A bond is a guarantee, issued by a third party in favour of the beneficiary, that the contractual obligations of the principal will be fulfilled. A surety bond is not a contract of insurance, but it does provide financial protection for the beneficiary against loss if the principal breaches contract and does not discharge damages.
Bonds are usually an undertaking by a bank or insurance company to make a payment in the event of non-performance of the contract by the contractor. On the whole, it may be advantageous to use a surety provider (insurance company) as opposed to the traditional banking method.
They can often be required to help businesses secure work and are most commonly used within the construction industry.
There are a variety of types of bonds available and regularly used. These are outlined below.
What types of bonds are available?
Performance Bonds
Secures the performance of contractual obligations and provides an entitlement to payment against a surety in addition to those available against the contractor under the contract.
‘On Demand’ Performance Bonds
Provides independent obligation, requiring the surety to pay the employer. The contractor or surety cannot raise a contractual defence. Payment will normally be made despite contractor protests and without requiring the employer to find a contract breach. The only defence is proven fraud.
Retention Bonds
The employer retains a percentage of interim payments to provide funds if the contractor becomes insolvent or fails to rectify defects during the maintenance period. If the contractor requests that the deduction of retentions is waived, the employer will ask for a RB to protect the early release.
Advance Payment Bonds
Required when a payment is made by the employer to the contractor ahead of work beginning. The APB could be for any amount and will not reflect a standard percentage of the contract value.
Highway Act Bonds (Section 38/Section 104)
Guarantees the completion and maintenance of highways and sewers until adopted by the Local Authority. Typically, these will be required from developers of new estates.
Restoration Bonds
Often required for contracts that may affect the environment, to ensure that the landscape is restored following completion on the project.
HMRC Bonds
Duty deferment and customs bonds are used by importers to manage the payment of duty on goods and are issued to the benefit of HMRC.
A surety bond involves 3 different parties:
- The Principal: The party with the guaranteed obligations
- The Obligee: The party requiring the bond and to whom the bond is paid in the event of default
- The Surety: The party guaranteeing the principal can fulfil the obligation, often an insurance company
An obligee can request a principle obtain a surety bond as part of their contract. Underwriters will consider risks, terms & conditions and evaluate the applicant. Once an application is received, the surety underwriter will firstly determine the bonding risks by:
- Assessing the obligation required
- Considering bond wording and any other rules or regulations
- Determining the capacity of the applicants to perform
- Understanding terms and conditions
A surety bond involves 3 different parties:
- The Principal: The party with the guaranteed obligations
- The Obligee: The party requiring the bond and to whom the bond is paid in the event of default
- The Surety: The party guaranteeing the principal can fulfil the obligation, often an insurance company
An obligee can request a principle obtain a surety bond as part of their contract. Underwriters will consider risks, terms & conditions and evaluate the applicant. Once an application is received, the surety underwriter will firstly determine the bonding risks by:
- Assessing the obligation required
- Considering bond wording and any other rules or regulations
- Determining the capacity of the applicants to perform
- Understanding terms and conditions
Why use a surety provider over a bank?
Banks generally take 100% cash collateral as security for the contact duration, hindering cash flow. Therefore, using surety providers could help improve the contractor’s liquidity by freeing up bank lines for working capital needs. When using a surety provider, the bond sits away from the client’s banking facility and does not have the same effect on the cash flow.
In addition, banks can extend overdraft facilities and it is likely they will be secured by personal guarantees or a similar mechanism.
