Understanding Surety Bonds Definition, Parties, and History

In the world of finance, a surety, surety bond, or guaranty is a legal promise by one party to assume responsibility for the debt or obligation of a borrower if that borrower defaults. Essentially, it is a three-party agreement where a person or company (the surety or guarantor) promises to pay a specific amount to another party (the obligee) if a second party (the principal) fails to meet their contractual obligations.

Overview of the Surety Bond Process

A surety bond is a contract among at least three distinct parties:

• The Obligee: The party who is the recipient of the obligation (the entity that is protected).
• The Principal: The primary party who will perform the contractual obligation.
• The Surety: The entity that assures the obligee that the principal can perform the task.

In European markets, these bonds can be issued by banks (referred to as "Bank Guaranties" or "Cautions") or by surety companies. The primary purpose of the the bond is to induce the obligee to contract with the principal by demonstrating the principal's credibility and guaranteeing performance.

How it Works

The principal pays a premium, usually annually, to the bonding company in exchange for the surety's financial strength. If a claim is made, the surety investigates the claim. If valid, the surety pays the obligee and then seeks reimbursement from the principal for the amount paid and any legal fees. In some instances, the surety may have a right of subrogation, allowing them to "step into the shoes" of the principal to recover damages.

Key Terms and Risks

A critical term in almost every surety bond is the penal sum, which is the maximum amount the surety is required to pay in the event of a default. This allows the surety to assess the risk and determine the premium charged. One significant risk is the insolvency of the surety; if the surety becomes insolvent, the assurance is rendered worthless. Therefore, sureties are typically insurance companies whose solvency is verified by audits and governmental regulations.

History of Suretyship

The concept of suretyship is ancient, with the earliest known record of a contract of suretyship found on a Mesopotamian tablet from around 2750 BC. Evidence of individual surety bonds exists in the Code of Hammurabi (c. 1790 BC), as well as in Babylon, Persia, Assyria, Rome, and Carthage.

Evolution in the US and England

In medieval England, systems like Frankpledge were used for joint suretyship without formal bonds. The first corporate surety was the Guarantee Society of London in 1840. In the United States, the Fidelity Insurance Company became the first corporate surety in 1865, though it failed shortly after.

The US government has historically mandated surety bonds for federally funded projects. The Heard Act of 1894 required these bonds, which was later replaced by the Miller Act of 1935, which remains the current federal law mandating surety bonds on federally funded projects.

Why a Guarantor is Necessary

A surety is typically required when the principal's ability to perform is in question or when there is a public or private interest that needs protection from the default or delinquency of the principal. In most common law jurisdictions, these contracts must be recorded in writing and signed by both the surety and the principal to be enforceable under the Statute of Frauds.