A surety bond is a contractual obligation where a third party guarantees that the first party will live up to the terms of an agreement with the second party, or pay a penalty. They are often confused with insurance, but they are not. There is a wide variety of surety bonds to meet specific needs, including open penalty bonds.
A surety bond is a contract between three parties. There first party is the principal, or the person who will perform the acts or duties specified in a contract. Next is the obligee, a person who is the recipient of the principal's action. Third is the surety, or the person who guarantees that the principal does what he is contracted to do. If the principal fails to perform, the surety must perform in the principal's place. All surety bonds include a "penal sum," which defines the responsibility of the surety and principal. This usually includes an amount of money but may also include duties.
In a bid bond, the obligee guarantees that the principal will enter into the contract if his bid is accepted. If the principal bids on a job, wins the job, and then balks at signing the agreement to do the job, both the contractor and the surety become liable. Terms typically include payment of a sum based on what the estimate of doing another round of bids will cost.
Payment bonds guarantee that subcontractors and suppliers will be paid by the principal. In this case, the beneficiary of the bond is not the obligee but the subcontractors. However, this benefits the obligee by directing the ire of unpaid subcontractors toward the surety rather than himself.
A performance bond is a guarantee that the principal will complete the contract according to the set terms, especially relating to price and time. The surety is liable along with the principal. These bonds give the surety three choices: seeing the contract completed; joining the obligee in selecting a new contractor to finish the task; or allowing the obligee to finish the task, with costs paid by the surety.
Open Penalty Bonds
When a surety bond is written without any limit on the liability of either the principal or surety, it is known as an open penalty bond. These are not common, because of federal and state laws that limit liability to a company's assets. These require surety companies to not make commitments on any single bond beyond a specified percentage of their capital reserve. Open penalties would be unpredictable and possibly beyond that specified percentage.
Surety bonds are frequently needed in the construction industry. While most contractors know how to go about getting a surety bond, many construction business owners are not familiar with the specific legal obligations between the three parties to a surety bond. Therefore, just because the contractor renovating your kitchen is "bonded," it doesn't mean he fully understands his obligations.
Another example of a surety bond, and one unrelated to construction, is the importer entry bond. This surety bond guarantees the payment of tariffs and compliance with all regulations and requirements while importing goods. These bonds may either be for a set period or transaction or be continuous.
Another example of a non-construction surety bond is the bail bond. The principal is the accused person, the obligee is the government, and the surety is the bail bond company. If the accused fails to appear in court, the bail bond company is liable. The accused uses the funds to post bail and secure release from jail, pending trial. Typically, defaulting on a bail bond results in the seizure of whatever was offered for collateral on the bond; the bond company employs a bounty hunter to collect the accused.
Are Surety Bonds Insurance?
Bonds are not insurance, although they are often confused, perhaps in part because many insurance agents also sell bonds on behalf of surety companies. They guarantee performance. They do not indemnify as insurance does. They are not debt instruments, which is what a "bond" is commonly understood to be.