Contract Novation Letter: Everything You Need to Know
A contract novation letter is a document sent if you want to novate, or assign, your contractual obligations and rights.3 min read
A contract novation letter is a document sent if you want to novate, or assign, your contractual obligations and rights. In contract law, novation is an important concept, which allows one new party to step into the shoes of a party that departs the agreement. It replaces one obligation or participant in the contract with a different one and requires all parties involved to agree.
Creating a novation requires writing an agreement letter signed by all parties. This letter serves as an assignment, assumption and novation agreement. All parties in the agreement — the transferor, the counterparty (the other contracting party) and the transferee have to sign the novation agreement.
Why Novation Agreements are Necessary
There are many reasons why parties may sign Novation agreements. There could be contractual or legal restrictions on assigning obligations and rights under the contract. In the corporate world, there could be a large number of contracts requiring modifications, making novation agreements a necessity.
Novation vs. Assignment
There are fundamental differences between assignment and novation. A few of these include:
- Under novation, you can transfer both rights and obligations, whereas assignment can only transfer rights.
- An assignment doesn't necessarily require the benefiting party's consent, whereas novation does.
- An assignment doesn't eliminate the existing contract; novation nullifies it and replaces it with a new agreement.
Novation in Property and Construction Law
In property law, novation occurs when a tenant subleases their property, signing over their lease to someone else. This new person is then responsible for the property. They have to pay the rent and are liable for any damages according to the original lease terms. The original lease then stops being enforceable against the original lessee, and a new effective lease begins with the sublessor.
In the construction industry, a contractor can, with their client consent, transfer certain jobs to a secondary subcontractor in the same manner.
Novation in Financial Markets
In the finance industry, novation fills many important functions, but make take on somewhat different meanings. For example, in derivatives, novation refers to bilateral transactions that go through clearinghouses. Sellers will transfer their securities to the clearinghouse which then sells them to buyers, instead of sellers working directly with a buyer.
The clearinghouse, then, assumes the risk of default in such transactions. It helps to mitigate the credit risk that participants take, particularly when they don't have the means to vet all counterparties' credit ratings. Rather, the only risk is that the clearinghouse will lose solvency.
In finance, Novation can also allow for extending obligations or debt in a similar manner to a rollover. For markets that lack a clearinghouse, it provides for a process that allows one party to assign obligations to another, just like selling futures.
Federal Acquisition Regulation Agreements
Novation for commercial contracts follows a process that is very different from that involving federal projects. In fact, the process is so different that a full 38% of FAR novation agreements get denied by the contracting officer for failure to meet federal statutory requirements.
Any time a business with an existing government contract sells to another party or bought by another party, the federal novation process starts. Most likely, the business buyer will wish to acquire the government contract along with the business. It's vital to get this process right, or the government will deny the transfer, a decision that is left with the contracting officer.
The problem arises in 41 USC 6305, the Contracts Act. This act states that a party who contracts with the Federal Government may not transfer that contract to another party. Any attempt to do so results in the contract's annulment, except for the government's right to take action for breach of contract.
Working with the Federal Contracting Officer
The Federal novation process requires the contract be approved by the contracting officer with no automatic approval. Such approval is only granted if the contract is in the government's best interests. This process is long and complex. The first step is to identify the contracting officer.
While novation always follows the closing of a contract, it's still best to notify the contracting officer as early as possible. Doing so allows you to:
- Establish a positive working relationship in advance
- Make your case before the transfer happens
- Address any concerns before closing
- Discuss possibly waiving problematic documentation requirements
- Assess whether there's the risk of denial in advance.
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