A surety bond is a contract between three parties:
- The Obligee – this is the party that is getting the benefit of the contract. A lot of times this is the government.
- The Obligor – this is the party that needs the bond to guarantee their obligation. That obligation can be a contract that they are working on (such as a general contractor), or a guarantee that they pay their taxes, such as with a license bond.
- The Surety – this is the party that is guaranteeing the performance of the Obligor.
updated November 2019
What is a Surety Bond?
A Surety bond is an agreement where the surety (the party that issues the surety bond guarantee) works with another party (called the principal) and guarantees the principal's work for the benefit of a third party (the Obligee).
How Does a Surety Bond Work?
A Surety Bond is a three party contract. In this agreement, the Principal joins into the agreement with the Surety to guarantee the work for the benefit of the Obligee (the third party). Obligee: The party (corporation, person, or the federal government) that receives the benefit of the bond. In a general construction scenario, the owner of the property is typically the Obligee as they will get the bond payment if there is a default. Principal: The company that the Obligee requires to be bonded (this is You). Surety: Usually the surety is large insurance corporation who provides the guarantee of the Company/Obligor. So, the bond works by providing that the Obligor/Contractor performs timely and builds according to the terms of the contract. If not, the Obligee can make a claim on the bond and then the Surety would provide money or find another contractor to finish the work.
What Do You Need a Surety Bond for?
In its most simple terms: you need it because the Obligee requires it. However, the reason that the Obligee wants a surety bond is that it provides protection for them as it guarantees that the Obligor/Contractor will perform according to the terms of the contract, which reduces the uncertainty of a missed deadline or other delay. Finally, for federal work, the government requires a surety bond (under the Miller Acr) and most state governments and municipalities have passed similar legislation, called Little Miller Acts.
Types of Surety Bonds
A bid bond guarantees that the bonding company (“surety”) will provide a performance and payment bond on behalf of the principal once the principal is awarded the contract. A claim can be filed against the surety if they refuse to write the performance bond.
A performance bond is used once the contract is awarded. A performance bond protects the owner from financial loss in the event that the contractor fails to perform the contract in accordance with its terms and conditions. Most performance bonds include a provision that covers workmanship of the project for one year after completion. A performance bond is typically included with a payment bond.
Payment Bond – A payment bond, also known as a material and labor bond, protects certain specified tiers of subcontractors, material suppliers, and laborers against the contractor not paying. In general, these claimants have a tendency to look to get paid directly by the surety company pursuant to the terms of the payment bond.
What is a bond?
What does the term “bond” really mean? Unfortunately, there are a lot of bonds out there – from surety bonds to treasury bonds to other bonds, James Bonds. This is a simple explanation of a surety bond. A guarantee bond or surety is a promise to pay someone, called the obligee, a specific dollar amount if someone else, called the principal, fails to comply with some commitment. These commitments are typically something that is specified in a contract and are especially common in construction contracts. The surety bond safeguards the obligee against losses arising from the principal’s failure to comply with the commitment.
Parties to a Surety Bond
A typical surety bond contains three different parties:
- The obligee – this is the person that gets paid if someone else doesn’t do what they said they’d do;
- The principal – this is the person who made the commitment; and
- The surety – this is the person that pays the obligee because they assured the obligee that the principal can do the job.
A side note – European surety bonds are issued by banks and are called “Bank Guarantees” in English and “Caution” in French. They pay money to the limit of guarantee in the event of the default of the Principal to promote his obligations to the Obligee, without referring by the Obligee to the Principal and against the Obligee’s single confirmed declaration of case to the bank.
Back to the US – with a surety bond, the surety agrees to support, for the benefit of the obligee, the legal guarantees (commitments) made by the principal if the principal fails to uphold its assurances to the obligee.
The contract is formed so as to cause the obligee to deal with the principal, i.e., to show the trustworthiness of the principal and guarantee performance. Thus, the obligee gets some comfort with regard to the principal so that they can form a contract with the principal.
The principal will pay a price (usually annually) in exchange for the surety’s (bonding firm) fiscal backing so that they can get this surety bond. The principal is willing to pay for the surety bond because then they can get the contract and start some profit-paying work.
So, what happens if the principal cannot perform? Well, that circumstance, the surety will investigate the situation and determine if there is a valid claim (sometimes, the obligee complains, but that complaint is without merit). If the claim is valid, then the surety will pay it. The surety then looks to the principal for reimbursement of the amount paid on the case and any lawful charges sustained.
So, what happens if the principal defaults and the surety is also insolvent? In those cases, the surety bond is worthless. That’s why the guarantee on a bond is normally an insurance policy company whose solvency is verified by personal audit, government policy, or both.