Surety Bonds 101
In most bond required projects the “obligee” is a government agency. Surety bonds work as a type of insurance policy for the party requiring the bond. These bonds are put in place to guarantee the performance of the “principal” per the contract terms and the payment of all materials and subcontractors to be certain of a lien-free project.
Surety Bond Definition
A surety bond is a binding contract between three different parties, which includes the surety, being the company who provides the bond, the principal, who needs the bond, and the obligee, which would be the owner or department who is requiring the bond.
As mentioned, the surety bond provides a guarantee to the obligee that the principal will conduct themselves per the terms outlined in the surety bond and the signed contract.
How Does a Surety Bond Work?
Let us break down surety bonds, legally, discussing the obligations that are insured in this legally binding contracts.
The principal: whoever needs the bond
The obligee: the one requiring the bond
The surety: the insurance company guaranteeing the principal can fulfill the obligation
Surety bonds are a credit instrument. The principal is extended credit guaranteeing the performance of the contract. If the bond’s requirements are not met, such as not performing contracted work or failing to pay suppliers or vendors, a claim may be filed against the bond. If there is a claim made against the bond and the surety is obligated to pay this claim, the principal is obligated to reimburse the surety.
The fact that the surety backs the bond, does not relieve the indemnified owners from responsibility. This agreement called “General Indemnity Agreement” and “General Agreement of Indemnity” binds all owners and spouses of owners to the contract requirements agreed upon.
The indemnity agreement pledges your corporate and personal assets to reimburse the surety for any claim(s) and legal costs that may arise. Please discuss with a qualified surety agent before agreeing.
Is Bonding necessary?
The necessity of bonding is because of you being required to provide one, which traditionally is laid out by the obligee in a few different forms. There are hundreds of surety bond requirements across the country for varying reasons and occupations. Some of the more common bond types are to get a business license, contractor license bonds, mortgage broker bond, and freight broker bonds, and not least payment and performance bonds for contractors.
Understanding How Your Covered or Not
A bond claim is never an enjoyable experience. It comes because of the contractor not abiding by the terms of the bond. If you fail to do so, a bond claim is made. There are a few reasons why this can be costly. This including but not necessarily limited to the claim itself and any legal cost incurred.
The surety is on the hook for the entirety of the bond, when a surety provides you a bond, they are saying you are in a strong enough financial position to cover any claims that may arise. This makes sureties look at the potential for a claim by the principal, and if a claim arises, the wherewithal of the principal to repay the claim.
How do I decide which type of bond I need?
Every business model is different, and so not every business requires the exact same type of bond. For the most part, three categories of surety bonds exist that could be required as part of doing business. These broad surety bond types include:
License and Permit Bonds -Various professionals are required to provide these bonds in order to operate legally. Some examples being auto dealers, licensed contractors, and freight brokers are some examples of professionals required to secure a license or permit bond.
Contractor Bonds- individuals or businesses working on public construction projects are likely required to obtain a contractor bond, often called bid, payment, and performance bonds.
Court Bonds -two examples being probate and judicial bonds. These bonds are required by certain courts for a variety of purposes.
How Can I Obtain a bond?
Once you have determined which type of bond is being required, it is important to determine the requirements surrounding it. Throughout the country, states, counties, and cities may have different surety bond requirements based on your profession or business. Obligee’s are very specific on the bond requirements and will not accept an incorrect bond.
These are steps to follow to ensure you are getting the right bond:
Contact your state or local licensing authority or the obligee requesting the bond to ask which category of bond you need, and in what amount.
Contact a professional for assistance to determine the appropriate bond to meet your need.
Why Choose a Surety Bond?
There are a few benefits to choosing to obtain a surety bond beyond the actual requirement of the obligee. Getting a surety bond shows the obligee you can secure credit and expresses the fact that you have been vetted in some form by the surety. This can make you more competitive for bonded and unbonded projects. As the principal of the bond, this credit from the surety is often a more cost-effective way of meeting obligee requirements compared to the alternatives.
Letters of Credit and holdings by custodians can be utilized in some cases. These options can be significant financial burdens both upfront and, in the future, they come with a slew of downsides.
Some alternatives and thoughts can include:
100% Collateral – Business and personal assets are used to make the guarantee instead of providing the bond.
Working Capital Change - Generally, the bond premium cost is less than the opportunity cost of investments or the effect of the funds being lost from the companies working capital. You should always consult your bond agent before doing so, to see how this might impact the organization.
Banking Impact – Banks look at liquidity when considering loans. Posting your own assets, including cash, in lieu of purchasing a bond decreases your liquidity. This can make it more difficult to get financing or cover major expenses in the future, which could lead to financial stress and possible bankruptcy.
Claims Investigation – When providing a bond, the surety is in your corner. The legal resources of the surety are there to ensure your rights are protected to the extent of the law. A surety works through an investigation process when a claim against a bond is made. On the other hand, your assets are previously pledged and the arduous process of reclaiming them can be long.
Although these options provide a way to meet obligee requirements without posting a surety bond, the downsides can be substantial. With a bond, the biggest benefit you receive is the bonding company is making a guarantee on your behalf while you are only having to post a small amount of it. This, for many, can be a better alternative.
It is important to understand that the indemnity agreement that requires you to back your promise with corporate or personal assets also may make more sense. The surety is extending surety credit with only a signature as collateral.
Compared to other extensions of credit that require physical collateral, such a mortgage on your home, a bond is less risky. If you have a claim to pay and you used a mortgage to pay the up-front cost, the financial institution uses your home as collateral if you cannot pay through other means.
How to Avoid Claims
The best way to avoid claims is the avoid claims activity from the beginning. Begin by having a clear understanding of what the bond is guaranteeing you’re your will or will not do.
Unfortunately, this is not always easy, unless you are also an attorney. Bond form language contains legalese that may be difficult to understand. Often statutes are mentioned in contracts adding to the level of difficulty.
Having a surety bond agent that is able to explain specifically what your bond guarantee is imperative Be sure to work with a surety that provides this education on your specific bond so you can avoid claims whenever possible.
Understanding What a Surety Bond Does
Bond forms are the map to the obligation of the bond and therefore the guarantee. The form combined with the contract language you will be able to determine your exposure.
Each state has different requirements on their bond forms. Although parts can be universal, it is extremely important to understand what your bond is guaranteeing, but with thousands of different bond forms for a variety of bond types required throughout the country, there is no general answer to this question. What may be beneficial is reviewing common bond types and what they guarantee.
It is also helpful to understand the various bond categories, as we laid out above. Some common surety bonds that are required for licensing court bonds, fidelity bonds, financial guarantee bonds to name a few.
The most common surety bonds needed to perform work on public projects include bid, payment, and performance bonds.
You are not expected to become a surety expert, and therefore relying on your bond agency to provide insight into the bonds you need, and the obligations attached are crucial. Having a bond agent that can take the mystery out of bonding should be your goal in choosing one.
NIELSON HOOVER AND COMPANY
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