Novation Agreements Explained: Types, Uses, and Key Differences

Key Takeaways

• Novation replaces a party in a contract or swaps one obligation for another with consent from all involved.
• There are three primary types of novation: standard novation, expromissio, and delegation.
• Novation differs from assignment in that it transfers both rights and obligations and requires consent from all parties.
• It is commonly used in real estate, finance, construction, and corporate transactions such as mergers and acquisitions.
• While novation can shield the original party from future liability, it’s more complex and formal than assignment.
• Legal advice is often essential when drafting or reviewing a novation agreement to ensure enforceability.

A novation agreement transfers the contractual obligations of one party to a third party or replaces a contractual obligation with another one. All parties involved in this type of contract must consent to the changes.

About Novation

When a third party enters the agreement, it takes the place of the departing party. Usually, novation happens when a new party assumes an obligation to pay that an original party had incurred.

The debts transfer to someone else, releasing the original debtor from the obligation. The nature of the transaction depends on the agreement that the parties make.

Three parties are involved in a novation:

• The transferee
• The transferor
• The counterparty

All must sign the novation agreement.

Corporate actions such as acquisitions and mergers involve a large number of novation contracts, and it's a common method for rescheduling loans.

When Is Novation Used?

Novation is often used when a contract needs to be maintained but the identity or obligations of one party change. This can occur in various business contexts:

• Real Estate Transactions: A buyer may be replaced by another before closing, with the seller's consent. This relieves the original buyer of liability while keeping the contract terms intact.
• Business Sales and Mergers: In mergers and acquisitions, novation allows the acquiring entity to take over contractual obligations from the target company.
• Finance and Derivatives: In the financial industry, especially with derivatives, clearinghouses often use novation to assume counterparty risk between buyers and sellers.
• Construction Contracts: A client may novate a contract from a designer to a contractor to maintain continuity in a design-build project.

The key feature in all these scenarios is the formal replacement of one party with another, rather than merely assigning rights.

Different Kinds of Novation

There are three ways to make a novation and each is distinct.

1. The first, which has no official name, is simply known as a novation. This doesn't involve the introduction of a third party. Instead, someone who owes a debt enters into a new agreement with his or her creditor.
2. The second is called an expromissio, and this involves a third party entering the picture. The new party, or debtor, takes on the debt of the former debtor. When the creditor accepts this change, it discharges the first debtor from the debt.
3. The third kind is called a delegation, and this happens when a new creditor enters into the agreement in place of the old one. The debtor is discharged from the debt by the original creditor, who contracts some obligation for the new creditor.

Key Elements of a Valid Novation Agreement

To ensure a novation agreement is legally valid and enforceable, the following elements are typically required:

1. Consent of All Parties: The outgoing party, incoming party, and remaining party must all agree to the novation.
2. Discharge of Original Contract: The original agreement must be expressly terminated or replaced.
3. New Contract Terms: A new contractual relationship is formed, often mirroring the original but with updated parties.
4. Consideration: Just like other contracts, novation requires consideration, such as continued services or financial payment.

These requirements prevent disputes and make clear who holds rights and duties under the new arrangement.

Novation vs. Assignment

While novation and assignment are similar, there are important differences between them. A novation involves three parties, and all involved parties must consent to the new contract. A novation is able to transfer obligations as well as rights. An assignment doesn't transfer obligations.

Sometimes, a novation is called a “Hail Mary” defense for someone trying to avoid contractual liability. To establish novation, however, requires a rather high standard.

By contrast, assignment and assumption only transfer a party's contractual rights and benefits. Therefore, the original assignor/seller still has an obligation. This party can actually be held responsible if the assignee/purchaser doesn't fulfill the contractual performance. In order to protect itself from potential liability, an assignor may want to obtain an indemnity from the assignee.

Assignment doesn't necessarily require the consent of the third party the way that a novation does, and the original contract remains valid. Based on the agreement's terms, the assignor may only need to provide notice to the non-assigning party of the change.

In property law, for example, novation occurs when one tenant signs a lease over to another person. This new tenant then becomes responsible for paying rent and is liable for property damage. Novation is also common within the construction industry, when a contractor transfers a job to another contractor, as long as he or she has the consent of the client to do so.

Legal and Practical Differences: Novation vs. Assignment

While both novation and assignment involve transferring interests in a contract, they serve different purposes:

In short, novation results in a brand-new contract, while assignment simply delegates benefits to a new party.

Pros and Cons of Both

In many cases, assignment and assumption are more convenient for the seller than a novation since a seller might not need consent from a third party before assigning its interest. Still, the seller has to understand the liabilities it potentially faces if the purchaser doesn't meet contractual performance.

While a novation may protect sellers from future liabilities, it tends to be a more tedious process. In addition, if the third party doesn't provide consent, novation will not be possible. Before going ahead with novation, it's important for all involved parties to assess their relationship, particularly with the third party. If they don't believe the third party will provide the necessary consent, they may have to go with another option.

When faced with the scenario of transferring contractual rights and/or obligations, it's important to understand exactly what is being transferred. This is why it's vital that you fully comprehend all of the complex language in a contract. Consulting with a legal professional is one way to ensure you know what you're agreeing to before you sign a legally binding document.

Risks and Considerations with Novation

Although novation offers clarity and liability protection, it carries some risks:

• Delayed Consent: If a third party doesn’t consent, the novation cannot proceed, stalling the transaction.
• Enforceability Issues: Ambiguous language can lead to disputes about whether a valid novation occurred.
• Complex Documentation: Proper legal drafting is essential to avoid unintended liabilities or obligations.
• Financial Exposure: If the new party defaults, and the novation was improperly executed, the original party could still be liable.

For these reasons, parties should involve legal counsel early in the process to confirm the novation is valid and properly documented.

Novation in Real Estate: A Closer Look

Novation plays a unique role in real estate, particularly in purchase agreements and lease transfers. Here’s how it’s commonly applied:

• Purchase Agreements: If a buyer backs out of a deal but finds a substitute, novation can transfer the contract to the new buyer with seller approval.
• Lease Agreements: A tenant may novate a lease to a new tenant, releasing themselves from rental obligations once the landlord agrees.
• Land Development: Novation may be used to substitute contractors or investors as projects evolve.

In each case, novation ensures that obligations continue seamlessly, and liability is clearly assigned to the appropriate party.

Frequently Asked Questions

1. What is the main purpose of a novation agreement?
   To replace one party in a contract with another or substitute contractual obligations, with the consent of all involved.
2. Is novation better than assignment?
   It depends on the goals. Novation transfers both rights and obligations, relieving the original party of liability, while assignment only transfers rights.
3. Does a novation need to be in writing?
   Yes, for clarity and legal enforceability, novation agreements should always be documented in writing and signed by all parties.
4. Can novation be used in real estate deals?
   Absolutely. It's commonly used to replace buyers or tenants with new parties, provided all sides agree.
5. Who should draft a novation agreement?
   A qualified attorney should draft or review the agreement to ensure it’s legally sound and protects the interests of all parties involved. You can find experienced attorneys on UpCounsel to assist.

If you need help with novation agreements or other legal matters, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.