What is Novation?

What is Novation?

As a general rule, contractual obligations cannot simply be transfers or assigned to another person to avoid liability under the contract. Liability for failing to perform the legal obligations set out in a contract may not be assigned to a third party to the contract. Privity of contract provides that only original parties to a contract can enforce its terms.  In order to transfer a contract to another person, it must be novated. Novation has a set of legal requirements which must be satisfied to transfer legal obligations from one person to another. 

Novation is essentially a legal transaction in which a current contract is substituted and replaced with a new contract with the consent of all parties; it so happens that the second contract is usually on the same or similar terms as the first contract, although there is no requirement for this to be the case.

This substitution takes place when there is an outgoing party (who will no longer have any obligations under the contract), an incoming party (who will be assuming the outgoing party’s obligations) and the new contract.  An agreement must be formed between the incoming party and the continuing party in order for all of the rights and obligations to be transferred away from the outgoing party.

What are the Requirements for Novation?

The requirements for novation are simply acceptance of the transaction on the part of all the parties to the old and new contract. The remaining party must accept the new party, while the new party must accept standing liability under the contract. Both parties must accept performance of the new contract as performance of the original contract. Contractual consideration must be provided unless novation is documented in a deed signed by all of the parties. The consideration is usually the price to be paid by the new party in return for a service from the continuing party.

How Does Novation differ from Assignment?

Novation is often confused with assignment; there are unique features that can be outlined to highlight the distinction between the two concepts which are as follows:

• Novation, like assignment, involves the transfer of interests in a contract from one party to another.
• Novation enables all of the interests to transfer whereas assignment can only transfer the benefit (say, to pay money) and not the burden of a contract (say, to supply goods or services). Assignment is therefore usually accompanied by an agreement that the assignee will take over performance of the contract which is backed by a warranty given to the assignor.
• Novation requires unanimous consent by the parties for validity.
• Assignment can be take place simply by agreement between the outgoing party and the incoming party, although the right to assign is usually qualified by conditions in the contract.
• Novation creates a new contract but remains on the same terms as the first agreement. In an assignment the original contract remains the primary agreement.
• Novation means that the original contract is only discharged not extinguished but the new party can be bound by the same obligations and liabilities that the outgoing party held if these are also novated.

These common law rules are of course able to be displaced by express written agreement between the parties. For instance, the two initial contracting parties might agree that one or both of them is able to assign the benefit and the burden of the contract without the consent of the other.

When is Novation Used?

Novation is a legal mechanism that is relevant to contract management in all industries. The same legal principles apply. Taking an example in the construction industry, novation may be required where a design and build contractor transfers a construction contract to a new contractor. However, it is also applicable to other scenarios, including those where a seller of a business transfers contracts with suppliers to the buyer of that business. Incoming businesses would be well-advised to undergo a contract review to minimise the risk of unwanted surprises in the force and effect of the contract they are about to take on.

Novation is also used in financial derivatives markets to enable futures and options trading and also over the counter swap trading. Exchange traded derivatives markets have central clearing houses to facilitate the validation, delivery and settlement of transactions by removing the need for buyers and sellers to clarify credit-worthiness. Clearing houses do this by becoming the legal counter party in all transactions with both buyers and sellers to reduce settlement risk; this requires the individual contracts to be novated.

With well-established case law which defines what is required for novation, the principles are readily extended to other types of contracts, such as supply contracts, technology agreement and agreements to supply services.

Our commercial solicitors in London advise on management of business contracts, reviewing contracts for novation prior to assigning contractual rights to incoming contracting parties.