A surety bond is defined as a contract that legally binds three parties: a principal who needs the bond, an obligee who requires the bond and a surety that provides the bond.
The bond guarantees the principal will act in accordance with certain laws. If the principal fails to do so, the surety will cover resulting financial damages.
What Is the Purpose of a Surety Bond?
Surety bonds provide financial guarantees that contracts and other business deals will be completed according to mutual terms. Their primary purpose is to protect consumers and government entities from loss due to poor workmanship, malpractice, theft and fraud.
When a principal breaks a bond's terms, the harmed party can make a claim on the bond to recover losses. For example, most municipalities require construction bonds on public works projects. A public contractor must file a payment bond guaranteeing they will pay subcontractors and suppliers even if the contractor defaults.
In this example, the surety bond covers the municipality and subcontractors against financial harm, but it is not insurance. The bonded contractor must fully repay the surety for any claims.
What Is a Surety?
The surety in a bond contract refers to the company that issues the bond. Bonds are a form of financial security, and the surety is the entity that backs the bond. In doing so, a surety takes on responsibility for another’s debt.
Guarantees and sureties are both legal instruments that create more security in business contracts. You may hear the terms used interchangeably, but the legal definition of a surety bond is different from a guarantee.
- Sureties: Join the business deal as a third-party and offer a layer of security that the contract will be fulfilled by issuing a surety bond.
- Guarantees: Create an independent financial commitment outside of the contract in which the guarantor is financially responsible if the principal defaults.
