Surety
A surety is an individual or entity that assumes responsibility for the performance of another person’s duties or obligations. In a financial context, the term “surety” is most commonly associated with surety bonds, which are contracts involving three parties:
- Principal: The primary party who will be performing a contractual obligation.
- Obligee: The party who is the recipient of the obligation or the one to whom the obligation is owed.
- Surety: The party that assures or guarantees the obligee that the principal can perform the task. If the principal defaults or fails to fulfill their obligations, the surety is responsible for compensating the obligee for any losses incurred or ensuring that the task is completed.
Surety bonds are commonly used in a variety of industries:
- Construction: To ensure contractors complete projects as per their contractual obligations.
- Court: To guarantee payment for court-mandated judgments.
- Business Licenses: Some professionals or businesses are required to have license bonds before they can legally operate in certain jurisdictions.
- Public Officials: To ensure the honest performance of their duties.
It’s important to note that surety bonds are not insurance. While insurance is designed to compensate the insured party for unforeseen events or risks, surety bonds protect the obligee from any breach of duty or misconduct by the principal. The surety, after compensating the obligee, will usually seek reimbursement from the principal for any amounts paid out due to the principal’s default or failure.
Example of a Surety
Let’s delve into a construction scenario to demonstrate how a surety works.
Scenario: The “Green Valley City Council” wants to build a new public library. To ensure the project’s completion, they require bidding contractors to provide a surety bond.
Parties Involved:
- Principal: “BuildFast Construction,” a construction company bidding for the project.
- Obligee: “Green Valley City Council,” the entity commissioning the new library.
- Surety: “StableSure Insurance Company,” a company that issues surety bonds.
Sequence of Events:
- Bidding Process: “BuildFast Construction” wins the bid to construct the library for $2 million. As part of the contract, Green Valley City Council requires BuildFast to provide a performance bond, a type of surety bond, to ensure the project’s completion.
- Surety Bond Obtained: BuildFast approaches “StableSure Insurance Company” to get a performance bond. After assessing BuildFast’s financial health and past performance, StableSure agrees to act as the surety for the project. For this service, BuildFast pays a premium to StableSure.
- Project Underway: Construction begins. However, eight months in, due to financial mismanagement, BuildFast is unable to continue the project and defaults on their contractual obligation.
- Obligee Claims: Green Valley City Council, left with an unfinished library, makes a claim on the surety bond, requesting StableSure to fulfill BuildFast’s obligation.
- Surety’s Response: StableSure has two primary options:a. Finance BuildFast: Provide financial support to BuildFast, helping them to complete the project.b. Hire a New Contractor: Contract another construction firm to finish the library.StableSure decides to opt for the latter and hires “ConstructRight Inc.” to complete the remaining work. Any additional costs incurred beyond the original contract amount with BuildFast are covered by StableSure.
- Reimbursement : After the project’s completion, StableSure seeks reimbursement from BuildFast for the extra costs incurred due to the default. This includes the difference in project completion costs and any legal fees associated with the process.
This example highlights the role of the surety in providing a safety net to the obligee, ensuring that projects or obligations are fulfilled even if the principal defaults. However, the principal (in this case, BuildFast) is still ultimately responsible for the obligations and any costs the surety incurs.
