What Is Novation?
Novation is the replacement of one of the parties in an agreement between two parties, with the consent of all three parties involved. To novate is to replace an old obligation with a new one. For example, a supplier who wants to relinquish a business customer might find another source for the customer. If all three agree, the contract can be torn up and replaced with a new contract that differs only in the name of the supplier. The old supplier relinquishes all rights and obligations of the contract to the new supplier.Key Takeaways
- To novate is to replace an old obligation with a new one.
- In contract law, a novation replaces one of the parties in a two-party agreement with a third party, with the agreement of all three parties.
- In a novate, the original contract is void. The party that drops out has given up its benefits and obligations.
- In the financial markets, using a clearinghouse to vet a transaction between two parties is known as a novation.
- Novation is different than an assignment, where the original party to the agreement retains ultimate responsibility. Therefore, the original contract remains in place.
How Novation Works
In legal language, novation is a transfer of both the "benefits and the burdens" of a contract to another party. Contract benefits may be anything. For example, the benefit could be payments for services. The burdens are the obligations taken on to earn the payment—in this example, the services. One party to the contract is willing to forgo the benefits and relinquish the duties. Canceling a contract can be messy, expensive, and bad for an entity's reputation. Arranging for another party to fulfill the contract on the same terms, with the agreement of all parties, is better business. Novations are often seen in the construction industry, where subcontractors may be juggling several jobs at once. Contractors may transfer certain jobs to other contractors with the client's consent. Novations are most frequently used when a business is sold, or a corporation is taken over. The new owner may want to retain the business's contractual obligations, while the other parties want to continue their agreements without interruption. Novations smooth the transition.Types of Novations
There are three types of novations:
- Standard: This novation occurs when two parties agree that new terms must be added to their contract, resulting in a new one.
- Expromissio: Three parties must be involved in this novation; a transferor, a counterparty, and a transferee. All three must agree to the new terms and make a new contract.
- Delegation: One of the parties in a contract passes their responsibilities to a new party, legally binding that party to the terms of the contract.
Novation vs. Assignment
A novation is an alternative to the procedure known as an assignment.
In an assignment, one person or business transfers rights or property to another person or business. But the assignment passes along only the benefits, while any obligations remain with the original contract party. Novations pass along both benefits and potential liabilities to the new party. For example, a sub-lease is an assignment. The original rental contract remains in place. The landlord can hold the primary leaseholder responsible for damage or non-payment by the sub-letter. Novation gives rights and the obligations to the new party, and the old one walks away. The original contract is nullified.In property law, novation occurs when a tenant signs a lease over to another party, which assumes both the responsibility for the rent and the liability for any subsequent damages to the property, as indicated in the original lease.
Generally, an assignment and a novation require the approval of all three parties involved.Novation Uses
Because a novation replaces a contract, it can be used in any business, industry, or market where contracts are used.Financial Markets
In financial markets, novations are generally used in credit default swaps, options, or futures when contracts are transferred to a derivatives market clearinghouse. A bilateral transaction is completed through the clearinghouse, which functions as an intermediary.
The sellers transfer the rights to and obligations of their securities to the clearinghouse. The clearinghouse, in turn, sells the securities to the buyers. Both the transferor (the seller) and transferee (the buyer) must agree to the terms of the novation, and the remaining party (the clearinghouse) must consent by a specific deadline. If the remaining party doesn't consent, the transferor and transferee must book a new trade and go through the process again.
Real Estate
Contracts are a part of real estate transactions, so novation is a valuable tool in the industry. If buyers and sellers enter into a contract, novation allows them to change it when issues arise during due diligence, inspection, or closing. Commercial and residential rental contracts can be changed using novation if tenants or renters experience changes that affect their needs or ability to make payments.Government Contracting
Federal, state, and local governments find it cheaper and beneficial for the economy to contract specific tasks rather than create an official workforce. Contracts are critical components for private or public companies who win a bid to do work for governments. If the contractor suddenly can't deliver on the contract or other issues prevent it from completing its task, the contractor can ask the government to recognize another party to complete the project.