What is novation?
Novation means that a contract is replaced with an entirely new one. In most cases, a new contractual party takes the place of a former party. Novation can only take place with the consent of all parties involved. It is mostly used for business sales and during takeovers of corporations.
The mechanics of novation
Novations can only happen with the consent of all parties involved. This distinguishes them from assignments, where one contractual party assigns a contractual obligation or benefit to a third party outside of the original agreement.
A novation completely nullifies the original contract and replaces it with a new one. This does not mean that the wording of the contract has to be amended in any way. It simply means that the business transaction or relationship established by the original contract ceases to exist.
To provide an overview of how novations are applied:
- A contract establishes a contract between party A and party B, stating that party A provides a service to party B over a period of two years in exchange for payment.
- Party A can no longer provide said service after one year but a third party, party C, could provide the same service to party B.
- All parties consent to a novation and the original contract is terminated and replaced with a new contract.
- The new contract contains the same terms with the difference that party A is not included in it. Instead, party C is now providing the service to party B.
- If there are any outstanding obligations from party A towards party B, these are also transferred to party C in the course of novation.
Novation is often included in contracts between companies to ensure, that if either company sells, merges or transfers their core business operations to/with another company, the new company assumes all duties and obligations under the contract originally belonging to the old company.
In property law, novation comes into play when a lease is novated to replace the original tenant with a new one, thereby transferring the responsibility for paying the rent as well as the liability for any damages inflicted on the property.
In the finance sector novation refers to an arrangement, where trades between two parties involve a clearinghouse acting as a middleman which buys and sells. Parties transfer securities to the clearinghouse which takes on the responsibility of verifying the trading parties. It also assumes the risk of one of the parties defaulting.
Novation can also function as a means to acquire new land titles in international law. For example Orkney and the Shetland Isles which were pledged to Scotland by the Norwegian king instead of repaying outstanding debt. They were annexed in 1472.