Novation Agreement: Everything You Need to Know
When a third party enters the agreement, it takes the place of the departing party. 3 min read updated on February 01, 2023
Updated October 8,2020:
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.
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.
Different Kinds of Novation
There are three ways to make a novation and each is distinct.
- 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.
- 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.
- 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.
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.
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.
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