Novation Agreement Essentials: Types, Rules & Use Cases

Key Takeaways

• A novation agreement legally replaces one party in a contract with another, extinguishing the original contract.
• All three parties—the outgoing party, incoming party, and counterparty—must consent to a novation.
• Novations are commonly used in loan restructuring, mergers and acquisitions, and federal contract transfers.
• There are three main types: simple novation, expromissio (new debtor), and delegation (new creditor).
• Novation agreements differ from assignments in that obligations (not just rights) are transferred.
• Novations are often required in government contracts where assignment is restricted by law.

Novation of contract is what happens when a new contract is substituted for an old one. There are three types of novation of contracts, with specific circumstances called for and outlined for each one. They're known as the following:

• Novation
• Expromissio
• Delegation

About a Novation of Contract

Under a novation of contract, the new agreement voids the old contract. Therefore, the rights and obligations spelled out in the old agreement are extinguished. The agreement between various parties affects the nature of the individual transaction.

In another instance, the new contracting party replaces the original contracting party, so the old contracting party is excused. The original party who gets replaced also gives up all rights it holds against the other original contracting party. It's required for all three parties — the party who's transferring rights, the party whose rights are being transferred, and the counterparty — to sign a novation contract.

It may be necessary to have a novation agreement due to contractual and/or legal restrictions on the assignment of contractual obligations or rights. Mergers and acquisitions in the corporate world often involve a large number of novation of contracts.

A novation typically comes up when a new individual takes on an obligation to pay that was originally incurred by another contractual party. In the event of novation, the original debtor is completely released from the obligation, and this obligation is transferred to another party.

A novation may also occur when the original contractual parties continue their obligation to each other, but they form a new agreement in place of the old contract. This is a common method for rescheduling loans.

When Is a Novation Agreement Required?

A novation agreement is typically required in situations where simply assigning a contract is not legally permissible. This often occurs in:

• Government contracts, where the Anti-Assignment Act prohibits assignment without consent. In these cases, a novation agreement is required to formally substitute the original contractor with a new one.
• Mergers and acquisitions, especially when the acquired company has active contracts that must be transferred to the new entity.
• Loan restructuring, where a borrower’s obligation is transferred to another person or entity.
• Corporate reorganizations, such as spin-offs, where contractual obligations must move with the new company.
• Partnership changes, including when a partner exits a business and is replaced by a new partner who assumes the existing obligations.

In each case, the core function of the novation is to create a clean legal break, ensuring that the outgoing party is released from all future liability under the contract​​.

The Various Kinds of Novations

There are different ways to make a novation of contract, and each method is distinct.

• In the first type, there's no intervention of another party. Instead, a debtor contracts a new agreement with the creditor and is liberated from the original contract. There's no official name for this novation of contract, so in general, it's simply called a novation.
• The second type of novation of contract involves the entrance of a new debtor. This new debtor takes the place of the former debtor, and the creditor accepts this intervention. The original debtor is then discharged from the debt. The new debtor who enters the picture is called the expromissor. This type of novation of contract is called an expromissio.
• The third type of novation of contract involves a new creditor taking the place of the original creditor. The debtor is discharged by the old creditor, who orders that the new creditor contracts the debtor's obligation. This novation of contract is called a delegation.

Common law dictates that a mere agreement to substitute something in lieu of the original contract isn't legally binding. The agreement must be executed and accepted as satisfactory for it to be valid. There can be no action on the new contract, and the contract cannot be used as a bar to the original demand. 

However, when an agreement is entered into by deed, the deed itself gives a cause of action. The act of giving such a deed may be satisfactory for a simple contract debt.

The general, the accepted rule is that if an individual is indebted to another party by simple agreement, that individual cannot present the creditor with a promissory note of the same sum, with no new considerations, that satisfies the original debt unless the creditor agrees to accept these terms. If the individual transfers the note, he or she can't sue on the original contract if the note is no longer in his or her possession.

Contracts can be very complicated, and this includes original agreements and novations. To help you better understand all of the complex legal language, you may wish to consult with an expert in contract law. It's important that you don't sign on the dotted line until and unless you fully comprehend what you're agreeing to.

You should also know when a novation of contract is necessary and how the change will personally affect you. Again, when novations occur, you should understand all the changes that will take place under the new agreement terms to better protect your legal and financial interests.

Novation Agreement vs. Assignment

While both novation and assignment involve changes to a contract, they differ significantly:

Understanding this distinction is essential when determining the correct legal tool to use for a contractual change​​.

Federal Contracts and Novation Agreements

Novation agreements play a vital role in the context of U.S. federal government contracts. Under the Federal Acquisition Regulation (FAR) 42.1204, novation is required when a contractor’s assets, including contracts, are transferred due to:

• Asset sales
• Corporate mergers
• Divestitures or reorganizations

The government must approve the novation through a written agreement. This agreement must demonstrate that:

• The transferee (new party) is capable of performing the contract.
• The transfer is in the government's best interest.
• The original contractor is properly released from liability.

The government typically requires detailed documentation, such as:

• The purchase/sale agreement
• Board resolutions
• Consent of sureties (if applicable)
• A draft novation agreement for review

Without a valid novation agreement, attempts to assign or transfer a government contract can be void and unenforceable​.

Key Clauses in a Novation Agreement

A comprehensive novation agreement should include the following key provisions:

• Identification of Parties: Full legal names and roles (transferor, transferee, counterparty).
• Release of Liability: A clause stating the outgoing party is released from all future obligations.
• Assumption of Obligations: A clause where the new party agrees to take on all terms and liabilities of the original contract.
• Consent of the Counterparty: Acknowledgment that the remaining party agrees to the substitution.
• Effective Date: The date when the novation takes legal effect.
• Representations and Warranties: Each party affirms their legal authority to enter into the novation.

Failing to include these clauses can result in legal uncertainty or the novation being deemed invalid​.

Sample Novation Agreement Structure

If you’re searching for a hardship clause sample or looking to draft a novation agreement, the following structure is commonly used:

1. Title: "Novation Agreement"
2. Recitals: Background facts about the original agreement and parties.
3. Agreement Clause: States the substitution of parties and assumption of obligations.
4. Release Clause: Discharges the outgoing party from liability.
5. Representations and Warranties
6. Governing Law
7. Signature Blocks: For all three parties

Though templates can be found online, legal counsel is strongly recommended to ensure the document meets jurisdiction-specific requirements.

Frequently Asked Questions

1. What is a novation agreement used for?
   It is used to transfer both rights and obligations from one party to another, replacing an old contract with a new one.
2. How is novation different from assignment?
   Novation transfers obligations and requires all-party consent, while assignment typically transfers only rights and may not require counterparty approval.
3. Is novation legally binding?
   Yes, provided all parties consent and the agreement meets the requirements of a valid contract.
4. Can a novation be oral?
   No, novations should be in writing to be enforceable, especially in complex or regulated environments like federal contracting.
5. Do all contracts allow novation?
   Not necessarily. Some contracts prohibit novation or require specific approval processes. Always review the contract terms first.

If you need help understanding novation agreement, 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.