Contract Novation: Everything You Need to Know
A contract novation occurs when a member of the contract, with permission from the opposite member, passes on his or her benefits and liabilities given by the contract to a separate individual or group. 3 min read
A contract novation occurs when a member of the contract, with permission from the opposite member, passes on his or her benefits and liabilities given by the contract to a separate individual or group.
Definition of Novation
A novation consists of replacing either an initial member of a contract or an initial contract with a new member or contract.
Once replaced, the excused member or group is no longer held liable under the contract and there is no need for an express release.
A novation is never assumed, but rather must be made known in one of the following ways:
- A novation agreement given in writing.
- Made clear by the acts and behavior of the groups involved.
Typically, a novation occurs when a new party takes over a liability that was originally obtained by the initial contract member.
This differs from a scenario where a party assures that a borrower will pay what he or she is obligated to pay to a collector.
Under a novation, the initial borrower is fully relieved of his or her duty to pay because the obligation has been passed on to another party.
A novation can also occur when an original contract is replaced by a new one without changing either of the initial parties.
Novation can occur under situations such as:
- Under property law, a renter transfers his or her lease to a new tenant making the new individual or group responsible for all dues and liabilities mentioned in the initial lease.
- In construction, a contractor can assign various tasks to an additional contractor as long as he or she has permission from the client.
- Australian companies will often allow employees to lease a car under novation by withdrawing the proper amount from the employee's pay in exchange for the employee taking responsibility for the vehicle.
The Process of Novation
A novation can occur in three different ways:
- A borrower can establish a new agreement with his or her creditor, negating the obligations held under the original contract.
- An expromissio novation occurs when a new party, called the expromissor, replaces the original party, releasing him or her from the contract and assuming his or her debts.
- A delegation is a type of novation that develops when a new creditor replaces the original creditor creating a contract between the debtor and the new creditor and dismissing the original contract.
Novation in Action
The following are examples of how novation can be used:
- If Jared purchases a car from Stephen for $6,000 then proceeds to sell the car to Justin under the same conditions, he can remove himself from the contract by convincing Stephen and Justin to establish a novation contract transferring his debt to Justin and releasing him from the contract.
- If Nicole owes Nathan $500, and Nathan owes Anita $500, novation could be used to cut out the middle man and simply create an agreement between Nicole and Anita.
- If Maggie owes Ryan $300 cash, but has an asset worth $300, the two could use novation to create a contract replacing the liability to pay cash with a liability to hand over the $300 asset.
- A contract novation should be used to assign contracts when an owner sells his or her business to a new owner.
- If a contractor assigns a job contract to a subcontractor, a novation contract should be established.
- If an individual no longer wants to work with his or her current business partner, a novation can be used to replace the old partner with a new individual or group.
- If a group or individual wishes to partner with a new company at the end of a contract rather than renewing, he or she can use a contract novation.
Contract Novations in the Financial Market
Novation plays a somewhat different role in the financial markets.
In the markets, rather than selling securities straight to the buyers, owners sell their securities to an intermediary, who then sells them to the buyers. By doing so, the intermediary takes on all of the risk involved in the transactions.
A contract novation in this situation lowers the risk for sellers and buyers between each other; however, it does add the risk of the intermediary becoming bankrupt.
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