Novation

What Is Novation?

Novation is the replacement of one of the parties in an agreement between two parties, with the agreement of all three parties involved. To novate is to replace an old obligation with a new one.

For example, a supplier who wants to relinquish a business customer might find another source for the customer. If all three agree, the contract can be torn up and replaced with a new contract that differs only in the name of the supplier. The old supplier relinquishes all rights and obligations of the contract to the new supplier.

How a Novation Works

In legal language, novation is a transfer of both the "benefits and the burdens" of a contract to another party. The benefits may be payments. The burdens are the obligations being taken on to earn the payment. One party to the contract is willing to forgo the benefits and relinquish the burdens.

Canceling a contract can be messy, expensive, and bad for the business reputation. Arranging for another party to fulfill the contract on the same terms, with the agreement of all parties, is better business.

Novations are often seen in the construction industry, where subcontractors may be juggling several jobs at once. Contractors may transfer certain jobs to other contractors, with the consent of the client.

Novations are most frequently used when a business is sold or a corporation is taken over. The new owner wants to retain the contractual obligations of the business. The other parties to the contracts want to continue their agreements without interruption. Novations smooth the transition.

Novation vs. Assignment

A novation is an alternative to the procedure known as an assignment.

In an assignment, one person or business transfers rights or property to another person or business. But the assignment passes along only the benefits, while any obligations remain with the original contract party. Novations pass along both benefits and potential liabilities to the new party.

For example, a sub-lease is an assignment. The original rental contract remains in place. The landlord can hold the primary leaseholder responsible for damage or non-payment by the sub-letter.

In a novation, the original party to the contract hands over both the rights and the obligations and walks away. The original contract has been nullified.

In property law, novation occurs when a tenant signs a lease over to another party, who assumes both the responsibility for the rent and the liability for any subsequent damages to the property, as indicated in the original lease.

Generally, both an assignment and a novation require the approval of all three parties involved.

A novation is not a unilateral contract mechanism. All concerned parties may negotiate the terms until a consensus is reached.

Novations in Financial Markets

In the derivatives markets, a bilateral transaction done through a clearinghouse, which essentially functions as an intermediary, is known as a novation.

In this case, buyers and sellers do not do business directly with each other. Instead, the sellers transfer their securities to the clearinghouse, which in turn sells the securities to the buyers. The clearinghouse assumes the counterparty risk of one party defaulting.

The clearinghouse is responsible for vetting the potential counterparty for creditworthiness.

Both the buying and selling parties bear the extremely modest risk that the clearinghouse will become insolvent before the process is completed.

A sub-lease agreement is usually an assignment, not a novation. The primary leaseholder remains responsible for non-payment or damage.

Example of a Novation

Consider the following example of novation. Maria owes Chris $200, while Chris, in turn, owes Uni $200. These debt obligations may be simplified through a novation. By agreement of all three parties, Maria pays Uni $200. Chris receives (and pays) nothing.

Novations also may allow for payment terms to be revised as long as the parties involved agree. In this example, Uni may agree to accept a piece of Maria's original artwork, which has an approximate value of $200, in lieu of the cash they are owed. The transfer of property constitutes novation and effectively jettisons the original cash obligation.

Novation FAQs

Here are the answers to some commonly asked questions about novations.

What Is the Difference Between a Novation and an Assignment?

In a novation, one party in a two-party agreement gives up all rights and obligations outlined in a contract to a third party. The original contract is canceled. In an assignment, one party gives up all rights outlined in the contract but remains responsible for the fulfillment of its terms. The original contract remains in place.

What Is Transferred in a Novation?

In a novation, both the rights and the obligations of one party to a two-party contract are transferred to a third party, with the agreement of all three parties.

For example, say that an ice cream vendor agrees to supply a supermarket with 100 gallons of chocolate ice cream a week. Down the road, the vendor decides that the supermarket is too far out of its area to service efficiently. It locates another vendor who is willing to take over the customer. All three parties agree to a new contract with identical terms, except for the name of the ice cream supplier. If the supermarket manager is dissatisfied with the new service, the legal recourse lies with the new vendor. The old vendor has no obligation to fix the problem.

What Are the Risks of a Novation?

Novations are a relatively easy, quick way to solve an immediate problem with no legal wrangling. In many cases, they may be virtually a formality, such as in the case of a newly acquired company revising its existing contracts to reflect a name change.

Novations, however, require the agreement of three parties: the transferor, the transferee, and the counterparty.

A risk for the counterparty occurs if it is uncertain that the new party to the contract (the transferee) can adequately meet the terms of the contract.

In this case, the more cautious approach would be an assignment. Then, the original party to the contract must ensure that the terms of the contract are met.

Then, there's a risk to the transferor. If the transferee fails to meet the new contract terms, the transferor remains responsible.