Surety Bond

A surety bond is a written guarantee in which one party, the surety, promises a second party, the obligee, that a third party, the principal, will perform an obligation or pay a debt. Federal regulations governing the Small Business Administration's bond program describe the principal as the person "primarily liable to complete the Contract" and "whose performance or payment is bonded by the Surety", and the obligee as the person "to whom the primary obligation of the Surety runs in the event of a breach by the Principal."

The principal pays the premium, so a surety bond is bought much as insurance is, but the protection runs the other way. Insurance moves a risk from the policyholder to the insurer. A surety bond leaves the obligation with the principal and adds a creditworthy backstop for the person the principal owes. This is also why the word "bond" here has nothing to do with the debt security an investor buys: a surety bond is a guarantee, not a loan.

Contract bonds. These back construction work. A bid bond guarantees that a contractor who wins a bid will sign the contract and provide the required bonds; a performance bond guarantees that the work will be completed under the contract's terms; and a payment bond guarantees that subcontractors and suppliers will be paid. The Miller Act, 40 U.S.C. 3131, requires a contractor awarded a federal construction contract above a dollar threshold to furnish both a performance bond and a payment bond "with a surety satisfactory to the officer awarding the contract", and the payment bond generally must equal the contract amount. The SBA guarantees bid, performance and payment bonds issued by participating surety companies, so that a small contractor that does not yet meet a surety's standards on its own can still be bonded.

License and permit bonds. A state can make a bond a condition of doing business. Oklahoma's Home Service Contract Act, for example, accepts a surety bond as one form of the financial security a home warranty company must place in trust with the Insurance Commissioner. When a business that must be bonded fails to meet the obligation the bond backs, the protected party, which may be the state or a customer, can claim against the bond up to its amount.

Court and fiduciary bonds. Courts use bonds to protect the people whose money a fiduciary controls. In Virginia, for example, a person named in a will as executor may not exercise the executor's powers until qualifying "by taking an oath and giving bond", and the court or clerk may allow a fiduciary to give bond without surety where the estate is small. Whether a will can waive the surety, and how much discretion the court keeps, is set by each state's probate law. A guardian or conservator can face the same requirement.

Why a surety underwrites like a lender. Because the principal stays primarily liable, a surety decides whether to issue a bond by judging whether the principal can perform and pay, which the SBA describes as a surety's "credit, capacity, and character" requirements. A surety that pays a claim can then look to the principal for the money. Montana's suretyship statute, for example, says that a surety that satisfies the principal obligation is owed reimbursement by the principal of "what the surety has disbursed, including necessary costs and expenses." For bonds the federal government accepts, the Treasury publishes Department Circular 570, the list of companies approved to write or reinsure federal bonds.

1. A requirement creates the need. A contract, a licensing statute or a court order specifies the kind of bond, its amount and who the obligee is.
2. The principal applies to a surety, directly or through an agent, and the surety reviews the principal's finances, experience and the obligation itself.
3. The surety issues the bond for a premium. The bond names the three parties, the obligation and the maximum the surety will pay.
4. If the principal defaults, the obligee makes a claim against the bond. The surety investigates and, if the claim is valid, pays up to the bond amount or arranges for the obligation to be completed.
5. The principal is still on the hook for the obligation itself; the bond added a guarantor, it did not take the debt away.

Consider an example on a construction job. A school district hires a contractor for a $400,000 renovation and requires a performance bond and a payment bond, each in the full contract amount. Halfway through, the contractor abandons the job having been paid $200,000 and leaving a supplier unpaid for $30,000 of materials already installed. The supplier claims on the payment bond and is paid the $30,000. The district claims on the performance bond, and the surety hires a replacement contractor who charges $260,000 to finish the work. The remaining contract balance is $400,000 − $200,000 = $200,000, so the surety covers the $260,000 − $200,000 = $60,000 difference, well inside the $400,000 bond amount. The district gets its building for the price it agreed, and the surety has paid $30,000 + $60,000 = $90,000 on claims arising from a default that was the contractor's, not the district's.

Pros

• Lets a contractor or licensed business prove it can be trusted with a job or a license without tying up cash as a deposit.
• Gives customers, suppliers, governments and heirs a solvent party to claim against if the principal fails.
• The SBA's guarantee program opens bonding to small contractors that a surety would not otherwise accept.

Cons

• It does not protect the principal. A business that buys a bond expecting it to work like insurance remains liable for the obligation the bond backs.
• Getting bonded means submitting financial statements and credit history, and a weak balance sheet can mean a higher premium, a smaller bond or none.
• Claims are limited to the bond amount and to the obligation the bond actually covers, which may be narrower than a customer assumes.
• Rules for court and license bonds vary by state, so the answer to whether a bond is required, or can be waived, depends on where it arises.