Surety Bonds: A Brief Guide

2007-03-08 10:33:40

( Financial )



The best way to understand the concept of surety bonds is to look at it in the context of the construction industry.

Imagine a businessman who wants to construct an apartment building. Of course, he needs to hire a contractor to do the actual construction. So, he finds a contractor that he likes and they strike up a deal.

The contractor, in turn, asks the businessman for a significant sum of money as a down-payment for the contract. This amount is typically used to purchase the raw materials and construction supplies for the building.

The businessman comes up with the money and hands it over to the contractor. It is a sizeable amount of money, but he needs to pay it so that his building can be erected.

Now, what if the contractor flees before he can even begin the project? What if the contractor takes the money and simply walks away without a second glance? At this point, not even the foundation for the building has been built. No construction has taken place. The contractor has nothing to show for his work but a few rubbles.

What happens to the businessman? Will he get his money back? Will he be protected against financial loss?

If he has a surety bond in place, the answer would be Yes.

What is a Surety Bond?

A surety bond is a contract between three parties:

(1) the Principal or Obligor, a party who is bound by an obligation;

(2) the Obligee, a party to whom the Principal has made an obligation; and

(3) the Surety, a third party who guarantees to the Obligee that the Principal will fulfill its obligation

In our little story above, the contractor is the Principal. He has made an obligation to the businessman, the Obligee. The obligation, obviously, is the construction of the building.

If the businessman had a surety bond in place before the down-payment was made, the Surety would then be obliged to either complete the work or pay him for any loss incurred.

Basically, the surety bond is a guarantee that the obligation will be completed in accordance with the contract documents. The main purpose of the bond is to protect the interests of the Obligor.

So, what will happen to the contractor?

Once a surety bond is established, the Surety would always demand an indemnity bond with the Principal. This bond guarantees that the Surety will incur no loss by providing the surety bond.

So, in this case, the Surety has a right to seek legal action against the contractor for its failure to comply with the contract. By law, the Principal is obliged to indemnify the Surety from financial loss.


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