A surety bond or surety is a promise by a surety or guarantor to pay one party (the obligee) a certain amount if a second party (the principal) fails to meet some obligation, such as fulfilling the terms of a contract. The surety bond protects the obligee against losses resulting from the principal’s failure to meet the obligation.
Characteristics of Surety Bonds
A surety bond is defined as a contract among at least three parties:
- the obligee – the party who is the recipient of an obligation
- the principal – the primary party who will perform the contractual obligation
- the surety – guarantees the obligation will be performed
Through a surety bond, the surety agrees to uphold — for the benefit of the obligee — the contractual promises (obligations) made by the principal if the principal fails to uphold its promises to the obligee. The contract is formed so as to induce the obligee to contract with the principal, i.e., to demonstrate the credibility of the principal and guaranty performance and completion per the terms of the agreement.
The principal will pay a premium (usually annually) in exchange for the bonding company’s financial strength to extend surety credit. In the event of a claim, the surety will investigate its liability under the bond. If a claim is validated, the surety will pay the obligee and then turn to the principal for reimbursement of the amount paid on the claim plus any legal fees incurred. In some cases, the principal has a cause of action against another party for the principal’s loss, and the surety will have a right of subrogation “step into the shoes of” the principal and recover damages to make up for the payment to the principal.
If the principal defaults and the surety turns out to be insolvent, the purpose of the bond is rendered nugatory. Thus, the surety on a bond is usually an insurance company whose solvency is verified by private audit, governmental regulation, or both.
A key term in nearly every surety bond is the penal sum. This is a specified amount of money which is the maximum amount that the surety will be required to pay in the event of the principal’s default. This allows the surety to assess the risk involved in giving the bond; the premium charged is determined accordingly.
Surety bonds also occur in other situations, for example, to secure the proper performance of fiduciary duties by persons in positions of private or public trust.
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