.E.M. Electric Services Corp., 2013-0148.  At issue in this case is the language necessary to transfer the risk of nonpayment by the owner on a construction project from the general contractor to a subcontractor.

Case Background

A.E.M was the general contractor on the construction of a swimming pool at a Holiday Inn in Maumee, Ohio. A.E.M. entered into a subcontract with Transtar Electric, Inc. (Transtar) to perform certain electrical work on the project. Transtar performed work pursuant to the contract totaling $186,709.  A.E.M. made payments to Transtar in the amount of $142,620.  A.E.M. did not pay Transtar the remaining balance of $44,088 because it contended the owner failed to pay it for Transtar’s work.

Section 4 of the subcontracting agreement includes this provision, which was in bold and in capital letters: “Receipt of payment by contractor from the owner for work performed by subcontractor is a condition precedent to payment by contractor to subcontractor for that work.”

The parties disagree as to whether this contract provision clearly and unambiguously transfers the risk of non-payment by the owner from the general contractor to the subcontractor.

The trial court granted A.E.M.’s motion for summary judgment, concluding that Section 4 was a “pay-if-paid” provision (as opposed to pay-when-paid) that evidenced the parties’ intent to transfer risk of nonpayment from A.E.M. to Transtar.  Therefore, A.E.M. did not breach the contract.

The Sixth District Court of Appeals reversed the trial court’s decision, finding that the language was insufficiently clear and unambiguous to indicate the parties’ intent to transfer risk of the owner’s nonpayment.  The Court, noting that pay-if-paid provisions are generally disfavored, held that while the term “condition precedent” is helpful, it is not sufficiently defined to charge both parties with an understanding of the transfer of risk involved, and thus, is not good enough to show intent to transfer the risk.  “It must be made plain, in plain language, that a subcontractor must ultimately look to the owner of the project for payment. ”  Consequently the clause in this case must be interpreted as a pay-when-paid provision, requiring payment from A.E.M. to Transtar, but allowing a reasonable time in which to do so.

Key Precedent

Thos. A. Dyer Co. v. Bishop Internatl. Eng. Co., 303 F.2d 655 (6th Cir. 1962) (in the construction industry, a general contractor normally assumes the credit risk of the owner. If this was not the intention of the parties, this must be clearly and expressly stated  in unequivocal terms. Additionally, conditions precedent are especially disfavored when the obligee has no control over the occurrence of the event in question.)

In Evans, Mechwart, Hamilton & Tilton, Inc. v. Triad Architects, 2011-Ohio-4979, the Tenth District Court of Appeals faced a similar dispute.  The Evans Court held payment provisions qualify as pay-if-paid provisions only if they expressly state that (1) payment to the contractor is a condition precedent to payment to the subcontractor (2) the subcontractor is to bear the risk of the owner’s nonpayment or (3) the subcontractor is to be paid exclusively out of a fund the sole source of which is the owner’s payment to the subcontractor.  If a payment provision fails unequivocally to evidence an intent to create a condition precedent or shift the risk of the owner’s nonpayment, then the provision will be interpreted as a pay-when-paid, and not a pay-if-paid, provision.

A.E.M.’s argument

A.E.M. argues that the Sixth District Court of Appeals ignored the fundamental concept of freedom to contract and the unambiguous intent of the parties to transfer risk.  A.E.M.  asserts that it is settled law that contracts making provisions contingent upon certain events are valid and enforceable.  A.E.M. suggests that virtually all jurisdictions have interpreted condition-precedent language as sufficient to create pay-if-paid clauses.

Citing  BMD Contrs., Inc., v. Fid. & Deposit Co., 679 F. 3d 643 (2012) a recent case from the Seventh Circuit Court of Appeals, A.E.M. argues that stating payment from the owner as a condition precedent to payment of the subcontractor exactly demonstrates the parties’ intent to transfer risk.  Furthermore, the Appeals Court held that “condition precedent” is a legal term with clear meaning.

A.E.M. maintains that the contract provision is a “pay-if-paid” clause, the language is unambiguous, and clearly defines the intent of the parties. Furthermore, the language is Section 4 is capitalized and in bold, and no contracting party would be confused by is language. Since the language of Section 4 is unambiguous, A.E.M. contends that it is unnecessary and inappropriate to consider parol or extrinsic evidence of contrary intent. A.E.M. argues that it is undisputed in this case that it was not paid by the owner for the work performed by Transtar, and therefore it had no obligation to pay Transtar.

On policy grounds, A.E.M. suggests that Transtar’s proposed proposition of law would create confusion and uncertainty in the construction industry because its proposition provides little guidance on what type of pay-if-paid clause is enforceable.

Finally, A.E.M. states that Transtar waived any argument under R.C. § 2305.31 and under the Ohio Constitution’s right to remedy provision because it did not raise these issues at trial.

Transtar’s Argument

Transtar asserts that a contingent payment clause is enforceable only if a subcontractor expressly accepts the risk of the owner’s nonpayment for a specific reason, based on a review of the entire contract.  Transtar urges the Court to affirm the Sixth District’s holding that the boilerplate language in this contract did not accomplish this. Transtar argues that no set of “magic words” can eliminate the need for full contract review and factual inquiry.

Transtar argues that this contract does not unambiguously indicate the intent of the parties to transfer risk.  The boilerplate clause cannot be viewed in isolation of the overall relationship, intent of the parties, and other subcontractor protections.  The contract contains several other provisions that implicate A.E.M.’s responsibility to pay Transtar regardless of the owner’s payment or nonpayment; therefore, any ambiguity in its terms must be construed against the drafter, A.E.M.

Additionally, Transtar argues that A.E.M. failed to submit evidence of why the owner did not pay it. Transtar asserts that the owner is not insolvent and, therefore, the owner’s insolvency is not the risk of nonpayment at issue.  Before any finding can be made in favor of A.E.M. the trial court must determine A.E.M.’s own role in the nonpayment.  Implicitly A.E.M. must demonstrate its good faith efforts to collect, and its own lack of culpability.

Transtar also argues the contract violates  R.C. § 2305.31 which states that any covenant purporting to indemnify the promisee against liability for its own negligence is void. Finally,  A.E.M.’s refusal to aid Transtar in collection leaves Transtar without remedy, a right guaranteed by the Ohio Constitution.

A.E.M’s Proposed Proposition of Law

The unambiguous language in the subcontract between the parties is a “pay-if-paid” provision, which without payment by the owner, does not require the contractor to pay the subcontractor.

Transtar’s Proposed Counter Proposition of Law

A contingent payment clause may be enforceable only if a subcontractor expressly accepts the risk of an owner’s non-payment for a specific reason, based on review of the entire contract, if operative facts meet that reason, and it other consideration exists.

Amicus Brief in Support of Transtar

The American Subcontractors Association, Inc.; The American Subcontractors Association of Ohio, Inc.; and The Ohio/Michigan Chapter of the National Electrical Contractors Association filed an amicus brief in support of Transtar Electric.  The amicus asserts that its membership, as contractor, subcontractors, and suppliers, will be profoundly impacted by the decision of the Court. It is their position that pay-if-paid provisions are inequitable and against public policy, or at least should be strictly limited.

The amicus asserts that as a result of the nature of contracting, subcontractors are subject to the will and whim of prime contractors.  Pay-if-paid provisions completely shift the burden of financial risk from the prime contractor to the subcontractor, who can least afford to assume that risk, and have no way to assess, control, or monitor it. Since the owner has a direct contractual relationship only with the prime contractor, if the owner fails to pay the prime contractor, or if the prime contractor shirks its duties, the subcontractor has no legal recourse .

The amicus mirrors Transtar’s claim that “magic words” like condition precedent are insufficient to invoke the dire consequences of a paid-if-paid clause.

Student Contributor: Katlin Rust

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