What is a Surety Bond?
A surety bond is a contract that is made between three parties where the guarantor guarantees to fulfill the specified task or sum to the creditor if the principal debtor dishonors the obligation or debt as mentioned in the bond hence protecting the creditor from the loss of nonperformance or nonpayment.
Who are the Parties involved in obtaining a Surety Bond?
Below are the three parties which are involved in obtaining a Surety Bond:
- Obligee – The person or company which requires the bondBondA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually.. The obligee is the entity that is protected by the bond.
- Principal – The person or a company that is purchasing the bond and promising to adhere to the terms of the bond. Usually, the principal must perform a task or refrain from doing a certain activity.
- Surety – The Surety is issuing and backing the bond for the principal and guaranteeing the indemnification to the obligee if a claim is made. In simple words, the surety guarantees to the obligee that the principal can perform the task.
Surety Bonds Example
Now let’s take an example and understand how Surety bond works.
Suppose a local USA Authority (Obligee) wants to construct an office building and hires XYZ contractor (principal) for the job. XYZ contractor is required by the local USA Authority to secure a construction performance bond to guarantee that they will full fill the terms of the contract. XYZ contractor will buy a construction performance bond form a reliable and trusted surety company.
Basically, the surety bond protects the local USA Authority by guaranteeing the performance by XYZ contractor to fulfill the obligation according to the agreement. Let’s suppose XYZ contractor fails to full fill the obligation then Surety Company must indemnify to local USA authority.
A house property and some financial assets are left by a deceased parent whose children are still minors, the court may then require a guardianship bond to be secured by the selected guardian. The bond is to ensure that the appointed guardian acts in the best interest to the person they had a guardianship (here court is Obligee and guardian is principal). The court approves the guardians on the evidence proving that the guardian will take care of financial assets in the best interest of minor children. If the guardian misuses the financials of the other person then the claim can be filed against that bond.
It is used as a guarantee that the principal will get the job done according to the terms of the contract, and if ever the obligee finds the terms of the contract are not fulfilled, a claim can be made against the surety bond if the surety finds that the claim is valid, then Surety will indemnify the obligee and the principal will be responsible for reimbursing the surety for the claim and any other cost. Therefore the Surety is in the middle offering a guaranteeing payment to one party and collecting the payment if a claim is made from the other party.
Types of Surety Bond
The following are types of surety bonds.
- #1- Court Surety Bond – This type of bond used to provides safety from loss which can occur in case of court proceedings. These bonds are required before a court proceeding.
- #2 – Fidelity Surety Bond – This type of bond is taken by the companies for protection from employee theft and from dishonest actions. These bonds are part of business risk management.
- #3 – Commercial Surety Bond – These types of bonds are used in favor of the General Public. These bonds are compulsory in some specific sectors by Government Agencies. For example, the liquor industry or any businesses with a license.
- #4 – Contract Surety Bond – This type of bond ensures that a construction contract will be fulfilled according to terms & conditions. On a single contract, always two surety bonds are issued one is to ensure the performance and the other is to ensure the payment.
- It provides protection from unwarranted claims.
- Maintain the confidentiality of all activities.
- It provides high credibility.
- Provide protection in case of any dispute.
- It gives assurance that the work will be completed as per the contract.
- A surety bond provides a guarantee that loss will be settled by a surety in case the principal’s inability to take up any unexpected cost.
- It provides greater leverage to the contractor because of this the can summit more tenders which provide additional revenues.
- It provides assurance to obligee that the contractor has a good financial position to handle the risk involved in the construction business.
- A surety bond is like a risk mitigation tool that provides protection to the customers of a business.
- Quality Compromise in certain cases since to minimize this, the surety can implement the least & cheapest remedy for contractor default which ultimately likely to compromise quality for the owner.
- The obligee has to quantify the loss that he had suffered in case of default by the contractor. If the obligee fails to calculate properly then oblige may not get the deficit from Surety.
- The cost of the contract increases since the Contractor is required to obtain a bond then he is going to include the cost of bond in to cost to contract.
- It may result in litigation because even though surety provides a guarantee in event of default by the contractor, the obligee has to prove to the surety that the contractor defaulted the conflict between Surety and Obligee which may result in litigation.
All the above advantages and disadvantages factors should be kept in mind and cost-benefit analysisCost-benefit AnalysisCost-benefit analysis is the technique used by the companies to arrive at a critical decision after working out the potential returns of a particular action and considering its overall costs. Some of these models include Net Present Value, Benefit-Cost Ratio etc. should be done for each construction project to determine where a bond is appropriate for a particular project or not.
Change in Surety Bond
The bond rider is the legal way to update information on Surety Bond. The following are the points which can be changed and then accordingly, Surety Bond should be rewritten.
- Change in the address of the principal.
- Increase in Bond Amount.
- Change in Date of bond or Term of a bond.
- If there is an error in the original bond that can be corrected.
Surety Bond in its simplest sense is a promise by a Surety that a specific task will be completed as per the terms of the contractor in line with the regulations. Most often Surety bonds are required by Government Agencies, Regulation Department, State Court, or Federal court or General Contractors for formal protection.
Thus, the crux is bond use to act as an insurance to the Obligee since he is beneficiary and credit to the Principal because claim should be repaid by the Principal to Surety.
This has been a guide to what is Surety Bond and its definition. Here we discuss the examples, types of surety bond along with detailed explanations. Here we also discuss the advantages and disadvantages. You can learn more about accounting from following articles –