News & Insights

Energy Law Exchange

April 1, 2012

Performance Security - Protections Available to Mitigate the Risks of Contractor Default During Construction of a Large Energy Project

Though there are numerous risks inherent in the energy industry, certain risks can be mitigated, such as the risk of contractor default during the construction of a large energy project. Different types of performance security are available to mitigate this risk, with each type providing its own unique advantages and disadvantages. Generally, an owner should obtain sufficient security to ensure that the general contractor performs and that subcontractors and other remote lien claimants are paid. In some cases, multiple types of security may be used in combination to achieve the desired risk profile for a project.

Performance and Payment Bonds Issued in the United States

Performance and payment bonds issued by a surety are commonly employed in the United States. Performance bonds protect against contractor default, whereas payment bonds protect the project from the liens of subcontractors and suppliers who have not been paid. The principle advantage of performance and payment bonds is that they provide significant security, typically with each bond equal to 100% of the contract price. The principle disadvantage pertains mainly to the difficulty in enforcing performance bonds, as the surety may in some cases become an unwilling participant. A suretys decision prematurely to admit liability may preclude it from collecting its expenses if the contractor is later found to be without fault. Consequently, the surety will generally not cure a default unless it believes the contractor is responsible, which may require the owner to sue the surety to collect on the bond. Thus, some view a performance bond as merely a deep pocket from which to collect damages at the end of a lawsuit.


During construction of a project, owners may retain portions of each progress payment to a contractor that will remain under the owners control until completion of the project. These portions of retained funds, or retainage, generally amount to 10% of the value of each payment. Retainage is an excellent source of performance security that an owner can quickly access when problems arise. However, not all owners will utilize retainage on energy projects but instead will rely on other sources of security.

Standby Letters of Credit and Bank Guarantees

Standby letters of credit are commonly found in large energy projects and used in lieu of performance bonds. Standby letters of credit are procured by the contractor and issued by banks in the United States in favor of the owner, usually in an amount equal to 10 or 15% of the contract price. To collect on the letter of credit, an owner merely claims that the contractor is in default and demands payment from the bank for the resulting damages. Demands for payment are honored unless there is evidence of fraud. Because of the ease of collection, standby letters of credit are an excellent alternative to retainage.

Outside the United States, bank guarantees are commonly used in lieu of letters of credit. Similar to the letter of credit, the beneficiary of a bank guarantee can collect on demand.

Parent Company Guarantees

Parent company guarantees are issued by a contractors parent company in favor of an owner. Parent company guarantees require the contractors parent company, in the event of contractor default, to step in the contractors shoes and perform. These guarantees are sometimes issued in combination with a letter of credit, and also provide a useful alternative to performance bonds when the parent company has substantial assets.


Several different types of performance security are available to owners and developers of large energy projects to reduce the risks associated with contractor default, with each type having varying degrees of convenience, cost, and overall security. In most cases, an owner will need to (i) balance its desire for full coverage with the need for quick payment and ease of use and (ii) weigh the cost of each type of security against the benefits received. Though it would be ideal to have a zero-risk construction project, the costs for achieving it are usually prohibitive. And notably, no amount of security will substitute for a well-drafted construction agreement that clearly defines the contractors obligations and the consequences of default. In conjunction with such an agreement, the right performance security heavily strengthens the owners position by providing additional remedies when a default occurs.