A surety bond is a contract that involves a guarantee that a legal agreement will be completed. It is commonly used to ensure that performance is completed under the terms of a contract. A bond agreement involves the participation of the following three entities:
- The principal. This is the party that is supposed to perform in accordance with the requirements of a contract.
- The obligee. This is the party receiving the obligation; typically the counterparty to the contract with the principal.
- The surety. This is a third party that does not directly perform the requirements of the contract, but rather who guarantees the performance of the principal under the contract.
Thus, the surety bond is a promise to pay the obligee if the principal does not perform under the contract. The surety makes the payment to the obligee. In exchange for this service, the principal pays a fee to the surety for as long as the surety bond is outstanding. In cases where the financial resources of the principal are in doubt, the fee will be quite high, or the surety will insist that all or most of the bond be kept in escrow during the term of the bond.
If there is a claim by the obligee for reimbursement under the surety bond, the surety will investigate the claim, pay it if the claim is valid, and then turn to the principal for reimbursement.
There are a number of types of surety bonds, including the following:
- Bail bond. The bail bondsman guarantees that an individual will appear in court.
- Bid bond. The principal guarantees that it will enter into an agreement with the obligee if awarded the contract.
- Performance bond. The principal guarantees that will perform the services specified in the contract.
The principal agrees to enter into a surety bond arrangement in order to mitigate the risk to the obligee that the contract between the two parties will not be fulfilled. Also, it is common practice in some industries (particularly the government and construction sectors) to always require a surety bond of any party that does a certain minimum amount of contractual business with an entity.
While a surety bond does show that a business has a certain amount of capital, it also acts to block smaller competitors unable to obtain a surety bond from bidding against them. Thus, a surety bond tends to reduce competition.