Surety
In finance, a surety, surety bond, or guaranty involves a promise by one party to assume responsibility for the debt obligation of a borrower if that borrower defaults. Usually, a surety bond or surety is a promise by a person or company to pay one party a certain amount if a second party 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.
Overview
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: who assures the obligee that the principal can perform the task
Through a surety bond, the surety agrees to uphold—for the benefit of the obligee—the contractual promises 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 guarantee performance and completion per the terms of the agreement.
The principal will pay a premium in exchange for the bonding company's financial strength to extend surety credit. In the event of a claim, the surety will investigate it. If it turns out to be a valid claim, the surety will pay and then turn to the principal for reimbursement of the amount paid on the claim and 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 to "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 assurance is rendered worthless. 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.
History
Individual surety bonds represent the original form of suretyship. The earliest known record of a contract of suretyship is a Mesopotamian tablet written around 2750 BC. Evidence of individual surety bonds exists in the Code of Hammurabi and in Babylon, Persia, Assyria, Rome, Carthage, among the ancient Hebrews, and in England. The Code of Hammurabi, written around 1790 BC, provides the earliest surviving known mention of suretyship in a written legal code.Suretyship was not always accomplished through the execution of a bond. Frankpledge, for example, was a system of joint suretyship prevalent in medieval England which did not rely upon the execution of bonds.
The first corporate surety, the Guarantee Society of London, dates from 1840.
In 1865, the Fidelity Insurance Company became the first US corporate surety company, but the venture soon failed.
In 1894 the US Congress passed the Heard Act, which required surety bonds on all federally funded projects. The US Supreme Court held in 1896, in Prairie State Bank v. United States, that an equitable claim by a surety to percentages of payment retained by the US government had priority over the claim of an assignee/lender.
In 1908 the Surety Association of America, now the Surety & Fidelity Association of America, was formed to regulate the industry, promote public understanding of and confidence in the surety industry, and to provide a forum for the discussion of problems of common interest to its members. SFAA is a licensed rating or advisory organization in all states and is designated by state insurance departments as a statistical agent for the reporting of fidelity and surety experience. The SFAA is a trade association consisting of companies that collectively write the majority of surety and fidelity bonds in the United States. Then in 1935 the Miller Act was passed, replacing the Heard Act. The Miller Act is the current federal law mandating the use of surety bonds on federally funded projects.
Reason for having a guarantor
A surety most typically requires a guarantor when the ability of the primary obligor, or principal, to perform its obligations to the obligee under a contract is in question or when there is some public or private interest that requires protection from the consequences of the principal's default or delinquency. In most common law jurisdictions, a contract of suretyship is subject to the Statute of Frauds and is unenforceable unless it is recorded in writing and signed by the surety and by the principal.United States industry
The SFAA published preliminary US and Canadian H1 surety results for the 2022 calendar year. Direct written premium totaled $8.6 billion and a direct loss ratio of 14.5%, highlighting strong profitability in the surety industry. The industry remains highly fragmented with over 100 companies directly writing surety bonds with new market entrants entering or reentering on a fairly common basis.annual US surety bond premiums amounted to approximately $3.5 billion. State insurance commissioners are responsible for regulating corporate surety activities within their jurisdictions. The commissioners also license and regulate brokers or agents who sell the bonds. These are known as producers; the National Association of Surety Bond Producers is a trade association which represents this group.
Miller Act
The Miller Act may require a surety bond for contractors on certain federal construction projects; in addition, many states have adopted their own "Little Miller Acts".The surety transaction will typically involve a producer; the National Association of Surety Bond Producers is a trade association that represents such producers.
Right of subrogation
If the surety is required to pay or perform due to the principal's failure to do so, the law will usually give the surety a right of subrogation, allowing the surety to "step into the shoes of" the principal and use the surety's contractual rights to recover the cost of making payment or performing on the principal's behalf, even in the absence of an express agreement to that effect between the surety and the principal.Distinction between a suretyship arrangement and a guaranty
Traditionally, a distinction was made between a suretyship arrangement and that of a guaranty. In both cases, the lender gained the ability to collect from another person in the event of a default by the principal. However, the surety's liability was joint and primary with the principal: the creditor could attempt to collect the debt from either party independently of the other. The guarantor's liability was ancillary and derivative: the creditor first had to attempt to collect the debt from the debtor before looking to the guarantor for payment. Many jurisdictions have abolished that distinction, in effect putting all guarantors in the position of the surety.Contract surety bonds
Contract bonds, used heavily in the construction industry by general contractors as a part of construction law, are a guaranty from a surety to a project's owner that a general contractor will adhere to the provisions of a contract. The Associated General Contractors of America, a United States trade association, provides some information for their members on these bonds. Contract bonds are not the same thing as contractor's [|license bonds], which may be required as part of a license.Included in this category are bid bonds ; performance bonds ; payment bonds ; and maintenance bonds. There are also miscellaneous contract bonds that do not fall within the categories above, the most common of which are subdivision and supply bonds. Bonds are typically required for federal government projects by the Miller Act and state projects under "little Miller Acts". In federal government, the contract language is determined by the government. In private contracts the parties may freely contract the language and requirements. Standard form contracts provided by the American Institute of Architects and the Associated General Contractors of America make bonding optional. If the parties agree to require bonding, additional forms such as the performance bond contract AIA Document 311 provide common terms.
Losses arise when contractors do not complete their contracts, which often arises when the contractor goes out of business. Contractors often go out of business; for example, a study by BizMiner found that of 853,372 contracts in the United States in 2002, 28.5% had exited business by 2004. The average failure rate of contractors in the United States from 1989 to 2002 was 14% versus 12% for other industries.
Prices are as a percentage of the penal sum ranging from around 1% to 5%, with the most credit-worthy contracts paying the least. The bond typically includes an indemnity agreement whereby the principal contractor or others agree to indemnify the surety if there is a loss. In the United States, the Small Business Administration may guaranty surety bonds; in 2013 the eligible contract tripled to $6.5 million.