A surety bond is a legally binding contract entered into by three separate parties. Firstly, the obligee is a party in a two-way contract unsure that their opposite party in the contract will fully meet its terms. In international trade transactions, the obligee is usually an importer looking to import goods from a supplier based in a foreign legal or trade jurisdiction. That supplier, referred to as the principal, is the second party in the contract.

Transacting with international suppliers can create significant risks. For example, if a supplier in a foreign jurisdiction enters into insolvency, many governments put legal protections in place to ensure that firms repay their debts to citizens of the suppliers country before repaying any debts to foreign investors. To mitigate this risk, an obligee may require the principal in a contract to come forward with a surety to reduce this risk.

As the third party in the contract, the surety would provide a surety bond which assumes the risk of the principal not fulfilling their contract with the obligee. If the principal fails to deliver on the terms of the contract, the obligee can then claim against this bond to recover any losses incurred. If the claim is upheld, the surety will pay the value of the bond to the oblige in reparation for the failure, and recover the amount from the principal.

Surety vs Guarantee vs Insurance

A surety is similar to a guarantee; it is provided by a third party to mitigate the risk of a breach of contract by two contracting parties. However, sureties are specific financial products which deal with the breach of a contract (such as its immediate termination due to insolvency). In contract, guarantees take a number of forms in order to mitigate different financial risks created by contracts, such as late performance or failure to make good on a pitch for a contract which has been accepted.

Moreover, a surety has several key differences from an insurance policy. First, a surety is provided on “recourse terms”; if the surety has to pay the obligee for a breach of contract made by the principal, it is entitled to pursue reimbursement from the principal for the amount paid. This means the obligee does not have to expend time and resources recovering the amount owed, but the principle remains liable for the debt whilst the surety recovers it. In contrast, insurance policies agree to pay their owners a fixed fee in the event of a successful claim, with no further financial liability. Second, the fees associated with surety bonds are fees charged for the services provided by the surety (namely, their substantial financial backing). This is in contrast to insurance premiums, which effectively pay towards the cost of an insurer reimbursing insured parties who do claim on their insurance.

History

The United States has required federal construction projects to be underpinned by a surety since 1894.

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