What is novation of contract? The exact answer to this question is country- and industry-specific. But in general, novation of contract refers to the act of substitution of a party or obligation in a contract. 

Novation Definition

Novation stands for a consensual replacement of a contract's party or obligation with a new one. The new party takes on the obligation of the original party, thus completely releasing the former party of that obligation. The novation agreement must be signed by the transferor, the transferee, and the counterparty (the other contracting party).

Though similar in concept to assignment, novation is fundamentally different from it. While novation is a consensual transfer of rights or obligations, assignment can transfer only obligations and does not require the consent of the benefiting party. Novation terminates the original contract, but assignment does not.

An example of novation that replaces a contract's party: If Anna owes Emmy $100 and Emmy owes $100 to Jose, novation could transfer Anna's debt to Jose and have Emmy owe nothing.

An example of novation that replaces a contract's obligation: Anna and Jose then decide to settle the debt with a piece of artwork they both agree is worth $100 instead of with cash. This novation will replace the original obligation to pay $100 in cash with a new obligation to pay with the piece of artwork.

A typical example of novation in property law is when a tenant passes the lease over to another person making him or her responsible for rent payments and any property damages according to the original lease contract. In the construction industry, it is a common novation scenario when one contractor transfers certain jobs to another contractor with the client's approval.

There are two novation agreement templates:

  • A standard novation agreement, under which the new party is assigned the rights and liabilities that came into effect sometime after the contract was signed.
  • An ab initio novatio agreement, under which the new party assumes all historic rights and liabilities.

Novation agreements become useful when assignment of contractual rights and obligation is restricted legally and contractually. Numerous contracts undergo novation in corporate transactions, such as mergers and acquisitions. A novation is beneficial for situations when payments or performance become impossible to execute under the terms of the original contract. A novation helps restructure debt to prevent the debtor's default or bankruptcy.

In England, novation is a standard procedure for rescheduling loans. In Scotland, novation discharges a contract by substituting a new obligation between the same parties.

Novation in Financial Markets

In derivatives markets, novation takes on a slightly different meaning and defines an arrangement where sellers transfer their securities to the clearinghouse, which in turn sells those securities to the buyers. The risk for these transactions is assumed by the clearinghouse. Such an arrangement reduces credit risk for the parties who for some reason do not screen their counterparties for credit worthiness. But the risk that all parties face is the clearing house's bankruptcy.

In the absence of a clearinghouse, novation defines assignment of obligations from one party to another (the same as futures contract). Similar to a rollover, novation is also used to extend the life of debt and obligations.

Three Kinds of Novation

The kind of novation is determined by the way it was executed. The three kinds of novation are:

  • A general novation that involves only the two original parties: A debtor and creditor sign a new agreement to be liberated from the former contract.
  • An expromissio novation that engages a new debtor who is now called expromissor: With the creditor's consent, the expromissor replaces the original debtor and takes on his obligations.
  • A delegation type of novation: This engages a new creditor who replaces the original creditor.

By common law, an agreement to make substitutions of the original obligation is only valid if it is signed and accepted by all parties. If a debtor presents his creditor with a promissory note for the same sum, the note will be invalid unless accepted by the creditor. Once the note has been accepted, the debtor cannot sue on the original contract.

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