What is a surety bond? Understanding the 4 types

Surety bonds have a long history in the U.S. of building trust between multiple parties in a business exchange. Different types of surety bonds provide different benefits based on the industry, state, and circumstances of the contract. For this reason, it's essential to know what types are available and how to get a surety bond that applies to you.

What is a surety bond and what’s its purpose?

A surety bond is essentially a security deposit. Surety bonds help small businesses win contracts and build clientele by offering the client a guarantee: Either the business will fulfill the obligations of their contract, or the client will receive compensation. Government agencies and financial services industries often require contractors to acquire a surety bond for large-scale projects.

Surety bond basics

Think of a surety bond as a three-party contract in which one party (the surety) guarantees another party (the obligee) that they will be financially liable for the performance of a third party (the principal). Each party has a particular role:

• The principal: the party responsible for performing a contractual and regulatory obligation, basically the contractor
• The obligee: the party that benefits from the principal's obligation, as in the client 
• The surety: the party that promises to pay the obligee if the principal doesn't perform the obligation, like a guarantor 

The amount that the surety promises to pay is called the penal sum. Since a surety bond is only as good as the solvency—the ability to pay—of the surety bond producer, this party is typically an insurance or surety company.

How surety bonds work

A surety bond is similar to an insurance policy. The principal pays a fee, called a premium, to the surety, who then provides the principal with a bond that incentivizes the obligee to trust the principal.

In the event of default—failure to fulfill the obligation—the surety pays the penal sum to the obligee and then seeks reimbursement from the principal. This contractual relationship—mediated by surety companies—offers the obligee a sense of security and the principal an opportunity to prove their capabilities.

Although state laws regulate surety bonds, federal law also may come into play if federal funding is involved.

When do I need a surety bond?

Construction agencies often need to get a surety bond to obtain large-scale federal development projects, especially those involving public property. This is because a contract surety bond—such as a performance bond—guarantees principals will fulfill the job according to the terms of the contract. In this way, surety bonds ensure adherence to government regulations. For example, the Miller Act prescribes surety bonds for all federal construction, supply, and service contracts over $150,000.

Similarly, new and used car dealers often need several surety bonds before they can obtain a license to sell cars from state or municipal authorities. A surety bond protects consumers—drivers—by holding businesses accountable to meet all industry rules and regulations.

This same system applies to many professional licenses in the U.S. Alcohol bonds, agricultural bonds, customs bonds, and Airlines Report Commission (ARC) bonds all exist to ensure that professionals in these industries prioritize the well-being of the consumer.

Types of surety bonds

There are numerous types of surety bonds, and there is no official or legal way to divide them into categories. However, it may be helpful to break them down into four categories: contract bonds, judicial bonds, probate court bonds, and commercial bonds.

Contract surety bonds

Contractor bonds, also called contractor license bonds, encourage the obligee to enter into a contract with the principal by offering tangible evidence of trust. If a principal holds a security bond, the obligee knows that the principal must fulfill the job according to the contract. Contract surety bonds are often used in construction and come in several variations:

• Bid bonds guarantee that a contractor who submits a bid will actually enter into the contract if the bid is accepted. They also guarantee that a contractor is able to fulfill the obligations of the contract before work begins.
• Performance bonds guarantee the contractor will fulfill the terms of the construction contract. These surety bonds tie contractors to their commitment to ensure the project's integrity and timely completion.
• Payment bonds guarantee that the contractor will pay subcontractors, laborers, and suppliers. Subcontractors also may be required to get bonded. Projects over $25,000 often require a payment bond to ensure smooth project execution and protect those providing labor and materials.
• Supply bonds guarantee that a supplier will produce supplies needed for a specific job or project. These bonds protect the purchaser against potential losses or setbacks for large projects involving many various materials or a high volume of just a few materials.
• Maintenance bonds guarantee that the contractor will provide upkeep or fix any problems that arise for a period of time after the project is finished. The duration of maintenance bonds varies, but essentially, they act as insurance on contractor workmanship.
• Improvement bonds, also known as subdivision bonds, are often required from developers or home builders by municipalities for subdivision developments. These surety bonds provide a promise to complete mandatory improvements to public buildings.

Judicial surety bonds

Judicial bonds, also known as court bonds, are useful in various situations involving court proceedings. For example, in a criminal case, bail bonds secure the defendant's appearance for trial or other future proceedings.

There also are several types of judicial bonds for civil cases:

• Appeal bonds, also called supersedeas bonds, protect the party that won in the original proceeding for damages in the event of a delay caused by an appeal by the losing party.
• Mechanic's lien bonds protect a defendant from damages that result from a mechanic's lien—a legal claim against a property if a supplier or contractor on said property isn't paid.
• Attachment bonds protect a defendant from damages in case of a property attachment—the seizure of property to pay a debt to a plaintiff who claims to be owed money by the defendant.
• Injunction bonds protect a defendant from damages that result from a wrongful injunction. An injunction is a court order to stop a person or entity from taking action, such as a cease-and-desist.

Probate court surety bonds

Probate surety bonds are used in probate proceedings—the court process where the terms of a will are approved by a judge, and assets are given to beneficiaries after all debts are paid off. A person appointed as a trustee, guardian, executor, or administrator in a probate proceeding has a special obligation to perform their duties with honesty, loyalty, and good faith. This is called a fiduciary duty.

A probate surety bond, also known as a fiduciary bond, guarantees that the trustee, guardian, executor, or administrator of an estate will faithfully perform their fiduciary duty to the beneficiaries.

Commercial surety bonds

A commercial surety bond is a general category for various bonds required for commercial businesses. Here are a few examples of types of commercial surety bonds:

License and permit bonds: Governments often require commercial businesses to acquire license and permit bonds before issuing a license or permit. This ensures compliance with regulations related to employee retirement plans, environmental protection, business-related taxes, and more.

Public official bonds: Notaries public, government officeholders, judges, and law enforcement officers often obtain public official bonds to demonstrate their commitment to faithfully performing their duties of office.

Business service bond: Small businesses that work on someone else's property may want to get this type of fidelity surety bond. This bond offers clients protection from a wrongful act by someone associated with the business.

For example, a business that provides office cleaning services may get bonded to guarantee protection against theft or property damage by its employees. Or, a brokerage or financial advisory company may obtain a fidelity surety bond to protect itself and its clients against employee embezzlement. Fidelity bonds help businesses and clients build a relationship on a foundation of trust.

There are many other scenarios in which a business can benefit from surety bonds:

• Establish lost promissory notes (written promises to repay a debt) and securities
• Guarantee self-insurance of a company for workers' compensation claims or employee fringe benefits.
• Obtain a commercial lease

Obtaining a surety bond

The steps to obtaining a bond can vary depending on the circumstances of your application and the surety you work with. However, there's a general process:

1. Research state or industry requirements to determine how laws and regulations impact surety bond requirements. Some industry bonds are also state-specific, such as the Florida Health Care Clinic Surety Bond and the New York Second Hand Dealer Bond.
2. Find a company you trust. You will want to make sure they are a state-approved and a licensed business with many years in business and a dedicated team of specialists that can help you get the appropriate surety bond. Check out the U.S. Small Business Administration's surety bond agency directory for agencies in your state.
3. Get a background check to determine the price of your premium and the amount of the bond. The surety will likely look at your credit report and business's financial history to determine the risk level of your bond.
4. Receive a bond premium that generally ranges from 1%-15% of the bond amount. You'll typically pay for premiums annually. If the U.S. Small Business Administration guarantees the surety bond, you'll receive an additional fee, but it will be easier for your business to obtain a bond.
5. Sign the necessary paperwork and pay the premium to receive your surety bond. This solidifies the contract between you and the surety. Often, you can receive your bond immediately after this step.
6. Hand over your bond information to the government agency or industry organization that requires it. Once you've turned in your bond, you're ready to begin your new project or obtain the commercial license and start your new business.

Knowing the different types of surety bonds that are available ensures you're better prepared if a situation arises in which you need the protection of a surety bond. For more information, consult with an attorney to learn more about the specific rights of the principal, obligee, and surety. An attorney can also walk you through the relevant rules and regulations in your state and how to find a company that fulfills those requirements.

Frequently asked questions

Keep reading for a quick look at common questions related to surety bonds.

How much is a surety bond?

The cost of a surety bond varies based on the amount of the bond claim and the scope of your business and liabilities. The surety bond will typically cost 1%-15% of the amount of the bond.

What are the consequences of a bond claim?

A surety bond is a contract between you, the surety agency, and the client or organization that requires you to live up to the level of work you promised. If you don't complete the work or the work doesn't meet the terms of the contract, the client or organization can file a claim with the surety company to reclaim any losses. The surety bond agency that provided your bond pays the claim amount, but you're required to pay the agency back over time.

What’s the difference between a surety bond and insurance?

An insurance policy covers you or your business from financial loss in the event of a claim, lawsuit, or other unfortunate circumstances. However, a surety bond protects the obligee if you or your business doesn't complete an obligation or doesn't complete it according to the terms of the contract.

Is there a surety bond that all industries need?

Any company, regardless of industry, that “handles funds or other property” of an employee benefit plan must obtain an ERISA Bond. This fidelity bond is for employers with employee benefit plans that protect the plan participants. 

Edward A. Haman, Esq. contributed to this article.