Payment Terms: Entitlement, Timing and Security

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1 Payment Terms: Entitlement, Timing and Security Introduction: Progress Payments and Final Payment Payments to construction subcontractors can be divided into two categories: progress payments and final payment. Progress payments are designed to supply the funds "necessary for the agreed performance," 1 so subcontractors can pay for labor and materials as the project progresses. Final payment, on the other hand, is a special case. This is because in most circumstances a subcontractor s acceptance of a payment that is designated as final payment constitutes the subcontractor's waiver of all outstanding claims, 2 including claims for unpaid, extra work. Another difference between progress payments and final payment is retainage. 3 "Retainage" is an agreed percentage that is withheld from progress payments, but which is ordinarily paid as part of the final payment, or immediately before final payment when the project is substantially complete. Amounts of Payments The amount of each progress payment that is made under a lump sum construction contract is ordinarily determined by comparing the actual work that has been performed to a schedule of values that apportions the total, lump-sum contract amount among separately identifiable stages of work, according to their relative values. 4 The seller is commonly entitled to submit applications for progress payments at periodic intervals (e.g. monthly) or to submit applications as certain milestones in construction are reached. To encourage advance procurement of materials and equipment, construction contracts typically allow the seller to apply for payment for materials and equipment stored at the construction site or some other agreed location. 5 The buyer is then entitled to inspect the work and delivered materials that underlie the application, to verify that the work has been properly performed, and that materials have been suitably stored and insured, before making payment. 1 Manganaro Corp. v. HITT Contracting,193 F.Supp.88, 97 (D.D.C. 2002). 2 See ASA s Payment Advocacy Year ( PAY! ) white paper for February 2003: Final Payment. 3 See ASA s white paper for July 2009: Retainage. 4 Frontloading and backloading occur when the relative values of the work are skewed so that the seller is either paid too much up front (frontloading), or too little until the end (backloading). Backloading is a way to disguise retainage. See ASA s white paper for July 2009: Retainage. 5 Guideline on Payment for Stored Materials and Equipment, Guidelines for a Successful Construction Project, Associated General Contractors of America, ASA, Associated Specialty Contractors, published at See also ASA s Payment Advocacy Year (PAY!) August 2003 white paper, Stored Materials. 1

2 A buyer of construction services ordinarily reserves the right, in the written contract, to withhold, or reduce the amounts of, payments otherwise due to the seller, based on dissatisfaction with the services that the seller has provided. In addition, the buyer frequently reserves the right to take set-offs against its payments to the seller to remedy defects in the work performed by the seller. In other words, buyers reserve contractual rights to backcharge the seller for the cost to hire another contractor to perform remedial work. Unfortunately, buyers of construction services often withhold payments for reasons that (1) the seller cannot control, and (2) have nothing to do with a seller s performance of its contract obligations. Subcontractors can mitigate the chances of unwarranted backcharges by insisting on contract terms that require their general contractor to provide them with notice of any claimed defects in their work before the general contractor incurs any backcharges. These terms should also afford subcontractor with a reasonable opportunity to avoid backcharges by commencing corrections on its own. These types of clauses should not be objectionable and maintain your ability to control your own work. In addition, it is always wise to insist on contract language that requires that any actual backcharges be billed promptly enough to permit verification and thus ensure authenticity and reasonableness of the charges. 6 Payment Timing and Entitlement: Pay-when-Paid and Pay-if-Paid Payment timing terms that are considered typical in the construction industry pose such extraordinary credit risks for subcontractors that it can be difficult for credit managers and other objective observers to understand how these objectionable terms have become so entrenched. A. Pay-When-Paid" vs. Pay-if-Paid Contracts Construction subcontracts typically provide that the general contractor s payments are not due and owing to the subcontractor until the general contractor actually receives payment from its customer (an upper-tier contractor or the project owner). These clauses are known as pay-when-paid clauses because they require the general contractor to pay only when it is paid. Pay-when-paid terms present extraordinary credit risks because the subcontractor who signs on to them accepts the risk that a party over whom it has no control, and with whom it has no direct communications, will fail to make payments in a timely fashion. Agreeing to pay-when-paid terms will be inevitable in many cases, considering that that the very 6 For example, the A subcontract requires the buyer to provide written compilations to the Subcontractor of services and materials provided and charged for such services and materials no later than the fifteenth day of the following month at

3 purpose of progress payments is to supply the funds needed to finance a lengthy schedule of performance. B. The Risks Involved With Accepting Conditional Payment Terms The fact that a construction buyer will not, in most cases, be able to afford to pay its subcontractor-seller until it receives payment from its own customer may be a sufficient reason to justify the use of pay-when-paid payment terms, but only where they do not shift the risk of total nonpayment to the subcontractor-seller. That fact does nothing, however, to alleviate the credit risk taken by the subcontractor-seller. To the contrary, the inability of the subcontractor s customer to afford to pay for construction services with its own resources which is always implied when pay-whenpaid or pay-if-paid terms are proposed clearly magnifies the subcontractor s own credit risks. One example of the extraordinary risk imposed by pay-when-paid terms flows from the fact that the subcontractor-seller necessarily has imperfect information about the precise time when the buyer receives payment from its customer. As a result, the subcontractor is left in the position of taking the general contractor s word about when its payments are actually due or past due! Moreover, the general contractor s need to push for timely payments from its own customer is necessarily eased when it is entitled to extend the time for its own payments to its lower-tiers. In other words, pay-when-paid terms reduce the general contractor/ buyer s natural incentives to ensure regular cash flow from its customer for the project. However, where the seller is a construction subcontractor who must (1) pay labor costs according to a strict payroll schedule, and (2) pay suppliers as well, the subcontractorseller s costs for late payments will far exceed the cost exposure of upper-tier contractors, who will only be exposed to the extent of their ordinary overhead costs. A payment delay of even a single day has much larger costs for a subcontractor who has to tap lines of credit, and pay interest on the borrowed funds, in order to keep current on its own accounts payable. What happens to the seller if the buyer is never paid by its customer? Although paywhen-paid terms pose extraordinary credit risks, in an overwhelming majority of jurisdictions, payment in accordance with a pay-when-paid clause must still be made within a reasonable time, even where the buyer never receives payment from its own customer. Payment terms that do clearly and unambiguously shift the risk of owner nonpayment are often called pay-if-paid terms to distinguish them from other paywhen-paid terms. 7 7 See, e.g., Farnsworth, E. Allan, Contracts, 3rd Edition (1999),

4 The distinction between a "pay-when-paid" and "pay-if-paid" clause is important. A payif-paid clause will clearly and unambiguously shift the risk of project owner nonpayment to the subcontractor. 8 The "pay-when-paid" clause will merely allow the general contractor-buyer additional time to make payment, but will not completely absolve it of responsibility to pay its subcontractors if payment from above does not come. In other words, even if the ultimate customer (i.e., the project owner) never makes a payment, the construction subcontractors who perform the work and supply the materials will still generally be entitled to be paid by the contractors who are their direct customers, unless the payment terms clearly and unambiguously shift the risk of owner (or upper-tier contractor) nonpayment to the subcontractor. C. Conditional Payment Terms and Late Payment Provisions Subcontractors are creditors, because they provide labor and materials on credit for a promise of future payment. As creditors, construction subcontractors should give careful consideration to the credit risks that they accept, and whether those risks can be ameliorated by terms providing for interest on late payments, costs of collection, and appropriate security. To collect interest on a late payment, for example, the contract should not only provide for a reasonable rate of interest, but also a way to determine when payment is late. Paywhen-paid terms, which require the buyer to make payment in a reasonable time, will almost never be considered late except in extreme circumstances, as where a monthly payment is several months overdue. As a practical matter, however, a monthly payment will have to be at least several months past due to be worth the cost of attempting to collect the accrued interest, and so that risk may be acceptable. Pay-if-paid terms, however, pose the risk that payment for services properly rendered will never, ever be due, and thus, never late. The effect can be similar in regard to security for payment. Can a mechanic s lien, or a claim against a payment bond, be used to secure a payment that is not, and may never, actually be due? Many jurisdictions recognize that a project owner should not be permitted to assert its own failure to pay for services it has received as a defense to the assertion of liens against the improved property, 9 and others have recognized that payment bond sureties should 8 Koch v. Construction Technology, 924 S.W.2d 68 (Tenn. 1996) (ASA appeared as amicus curiae). An excellent state-by-state summary of conditional payment laws prepared by Kegler, Brown, Hill and Ritter, Contingent Payment Clauses in the 50 States (2008 ed.), appears in the members-only section of the ASA Web site ( 9 See, e.g., Kansas Fairness in Private Construction Contract Act 3(c) (SB-33 (2005)) effective July 1,

5 not be permitted to assert the owner s nonpayment as a defense. 10 In many other jurisdictions, however, these questions are unsettled and may be resolved against the interests of subcontractors. Subcontractors who inform themselves about local laws in order to fully understand the credit risks posed by the payment terms of their proposed subcontracts will make much smarter business decisions. Payment Timing and Entitlement: Final Payment For construction subcontractors who specialize in work completed early in the project schedule, the release and payment of retainage always constitutes final payment because progress payments covering the entirety of their work will have been received well in advance of project completion. For later-finishing subcontractors, however, final payment may occur after release of retainage, because many construction contracts provide for release of most retainage upon the occurrence of substantial completion 11 of the project, subject to withholding of a smaller balance for completion of punch-list items (uncompleted or improperly completed project items). Amounts withheld from the release of retainage at substantial completion are generally a multiple of the estimated reasonable value of the punch-list items. 12 In such cases, final completion, and thus final payment, occurs after the punch-list and other close-out items (such as delivery of manufacturers warranties and maintenance instructions) are completed. Still, many general contractors and later-finishing subcontractors nonetheless associate release of retainage with final payment because many construction contracts provide that no retainage will be released until final completion, notwithstanding the earlier occurrence of substantial completion which is often combined with owner occupancy of the project. When retainage and change order approvals are withheld until final completion, a large fund remains after the substantial completion and owner occupancy of the project, which may potentially be used as leverage to unfairly resolve meritorious claims for extra work properly performed, for delay claims, and for other claims, often at the expense of faultless subcontractors who have properly completed their work. 10 See, e.g., Moore Brothers Co. v. Brown & Root, Inc., 207 F.3d 717 (4th Cir. 2000). 11 Commonly, substantial completion occurs when the owner can occupy and use the project improvements as intended. See, e.g., A at 9.8.1, DBIA 535 (1998) at , ConsensusDOCS 200 (2007) at See, e.g., AOD Form 2002GC (2002) at (menu allows retainage to be release at substantial completion less 200% of the reasonable value of remaining items, or release of ¾ of remaining retainage, or release of no retainage until final completion). 5

6 Whatever definition of final payment is used for a particular project, the risks of delay or non-receipt of final payment extend well beyond the ordinary risks of creditworthiness, miscommunication, or even outright dishonesty that may be associated with progress payments. Industry Practices on Payment Timing and Entitlement Industry payment practices are increasingly the subject of legal restrictions imposed by state legislation, suggesting that payment abuse in the construction industry is extensive. Public procurement laws, for example, usually address not only payment by public entities to prime contractors, but also payments by prime contractors to their subcontractors. Model contract documents published by industry trade associations vary widely in the way they address subcontractor payment concerns, suggesting broad differences of opinion on the proper treatment of subcontractor payment provisions. 1. Public Procurement Public procurement laws reveal that pay-when-paid terms for progress payments are common in the construction industry. Retainage, where it is still used on public construction projects, is normally held until final acceptance and not released upon substantial completion. Final payment may still be hostage to final settlement of all claims made by the public contractor. Federal procurement laws divide payments under construction contracts into progress payments and final payments. 13 Progress payments are required, by the federal Prompt Payment Act, to be made by a federal agency to a prime contractor on a construction projects within fourteen (14) days of the agency s receipt of a proper invoice from the construction contractor. 14 A proper invoice must include all the information and substantiating documentation required by regulation or by the contract, 15 but the federal agency is required to return any invoice that is not a proper invoice within seven (7) days after receipt specifying the reasons that the invoice is not a proper invoice, or else the fourteen (14) day period for timely payment is shortened by one day for each day the agency s response is overdue. 16 Contractors that fail to make timely payment face automatic interest penalties. 17 The federal Prompt Payment Act also imposes requirements on public contractors to pay their subcontractors promptly. It mandates that any construction contract awarded by federal agency must require the prime contractor to include a payment clause in any subcontract it awards obligating the prime contractor to make payment to the CFR (a)(1)(i) and (a)(1)(ii) U.S.C. 3903(a)(6) U.S.C. 3901(a)(3) U.S.C. 3903(a)(7) U.S.C. 3902, 3903(a)(6). 6

7 subcontractor within seven days of the prime contractor s receipt of payment. If it does not do so, the prime contractor must pay interest penalties. 18 The law also requires the prime contractor to pass along the same mandate to its subcontractors, so that each lowertier subcontractor or supplier will also be entitled to payment within seven days of its customer s receipt of payment. 19 Final payment on a federal construction project is made after completion and acceptance of all work and release of all claims against the Government, 20 requirements which essentially incorporate the state law concept of an accord and satisfaction at the time of final payment. Release of retainage and final payment are not interrelated on federal construction as with other projects. As a practical matter, the practice of holding retainage on federal construction projects has effectively ended. This is because retainage cannot be held on federal procurement contracts without cause, and should not be used as a substitute for good contract management by the contracting officer. 21 And general contractors cannot hold retainage because they are forbidden from requesting payment by the government for any amount to be withheld from a subcontractor. 22 Federal construction contracts may, however, provide for government use and possession of all or part of project improvements prior to completion. In such cases the contracting officer is responsible for furnishing a list of items of work remaining to be performed or corrected. 23 While the federal procurement rules avoid the terms substantial completion and punch-list, they nonetheless follow the general practice of using catch-all language to avoid binding the project owner, by providing that failure of the Contracting Officer to list any item of work on the punch-list "shall not relieve the Contractor of responsibility for complying with the terms of the contract. Final payment, then, is not tied to the punch-list, which is susceptible to being supplemented by additional punch-lists. However, the federal procurement rules are sensitive to at least some of the problems of the rolling punch-list, where they provide that the contractor is relieved of any responsibility for loss or damage to the work resulting from the Government s possession or use. 24 The practice of holding final payment hostage to settlement of outstanding, unapproved change orders should be less of a problem for subcontractors on federal projects because federal procurement regulations forbid contracting officers from directing or encouraging U.S.C. 3905(b) U.S.C. 3905(c) CFR (a)(1)(ii); see also 48 CFR (a)(3)(iii) (interest penalties not authorized for final payment where the amount is subject to further contract settlement actions ) CFR CFR (h) CFR , (a) CFR (b). 7

8 contractors to perform extra work without written change orders, 25 and changes cannot generally be requested without certification of funding. 26 Of course, contractors and contracting officers may disagree whether a change has occurred and whether a price adjustment is appropriate, 27 and so it is certainly possible for final payment to be delayed pending resolution of a dispute over changes and extras on a federal project. Nonetheless, recourse to contract appeals boards, and the general prohibition against arbitrary or capricious action by agency personnel under the Administrative Procedures Act, should provide some measure of relief against any opportunistic behavior at the time of final payment. Moreover, the contracting officer will not have any direct profit motive to engage in opportunistic attempts to underpay contractors. The District of Columbia and 49 states have also enacted prompt payment laws setting deadlines for payment of public construction contractors (only New Hampshire has no prompt payment law). Most are less generous than the federal law to public contractors in that they afford public agencies with considerably more than 14 days to pay. Deadlines of 30 or 45 days to pay public contractors on state jobs are not uncommon, and few states permit even longer delays. All but 10 of those 49 states with prompt payment legislation applicable to public procurement include deadlines for paying subcontractors. Only 6 of the 39 states with deadlines for paying subcontractors on public projects lack deadlines for paying lower-tier subcontractors. State procurement laws generally permit state public entities to hold retainage until final acceptance. Many of those laws do, however, permit the contractor to substitute securities for retainage, which earn interest for the benefit of the contractor. A few states have gone beyond the substitution of securities and directly require retained funds to be deposited in an account which earns interest for the benefit of the contractor and subcontractors Model Contract Forms Standard forms for prime contracts published by construction industry trade associations generally contemplate a monthly payment schedule, while standard form subcontracts published by the American Institute of Architects (AIA), ConsensusDOCS, and the Design-Build Institute of America (DBIA), all incorporate pay-when-paid payment CFR (a)(3) CFR In rare circumstances where certification of fund availability is not required, the contract must state that the government has no legal liability for work performed absent future appropriation, and so payment for the extra work still cannot be held hostage pending resolution of other claims. 48 CFR , See, e.g., 48 CFR (contractor must notify the Government in writing as soon as possible when it believes it has been asked to perform extra work amounting to a change). 28 See A Guide to Passing Retainage Reform in Your State, Appendix A ( Summary of Retainage Laws in the Fifty States ) (ASA, 2007). 8

9 terms. Retainage is required to be released upon substantial completion under some, but not all, standard forms of general conditions, and some, but not all, of the forms have a mechanism for the contractor to preserve outstanding claims at the time of final payment. Model prime contracts ordinarily require the prime contractor to submit an application for payment a specified number of days in advance of each scheduled payment to permit review, either by setting the number of days in the general conditions, or by requiring the parties to fix a particular number in a separate agreement document. They generally also require payment of interest on late payments. A. The ConsensusDOCS and Payment Terms The ConsensusDOCS form contracts are endorsed by the ASA and embody the best practices of the construction industry. Payment terms and interest payments are addressed in the ConsensusDOCS 200 (2007), which: provides for a monthly application for payment no later than the day of the calendar month; requires payment within twenty (20) days or written notice of deficiencies; and provides for late payment interest at the statutory rate at the place of the Project. 29 The ConsensusDOCS contract forms are distinguished by the ASA's endorsement and the ability to consider them together with subcontract forms published by the same group. The ConsensusDOCS Standard Form of Agreement and General Conditions Between Owner and Contractor expressly provides that a contractor can preserve its right to assert claims for additional money after receipt of final payment if it provides written notice and identification of unsettled claims with its application for final payment. 30 In addition, the ConsensusDOCS 750, Standard Form of Agreement between Contractor and Subcontractor, states that final payment does not relieve the Contractor for claims made in writing by the Subcontractor. 31 The ConsensusDOCS general contract expressly provides for release of retainage upon substantial completion, less a sum equal to two hundred percent (200%) of the estimated cost of completing or correcting remaining items. The ConsensusDOCS subcontract form allows for line-item release of retainage to early-finishing subcontractors, if the 29 ConsensusDOCS 200 (2007) 9.2.1, 9.3, ConsensusDOCS 200 (2007) at ConsensusDOCS 750 (2007) at

10 Subcontract Documents [elsewhere] provide for reduction of retainage at a specified percentage of completion. 32 If the owner retains all retainage until substantial completion, then the general contractor s payment to the subcontractor will be similarly delayed, even under the ConsensusDOCS, but final payment to the subcontractor shall be made within seven (7) days after receipt by the Contractor of final payment from the Owner for such Subcontract Work. 33 B. The Other Trade Association Forms Treatment of Payments/Interest Industry treatment of terms regarding payments and interest on late payments is as follows for the other (non-consensusdocs) forms: The EJCDC C-700 (2002) requires (1) the contractor to submit its payment application [a]t least 20 days before the date established in the Agreement for each progress payment and (2) the engineer, as the owner s agent, to within 10 days after receipt "either indicate in writing a recommendation or payment or return the Application to Contractor indicating in writing the Engineer s reasons for refusing to recommend payment. 34 The EJCDC C-700 does not set an interest rate for late payments, but also does not disclaim any existing right to claim statutory interest. In fact, it provides that where the Contractor stops work for nonpayment it may insist on payment of interest before starting work again. 35 The A , requires payment applications to be submitted 10 days before the payment date, gives the architect seven days to approve the application or provide notice of deficiencies to the contractor, and for interest at the legal rate on late payments. 36 The DBIA 535 (1998) refers to monthly progress payments, requires applications for payment to be submitted [o]n or before the date established in the Agreement. The DBIA 535 also requires the owner to give notice of deficiencies at least five days before the payment due date. If such payment is not made, interest will be assessed at the rate set forth in the Agreement ConsensusDOCS 750 (2007) at 8.2.2; also provides that the Contractor shall incorporate the Subcontractor s application for final payment into the Contractor s next application for payment to the Owner. 33 ConsensusDOCS 750 (2007) at EJCDC C-700 (2002) A.1, B EJCDC C-700 (2002) B. 36 A , 9.4.1, DBIA 6.2, 6.2.1, 6.3.1,

11 The AOD 2002GC, published by the Associated Owners and Developers, provides that Contractor may submit to Owner an itemized Application for Payment on or before the day of the month for the period ending on the day of the month. The 2002GC further requires that the owner provide notice of deficiencies at or before the time payment is due, and provides that any sums withheld shall become due within days after all reasons for withholding such sum have been removed. 38 The AOD form provides a 30-day grace-period before late payment interest, at a rate to be inserted by the parties, begins to accrue. 39 The CMAA A-3 (2005) requires payment applications to be submitted at least five (5) days before each progress payment is scheduled. But it also gives the construction manager fourteen (14) days to examine the application and send notice of deficiencies to the contractor. 40 The CMAA form provides for interest on late payments at the legal rate. 41 As for treatment of final payment in standard forms, when a contract is silent on the subject of a contractor s or subcontractor s right to pursue claims after final payment is received, any such claims may be waived by operation of state law upon acceptance of final payment. It is perhaps unsurprising, then, that the model contract form published by one association of project owners is silent on the effect of final payment as a waiver of claims. 42 The form essentially relies on the default legal rule of accord and satisfaction without employing a so-called red-flag explicitly providing for waiver of all claims on final payment. The same form, unsurprisingly, also omits any mention of release of retainage on substantial completion, although it does allow for owner occupancy of the project at that time. 43 Thus, the document leaves the entire fund of retainage for use as leverage to resolve all claims favorably to the owner in exchange for final payment. The standard form contract published by AOD provides a menu for the parties providing a choice between release of retainage upon substantial completion, 44 or upon final 38 AOD 2002GC 6.4.1, 6.5.3, AOD 2002GC CMAA A-3 (2005) , CMAA A-3 (2005) COAA Document B-200GC (2000) at Final Payment. 43 COAA Document B-200GC (2000) at AOD Form 2002GC (2002) The user has a choice between release of 75% of the retainage, or release of all retainage less 200% of the reasonable value of uncompleted work, where substantial completion is used as the benchmark. 11

12 completion. 45 The contract form expressly permits the contractor to preserve previously asserted claims. 46 The standard general contract form published by the Construction Management Association of America (CMAA) expressly provides that acceptance of final payment constitutes a waiver of all claims by the Contractor against the Owner. 47 The document is intended for use when the owner has hired a construction manager to serve as its agent to manage the construction project using another CMAA form, 48 and appears to put the leverage in the owner s hands with regard to final payment. The CMAA form document does not mention releasing retainage on substantial completion, even though it permits owner use and occupancy of the project. 49 The entire fund of retained money thus appears to, under the CMAA documents, remain in the owner s hands until final payment. C. ConsensusDOCS and DBIA Documents on Retainage and Claims after Final Payment The ConsensusDOCS 200 form makes an innovative attempt to tie release of retainage to the completion of punch-list items, by providing that the owner "shall pay the Contractor monthly the amount retained for unfinished items as each item is completed. 50 Standard forms published by DBIA permit both the design-builder and its subcontractors to preserve claims previously asserted in writing and remaining unsettled at the time of payment. The DBIA s Standard Form of General Conditions of Contract Between Owner and Design-Builder requires the design-builder to provide the project owner with a written release at the end of the project, expressly waiving, upon receipt of final payment, all claims except those claims previously made in writing to Owner and remaining unsettled at the time of final payment. 51 The DBIA documents similarly require general contractors and subcontractors working under the design-builder to provide written releases before final payment, and also allow claims against the designbuilder to be preserved if previously made in writing. 52 The DBIA documents provide for release of retainage to the design builder upon substantial completion. 53 Those working under the design-builder can expect their 45 AOD Form 2002GC (2002) AOD Form 2002GC (2002) CMAA A-3 (2005) at The document s first sentence provides that it is to be used in connection with the CMAA Document A CMAA A-3 (2005) at , , ConsensusDOCS 200 (2007) at DBIA 535 (1998) at DBIA 555 (DB-GC contract) (1999) at ; DBIA 560 (DB DB subcontract) (1999) at ; DBIA 570 (DB-nonDB subcontract) (2001) at DBIA 535 (1998) at 6.6.2, less an amount equal to the reasonable value of all remaining or incomplete items of Work. 12

13 retainage with final payment provided Design-Builder has received such retained amounts from Owner. 54 Otherwise, those working under the design-builder should still expect payment within ten (10) days after Design-Builder s receipt of final payment from Owner on account of Subcontractor s Final Application for Payment. 55 D. The AIA Documents on Claims after Final Payment and the Release of Retainage The AIA s A prevents waiver of claims previously made in writing and identified by that payee as unsettled at the time of final Application for Payment. 56 The A201 states that such claims are preserved after Acceptance of final payment by the Contractor, a Subcontractor or material supplier. While this is good, the AIA s A subcontract form does not directly address the issue of waiver on final payment. This means that subcontractors who use the A must ensure that the term incorporating the A by reference 57 is unadulterated to be certain that previously asserted claims will not be waived by acceptance of final payment. The A provides for release of retainage to the general contractor on substantial completion. 58 The A subcontract form provides for release of retainage to the subcontractor as soon as the subcontractor s work is substantially complete, if line-item release of retainage is permitted by the contract documents. 59 Otherwise, the subcontractor can expect payment of any owner-withheld retainage whenever it is received by the general contractor State Regulation of Private Payment Arrangements Timing and release of payments for private construction projects are increasingly the subject of state regulation. In 2002, for example, Missouri enacted a 10 percent limit on privately held retainage. 61 The law imposes a trust on retained funds for the benefit of the general contractor, subcontractors and suppliers, and also requires that contractors and subcontractors be permitted to substitute securities in lieu of retainage. A 2001 enactment in New Mexico requires both public and private retainage to be held in an escrow account with investment income inuring to the benefit of contractors and subcontractors DBIA 555 (1999) at 7.3.1; DBIA 560 (1999) at 7.3.1; DBIA 570 (2001) at DBIA 570 (2001) at 7.5.1; and see DBIA 555 (1999) at 7.6.1, DBIA 560 (1999) at A at A at A at 9.8.5, adjusted for Work that is incomplete or not in accordance with the requirements of the Contract Documents. 59 A at A at HB 1403, 91 st General Assembly, Missouri Revised Statutes HB 320 (2001) Retainage Act. 13

14 ASA maintains up-to-date resources detailing state restrictions on payment and retainage in its Guide to Passing a Prompt Pay Law in Your State and its Guide to Passing Retainage Reform in Your State, which are maintained as resources for legislative advocacy at the statement government level. Security for Payments: Trust Fund Terms, Liens and Bonds Project owners who are concerned that unpaid subcontractors may file mechanic s liens against their property can take steps when they request bids from prime contractors to increase the risk to the prime contractor for failure to pay subcontractors. One measure owners can implement is to insert "trust language" in the prime contract. This language will make the prime contractor a trustee of the funds it receives from the owner for the benefit of the subcontractors who are performing the work. As a trustee, the prime contractor cannot fail to pass payments through to subcontractors without subjecting itself to claims for breach of trust, punitive damages, and, in many states, criminal liability. Moreover, funds held by the prime contractor as a trustee are protected from the prime contractor s other creditors in the event of the prime contractor s bankruptcy. As one can imagine, a prime contract with trust language in it provides powerful protections to lower-tier subcontractors. For more details on imposing trust protections for subcontractor payments, see ASA s October 2003 Payment Advocacy Year (PAY!) white paper, Trust Funds. Another measure project owners can implement is to require the successful bidder to provide a payment bond. A payment bond is a guarantee provided by a surety of the prime contractor s obligations to pay its subcontractors. A list of sureties from whom the federal government will accept payment bonds for federal construction projects as required by the Miller Act (40 U.S.C et seq.) is published annually in U.S. Treasury Department Circular 570, which is available on the Internet at State government also all have their own, statutory bonding requirements for construction projects, called Little Miller Acts. For state-by-state details on state Little Miller Acts, read Lien and Bond Claims in the 50 States, available from the Foundation for the American Subcontractors Association ( If the owner does not act to impose a trust on funds paid to the prime contractor or to require payment bonds subcontractors must generally rely on statutorily-created liens against the project owner s property to secure their payments, commonly called mechanic s liens or construction liens. The rules for preserving and asserting a subcontractor s right to a mechanic s lien are as variable as the laws of the 50 states that provide for mechanic s liens. Subcontractors 14

15 should make themselves aware of the project owner s actual ownership interest in the property to be improved, as they may find themselves with a lien against a leasehold interest, rather than a lien against the equitable ownership interest in the improved real estate. For state-by-state details on mechanic s lien laws, read Lien and Bond Claims in the 50 States, also available from In addition to a mechanic s liens, construction contractors might also seek to obtain a lien against improvements they affixes to real estate through a fixture filing under Article 9 of the Uniform Commercial Code. A fixture filing lien may entitle the secured party to go back onto the land and repossess items that it has affixed to the real estate. For most construction contractors, a fixture filing would be inferior to a mechanic s lien because the lien of a fixture filing extends only to the particular piece of property that could be repossessed, rather than to the real estate itself. In addition, the provisions the Uniform Commercial Code that allow for fixture filing contain an exception for ordinary building materials incorporated into an improvement on land, as well as providing that the fixture-filing lien will, in most cases, be subordinate to a construction mortgage. 63 Finally, the financing statement that must be recorded in the land records to create the lien may require a signature from the debtor owning the real estate in order to impart record notice to creditors and purchasers, unlike a mechanic s lien, which requires no such signature. Not surprisingly, most debtors are unlikely to be particularly helpful to creditors seeking to lien their property. Thus, the lien laws of greatest importance to construction contractors and subcontractors are mechanics lien laws. Conclusion Issues about payment, payment timing, and payment security are fundamental credit issues that are central to the health of any business. In the contraction context, these issues are particularly critical to the survival of construction businesses which provide large amounts of labor and material on credit, for a promise of payment in the future. Subcontractors must identify, and recognize the differences between the kinds of payment arrangements that: (a) they consider acceptable; (b) are poor credit risks; and (c) are red flags indicating financial trouble is ahead. In taking these steps, and being aware of the best practices endorsed by the ASA and reflected in the 2007 ConsensusDOCS, subcontractors can better protect themselves from unpleasant and unnecessary payment risks. 63 UCC Article 9. 15