Novation

The process of substituting an existing contract with a replacement contract

What is Novation?

Novation refers to the process of substituting the original contract with a replacement contract, where the original party agrees to forgo any rights afforded to them by the original contract. In most novation agreements, the parties agree to extinguish the original contract and replace it with an entirely new contract.

 

Novation

 

One of the original contracting parties is replaced by a third party who takes up the rights and obligations afforded to the original contract. Therefore, the original contracting party transfers all rights and obligations to the new party in the contract.

Since novation is a complex process, all the contracting parties must agree to make the switch and sign the novation agreement. The main parties include the transferor, transferee, and the counterparty. Novation contracts are used in the sale of businesses, takeover transactions, and M&A deals.

 

Summary

  • Novation refers to the process of substituting an existing contract with a replacement contract, where the contracting parties reach a consensus.
  • One of the contracting parties in the original contract is replaced by an entirely new party that assumes the rights and obligations of the original party.
  • Novation agreements are used in the sale of businesses, takeovers, and mergers and acquisition transactions.

 

How Novation Works

Novation is the consensual replacement of a contract, when a new party takes over the rights and obligations of the original party, thus releasing the latter from that obligation. In a novation contract, the original party transfers its interest in the contract to another party – it is not a transfer of the entire entity or property. A novation is required in scenarios when performance becomes impossible to implement under the terms of the original contract.

Although similar to an assignment, a novation is fundamentally different from an assignment. While a novation passes along the benefits and liability of the original contract to a new party, an assignment only passes the benefits to the new owner, and all obligations of the contract remain with the original contracting party.

Also, novation is a consensual transfer of rights and obligations that requires all contracting parties to agree and sign the agreement. On the contrary, for an assignment to be completed, it does not require the consent of the new party.

 

What Happens After Novation is Completed?

When the contracting parties reach a consensus and sign the novation agreement, they release each other from any liabilities that may arise from the original agreement. It means that the new party cannot hold the original party accountable for any obligations resulting from the agreement.

Also, the parties agree to indemnify each other for losses incurred due to acts of the other party. For example, the incoming party agrees to indemnify the original party for any losses incurred in respect of acts executed by the original party.

 

Practical Example

Assume that John bought a car from Peter for $5,000 on credit terms, which he plans to clear in the next twelve months. Even before John makes the first monthly installment, he gets a medical emergency and needs immediate cash to settle the bill. Therefore, John decides to sell the car to Mary under the same terms as Peter. John wants to exit the transaction but owes obligations to both Peter and Mary.

Therefore, John decides to settle his debt obligation through a novation by talking Peter and Mary into a novation agreement. The parties agree to enter into the agreement by signing the novation agreement, where Mary takes over John’s obligations to Peter, and she will now be required to meet all the obligations that John owed Peter. The novation agreement may allow the repayment schedule to be renegotiated, on the condition that the parties agree on the new terms.

Novation may also occur in the real estate sector, where a tenant passes the lease tenure in a property to a third party. The tenant passes the lease agreement to the other party, which ultimately passes the responsibility of making lease payments, repairs for property damages, and other obligations specified in the original lease agreement. The contracting parties may retain the original lease contract or negotiate the terms of the agreement until a consensus is reached.

 

Novation in Financial Markets

The term “novation” is also used in the derivatives markets. It refers to the arrangement where security holders transfer their securities to a clearinghouse, which then sells the transferred securities to buyers. The clearinghouse acts as the middleman in the transaction and assumes the counterparty risk associated with one party defaulting on their obligations.

Such a form of novation simplifies the process for participants in the market, who do not need to ascertain the creditworthiness of the other party in the transaction. The only credit risk that participants face is the risk of the clearinghouse becoming insolvent, which is considered an unlikely event.

A novation can also occur in the absence of a clearinghouse, where a seller transfers the rights and obligations of a derivative to another party. It may occur in markets that lack a centralized clearing system, such as swap trading, where one contracting party assigns its role to another party.

 

More Resources

CFI is the official provider of the global Certified Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

  • Adhesion Contract
  • Definitive Purchase Agreement
  • Negotiation
  • Subrogation

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