How do Surety Bonds Work?
Surety bonds are a specialized type of guarantee, which is closely related to insurance. This type of guarantee is more than a simple type of assurance that is typically done between two parties. Instead, this type of surety is based on having an agreement that involves all parties.
Who are the Parties to a Surety Bond?
There are three parties to any surety bond. The first party is the Obligor. This is the party that is getting the bond. In a construction scenario, it would be the general contractor. The second party is the Obligee. This is the party that is getting the benefit of the surety bond. The third and final party is the surety itself. This is the party that is guaranteeing the performance of the Obligor.
Let’s look at an example. Let’s assume that Bob’s Construction needs a construction bond for its performance in building a store for Kohl’s. Kohl’s would require that Bob’s construction go out and get a performance and payment bond. This bond would assure that Bob’s Construction would build the store according to Kohl’s architectural plans and also make sure that all the materials were paid for and that any subcontractor was paid. If the store was not made according to the specifications in the underlying contract, or if a subcontractor were not paid, then Kohl’s (the Obligee) would be able to make a claim against the surety for damages. If the claim were determined to be valid, then the surety would find another contractor to fix the store or the surety would make sure that all subcontractors were paid.
Why a Three Party Agreement?
The defining characteristic of how a surety bond working is that it is a three party agreement and not a guarantee. In a three party agreement, each party is a direct beneficiary and signator of the agreement. What that means is that if there is any contractual dispute, then the party that believes it is aggrieved can bring an action directly against both parties, or either party. It does not have to first bring an action against one party and then bring a second action after that against someone else.
In a guarantee situation, the guarantor is not on the hook until there is a default against a party in an underlying agreement. That is, the guarantor is not directly at fault, or is a direct party, to that underlying agreement. So, the guarantor can have some delay or use certain legal defenses that are not available in a surety situation.
How does a Surety Bond Compare with Insurance?
A surety bond is very different from insurance. In a typical insurance scenario, the insurance is being sold with the premise being that the risk of a catastrophic event is being shared by multiple parties. Thus, although it is very certain that there will be an event, no one can know with any certainty to whom the event will happen. So, all the parties are sharing the risk through insurance.
Surety bonds are completely different. They do not work by spreading the risk. Instead, the typical performance bond is sold assuming that there will not be any event. This helps keep the cost down (otherwise the cost of a performance and payment bond would be prohibitive). Surety bonds are used to increase commerce by reducing the risk to the Obligee. If the cost were based like insurance, it would actually slow down commerce.
Surety bonds have three parties: 1) the surety; 2) the Obligor; and 3) the Obligee. The surety bond is different from a typical guarantee in that it is a three party agreement instead of a two party guarantee situation. The bond is not insurance either.