A business is “bonded” if it has purchased a surety bond, a financial instrument that one business provides to another, such as a customer or client. The bond guarantees that the recipient will be compensated if the business fails to complete a job, comply with the law, or fulfill some other obligation. The cost of a surety bond is set as a percentage of the bond amount (the amount of coverage or bond limit), typically varying between 1% to 15%.
Surety bonds are involved in many common business transactions, such as applying for a permit or bidding on a construction job. Some are required by law and others by the terms of a contract. To gain a better understanding of what bonded means, it’s important to learn more about surety bonds, how they work, and the types, including construction bonds, commercial bonds, and fidelity bonds.
Definition and Example of Surety Bonds
A surety bond is a contract that guarantees specific obligations will be met, such as paying a debt or completing a job. When a bond is in place, one party becomes answerable to a third party if a second party fails to perform its duties. If the second party doesn’t fulfill its obligations, the first party pays the third party the sum of money stated in the bond contract.
One of the most common types of surety bond is the bid bond. It’s purchased by a contractor for the benefit of a project owner. A bid bond protects the owner if the contractor bids on a project, wins the bid, then fails to sign a contract.
Alternate name: Performance bond
There are two key differences between bonds and insurance policies. First, bonds involve three parties while insurance policies involve only two (the insurer and the insured). Secondly, bonds protect a third party (the obligee) while insurance policies protect the insured.
How Do Surety Bonds Work?
A surety bond is a promise to be liable for the debt, default, or failure of another. All bonds involve three parties:
- Principal: The person or business that buys the bond
- Obligee: The person or business that requires the bond and is protected by it
- Surety: The insurance company that issues the bond in exchange for a premium paid by the principal
Here’s a hypothetical example of how a bond works:
Capital Construction has been hired by Premier Properties to build a shopping center. Capital solicits bids from subcontractors, and Easy Electric, an electrical contractor, responds. Easy submits a bid for $45,000 to install electrical panels and wiring. The solicitation document requires all bidders to purchase a bid bond with a bond amount (limit) of at least 10% of the bid amount. Easy purchases a bond with a bond amount of $4,500 from a surety called Buy-It-Now Bonding.
Easy Electric includes the bid bond in its proposal to Capital Construction. If Easy is awarded the electrical work but refuses to sign a contract, Buy-It-Now Bonding will be obligated to pay Premier Properties $4,500.
Principal Must Reimburse Surety for Bond Payments
In the previous example, suppose that Easy Electric backs out of the project after winning the bid, so Premier Properties files a claim under the bond. What happens next? Bond-It-Now will investigate the claim to evaluate its validity. It may try to convince Easy Electric to fulfill its obligations and sign a contract, or it may try to negotiate a solution. If its efforts fail, the surety must pay Premier Properties the $4,500 bond amount (also called the penal sum). Bond-It-Now will then demand reimbursement of its $4,500 payment from Easy Electric.
If the surety pays the penal sum to the obligee because the principal has failed to perform its duties, the principal must reimburse the surety for the payment.
Types of Surety Bonds
Most surety bonds fall into one of three categories: construction bonds, commercial bonds, and fidelity bonds.
As the name suggests, these bonds are used in the construction industry. They include bid bonds, performance bonds, and payment bonds. A performance bond is purchased by a contractor to protect the owner if the contractor fails to fulfill their obligations under the contract. A payment bond guarantees that the contractor will pay the complete costs of labor, materials, and other services related to the project for which the contractor is responsible according to the construction contract.
Commercial bonds are used by many types of businesses and individuals. Some of the most common are bail bonds, and license and permit bonds.
A bail bond is purchased by the defendant in a civil or criminal case to secure their release from jail. It ensures the defendant will appear for trial (in a criminal case) or pay money owed (in a civil case).
Meanwhile, a license and permit bond is often required by state or municipal agencies that issue licenses or permits. Applicants must purchase a bond as a condition of obtaining a license or permit. The bond provides a guarantee to the principal’s customers that the principal will perform its work in accordance with state or municipal laws and regulations.
Fidelity bonds protect businesses from crimes that are directly related to the misdeeds of their employees. One of the most common types is an employee dishonesty bond, which covers employee theft. A fidelity bond affords similar protection for an employer as employee theft coverage, a type of commercial property insurance.
- A business is bonded if it has purchased a surety bond, a contract that guarantees one party will fulfill its obligations to a second party.
- Bonds are typically purchased because they are required by law or a contract.
- Bonds involve three parties: the principal, the obligee, and the surety.
- Surety bonds fall into three categories: construction bonds, commercial bonds, and fidelity bonds.