Surety bonds are very important in industries like the construction and real estate businesses, and yet there are many misunderstandings or misconceptions when it comes to what surety bonds are and what they are used for. Although the term “surety bond” may sound like another category of insurance, surety bonds are very different from an insurance bond. Surety bonds protect the parties in a multi-party contract to ensure that levels of performance, payment, and practices are all met according to the terms of the contract. There are four main types of surety bonds that can be beneficial in a contract agreement, and it is important to know the differences between them and the benefits which they provide.
This is our guide to what you need to know about surety and why it’s important.
How Does Surety Work?
The purpose of this type of bond is to mitigate the risk in a contractual arrangement between two parties by providing an extra impartial party who ensures that the main two parties honor the terms. There are four main types of surety bonds, which are explained below, but it is first necessary to know how this third party protects the other two, making surety bonds uniquely secure contracts.
The neutral third party is called the surety, and they have the power to hold to account anyone who is shirking on those obligations. Sureties exist only in surety bonds and represent both of the other two parties; the principal and the obligee.
The principal is the individual or entity who is paying for the service which has been agreed in the contract. The best example to use is that of the construction industry because surety bonds are particularly important for construction contracts. A principal will often be a construction company who contracts a specialist individual or firm such as a landscaper (or landscaping company) to complete a certain part of the construction company’s larger project.
The obligee is the individual or entity who has agreed to perform the services paid for under the terms of the contract. There will be stipulations as to exactly what duties they must perform, for what money and in what time frame, and how much they will be paid by the principal upon satisfactory completion of those duties. In the above example, the obligee would be the landscaping firm.
What are the Four Types of Surety Bond?
The four main types of surety are performance bonds, payment bonds, maintenance bonds, and bid bonds:
Performance bonds ensure that the obligee in the contract completes the work to which they agreed to. This prevents the obligee from doing a shoddy job and still expecting full payment. In the example we have been using, it means that the landscaping company would have to do all of the landscaping work they agreed to and not cut any corners when it comes to materials used or the quality of the work. If the job is not up to scratch and the construction company has to bring in another landscaping company to sort it out, the surety would pay for that and then get the money back from the original landscapers with additional fees for the trouble.
Payment bonds ensure that there are no outstanding payments due to the obligee from the principal once the job has been completed according to the terms of the agreement. These may be payments for materials, labor, or completion bonuses. In our example, if the construction company failed to pay the landscapers, the surety would pay them and then get that money back from the construction company plus additional fees.
Maintenance bonds ensure that if the obligee leaves work outstanding such as maintenance and repairs that need doing, then they will come back to fix them. If, for example, the landscaping company didn’t finish the patio of a house and refused to come back, the surety would give the construction company the money they need to hire another landscaper, and would then get this money plus extra back from the original landscaping firm.
Bid bonds ensure that principles are protected from obligees claiming they have the resources to do the job being offered by the principle. For example, if a construction offered a landscaping contract and the firm which successfully bid for the contract did not actually have the resources to complete it, the surety would ensure that the construction company has the means to hire another company.
Surety bonds are essential in a host of business contracts in ensuring that the principal and the obligee meet their commitments. If either of these fails to do so, the other party will be protected by the surety, who will also take serious measures against the responsible party. Surety adds a level of protection which is above that in other types of contract, so it is always worth looking into.