Growing Prohibition on Pay-if-Paid Clauses: Virginia Joins North Carolina and South Carolina in Prohibiting Pay-if-Paid Clauses

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Imagine you are an electrical subcontractor working in Virginia for a general contractor on a commercial project. Because you perform electrical work, much of your scope falls after framing and roofing, and after the envelope for the structure is dried-in. All the predecessor work leads to countless opportunities for defects, delays, or other reasons that the owner elects not to pay the general contractor. You demand payment from the GC, but the GC claims it owes you nothing until it is first paid by the owner, pointing to a “pay-if-paid” clause in the contract. Here is one common iteration of a pay-if-paid clause:

The Parties agree that any payment by the Contractor to the Subcontractor is subject to the condition precedent that the Contractor is first paid by the Owner for the underlying work.

Until earlier this year, such a subcontractor performing work in Virginia might have found itself waiting for owner payments to the GC that never came. In fact, for nearly three decades Virginia expressly recognized and enforced pay-if-paid clauses. North Carolina and South Carolina both already had legislation on the books that prohibited enforcement of pay-if-paid provisions.^[1] But on April 27, 2022, Virginia joined the Carolinas when the Virginia Legislature Adopted and Governor Glenn Youngkin signed into law Virginia Senate Bill (SB) 550.^[2] SB 550 voids pay-if-paid clauses in Virginia by stating that “[p]ayment by the party contracting with the contractor shall not be a condition precedent to payment to any lower-tier subcontractor, regardless of that contractor receiving payment for amounts owed to that contractor[]” for both public and private contracts.^[3]

SB 550 becomes effective on January 1, 2023, at which time pay-if-paid clauses in Virginia will be unenforceable in contracts executed after that date. However, there is an exception applicable to only private projects that permits enforcement of a pay-if-paid provision when the upstream payments cannot be initiated, because the owner or upstream contractor is insolvent or a debtor in bankruptcy.^[4]

The new legislation also prompts implications for pay-when-paid provisions. A pay-when-paid clause is distinguished from pay-if-paid clauses by the former permitting only a delay in payment for a “reasonable time,” eventually expiring and requiring payment to the subcontractor, even if the upstream payer was never paid itself. The latter clause theoretically allows a total denial of payment to the downstream sub in the event upstream funds are never disbursed.

On January 1, 2023, private Virginia construction contracts under SB 550 will see their pay-when-paid provisions capped by a statutorily mandated reasonable period outlined as being “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.” Put more simply, receipt of funds from upstream triggers a seven-day window to pay one’s subcontractors for scope covered by the payment, while satisfactory completion of work plus a sub’s invoice for that work triggers a sixty-day maximum period for payment, regardless of the receipt of funds. Nevertheless, SB 550 still allows a contractor to withhold—in good-faith—amounts from payment relating to a breach of contract by the subcontractor, so long as the contractor notifies the sub:

1. in writing, of his intention to withhold all or a part of the subcontractor's payment with the reason for nonpayment;
2. specifically identifying the contractual noncompliance; and
3. the dollar amount being withheld, and the lower-tier subcontractor responsible for the contractual noncompliance; and
4. the lower-tier subcontractor responsible for the contractual noncompliance.^[5]

Prompt pay acts such as SB 550, and those in North Carolina and South Carolina, are meant to be a shield for downstream workers and are drafted so that they cannot be used as a sword against upstream contractors to extract funds for subpar work. For example, under North Carolina law, contractors may stop funds from making their way to subcontractors that have performed “unsatisfactory job progress; defective construction not remedied; disputed work” and several other statutorily enumerated deficiencies.^[6] South Carolina incorporates a cascading 21-7-7 default pay timeline where the owner must pay the contractor within twenty-one days of work “performed in accordance with the . . . contract,” and the contractor must pay its subs (and the sub must pay its own subs and suppliers) within seven days of receipt of payment.^[7] This 21-7-7 timeline can be changed in private contracts.^[8] Note that, like N.C., the work performed must still comply with the provisions of the contract.^[9]

While the above changes to pay-when-paid under SB 550 apply to private work, they do not apply to public work; therefore, the status quo under the Virginia’s Public Procurement Act (Chapter 43) remains unchanged. Within seven days of receipt of money paid to the contractor by the state or municipality for work performed by the subcontractor, the recipient contractor must either:

1. “Pay the subcontractor for the proportionate share of the total payment received from the agency attributable to the work performed by the subcontractor under that contract;” or
2. “Notify the agency and subcontractor, in writing, of his intention to withhold all or a part of the subcontractor's payment with the reason for nonpayment.”^[10]

It is worth noting that despite the changes SB 550 makes to the contingency and timeframe for payment, the legislation makes no changes to retainage provisions in construction contracts. Thus, contractors may still hold retainage until substantial completion or otherwise in accord with the contract terms.

Virginia is now in a steadily growing minority of states that deny enforcement of pay-if-paid provisions.

In sum, both prime and subcontractors operating in Virginia should be aware of these changes to the public policy on downstream payments taking effect for construction contracts executed on or after January 1, 2023. If you or someone you know could use assistance updating contracts accordingly, or fighting improper payments in a construction contract, we at Nexsen Pruet, LLC stand ready to serve you.

_{[1] N.C. Gen. Stat. § 22C-2 (2022); S.C. Code Ann. § 29-6-230 (2022).
[2] Va. Code Ann. §§ 2.2-4354, 11-4.6 (effective Jan. 1, 2023).
[3] §§ 2.2-4354(1), 11-4.6(C).
[4] § 11-4.6(C).
[5] Id.
[6] N.C. Gen. Stat. § 22C-4.
[7] S.C. Code Ann. § 29-6-30.
[8] § 29-6-50.
[9] § 29-6-40.
[10] Va. Code Ann. §§ 2.2-4354(1)(a) to (b).}