Understanding How a Bond Works
A typical use for bonds is to make sure an involved party upholds their part of an agreement. This means they must perform an action as promised. Bonds are generally used to cover people in positions of private or public trust.
For example, consider a company that offers a 401(K) plan to its employees. The company is required to have an ERISA Bond. If the administrator of the plan commits an act of fraud or dishonesty, then the ERISA will protect the retirement funds promised to the employees.
A city will also require a construction company to obtain a bond. If construction involves something such as digging up a sidewalk, then the city will likely require a bond. The construction company will need a bond from a surety company. The surety company will issue a bond that states they’ll help the city rebuild the sidewalk if the construction company fails to do so.
Three Parts of a Bond
1. The obligee is the party that requires the bond. In the construction example above, the city is the obligee.
2. The principal is the party who promises to perform a contractual obligation. In the construction example, the construction company is the principal.
3. The surety company is the party that offers the bond agreement. It insurers the principal and the promised obligation. If the principal fails to uphold its promises or obligations, then the surety company will pay a specified amount. The penal sum is the maximum amount the surety company will pay.