16.1 Surety and Fidelity Bonds
Key Takeaways
- Surety bonds involve three parties: principal (performs), obligee (protected), and surety (guarantees) - the surety has indemnity rights against the principal.
- Contract bonds are bid, performance, payment, and maintenance; the penal sum is the maximum the surety pays. The Miller Act requires bonds on federal projects over $150,000.
- Fidelity bonds protect an employer against dishonest acts of its own employees and behave like insurance (no expected recovery).
- ERISA requires plan-fund handlers to be bonded for at least 10% of funds, minimum $1,000, maximum $500,000 ($1,000,000 with employer securities).
Surety Bonds: A Three-Party Guarantee
A surety bond is not insurance in the traditional two-party sense. It is a three-party agreement that guarantees the performance of an obligation. Exam questions hinge on identifying the three parties correctly and on the surety's right of reimbursement, which fundamentally separates suretyship from ordinary insurance.
- Principal - the party who must perform the obligation (the contractor, the licensee, the fiduciary). The principal purchases the bond.
- Obligee - the party protected by the bond and to whom the obligation is owed (the project owner, a government agency, the public).
- Surety - the party (an insurer) that guarantees the principal will perform and pays the obligee if the principal defaults.
The defining trait: when a surety pays a loss, it has a right of subrogation/indemnity against the principal. In ordinary insurance the insurer absorbs the loss; in suretyship the surety expects to be reimbursed. Underwriting therefore resembles credit analysis (capital, capacity, character) rather than hazard analysis.
Contract Surety Bonds
Contract bonds guarantee construction obligations and are most common on public works, where federal projects over $150,000 require them under the Miller Act (state equivalents are called Little Miller Acts). The three core contract bonds:
| Bond Type | Guarantees | Typical Penal Sum |
|---|---|---|
| Bid bond | Bidder will enter the contract at the bid price and furnish required bonds | 5-20% of bid |
| Performance bond | Project completed per contract terms | Up to 100% of contract |
| Payment bond | Subcontractors and suppliers are paid | Up to 100% of contract |
The penal sum is the bond's maximum limit. On a performance bond, if a contractor defaults at 60% completion on a $2,000,000 contract with a 100% penal sum, the surety's exposure to complete the work is capped at the $2,000,000 penal sum, regardless of cost overruns above it. A maintenance bond extends a guarantee against defective workmanship for a stated period (often one year) after completion.
Commercial Surety and Fidelity Bonds
Commercial surety bonds include license and permit bonds (guaranteeing a licensee complies with regulations), public official bonds, court bonds (such as fiduciary bonds for executors and judicial bonds like appeal or injunction bonds), and federal bonds. They are not construction-related.
Fidelity bonds are different in character: they protect an employer (the insured/obligee) against loss from dishonest acts of its own employees - theft, embezzlement, forgery. Although called bonds, fidelity coverage behaves like insurance because there is generally no expectation of recovery from the dishonest employee. Key fidelity forms:
- Employee Dishonesty / ISO Commercial Crime (Form CR 00 21 or CR 00 22) - covers loss of money, securities, and other property from employee theft.
- ERISA compliance bond - the federal law requires anyone handling employee-benefit plan funds to be bonded for at least 10% of the funds handled, with a $1,000 minimum and a $500,000 maximum ($1,000,000 if the plan holds employer securities).
- Blanket vs. Scheduled - blanket forms cover all employees automatically; scheduled forms name individuals or positions.
A contractor wins a $5,000,000 public-works contract. Which bond guarantees that subcontractors and material suppliers will be paid?
Trap Spotting: Surety vs. Insurance
Exam writers love the distinction that suretyship anticipates no loss - the surety prices the bond as a service fee (a percentage of the contract or penal sum) on the assumption the principal will perform, and it retains indemnity rights to recover any payout. Ordinary insurance prices for expected losses and does not subrogate against its own insured.
Another frequent trap: the obligee is the protected party, not the buyer's customer in a generic sense. On a license and permit bond, the obligee is typically the government or the public it represents; the licensee is the principal. Finally, do not confuse the penal sum (the bond limit) with the premium. A $100,000 license bond might carry a $500 premium; the $100,000 is the maximum the surety will pay the obligee, recoverable later from the principal.
What most fundamentally distinguishes a surety bond from ordinary insurance?
Underwriting and the "Three C's"
Because the surety expects reimbursement, it underwrites the principal the way a lender evaluates a borrower. Surety underwriters weigh the Three C's:
- Capital - the principal's financial strength and net worth, assessed from CPA-prepared financial statements and working capital.
- Capacity - the technical ability, equipment, and experience to complete the bonded obligation (the contractor's track record on similar jobs).
- Character - the principal's integrity, reputation, and payment history.
The contractor signs a General Indemnity Agreement (GIA) in which the principal - and often its owners personally - agrees to reimburse the surety for any loss, expense, and attorney fees. This personal indemnity is why surety losses are recoverable. A higher penal sum or weaker financials raises the rate; well-capitalized contractors with strong banking relationships get larger bonding lines.
Worked Example: Bid Bond and Default
A contractor submits a $1,000,000 bid backed by a 10% bid bond ($100,000). The contractor is low bidder but refuses to sign the contract. The next-lowest responsible bid is $1,080,000, so the obligee must pay $80,000 more to get the work done. The surety pays the obligee's actual additional cost up to the $100,000 penal sum - here $80,000 - then seeks full reimbursement from the principal under the indemnity agreement.
Contrast a performance bond claim: if the same contractor defaults mid-project, the surety may (1) finance the original contractor to completion, (2) tender a replacement contractor, (3) complete the work itself, or (4) pay the obligee the cost to complete - never exceeding the penal sum. Knowing the surety's completion options is a common exam point.