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What is a Novation Agreement?
A novation agreement is a legal contract that transfers contractual obligations of one party to a third party or replaces a contractual obligation with another one. All parties involved, generally a transferee, transferor and counterparty, must agree to these changes.
Novation Explained
Novation is used in contract law and business law which defines the act of:
- Replacing an obligation with another obligation
- Adding an obligation to perform
- Replacing a party with another in an agreement.
There are three main ways to make a novation:
- Novation: A simple novation doesn’t involve entry of a third party. Instead, someone who owes debt enters in a new agreement with their lender.
- Expromissio: Expromissio involves entry of a third party on to an agreement. This new party takes on obligations of the original party.
- Delegation: In a delegation, new lenders enter into an agreement in place of an old one. The debtor is released from the old contract by the original lender and now has obligations towards the new lenders.
Novation vs Assignment:
Novation in contract and business law is different from assignment.
Assignment is generally valid as long as the party is provided notice whereas a novation requires agreement of all parties. An assignment only passes along benefits rather than obligations. For instance, a sublease is an assignment. The landlord can still hold the primary renter responsible. In a novation, the primary party of the contract would also transfer all obligations and cannot be held accountable for the contract after novation is complete.
There are advantages and disadvantages to both a novation and an assignment. Assignment is often more convenient than a novation. Novation can protect sellers from future liabilities despite being a tedious process.
Want to learn more about novation? Here is an article on novation for you .
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Purpose of a Novation Agreement
Novation is used when a third party enters an agreement to replace a departing party in a contract. Usually a new party would assume obligations to pay another party that the original party had intended to pay. This releases the debt from one party to another. There would generally be three parties involved: a transferee , transferor and the counterparty . All parties must sign the agreement.
Cancelling a contract can be messy and expensive. In such cases, one might find novation to be a better option. Through novation one party can simply find a third party to complete an original agreement.
There are certain risks of a novation. If the counterparty is unsure that the new party will be able to adequately complete obligations set under the contract, the counterparty might face consequences in the future but will not be able to hold the primary party accountable after novation.
Still not sure about the purpose of novation? Here is an article for you .
Examples of Novation
A few examples of novation can help you understand the process better. For instance, consider this case. Person A owes Person B $100. Person B already owes Person C $100. In this case, Person A and Person B can simply transfer their debt obligations through a novation. If all parties agree, Person A can just pay Person C $100. Person B will receive and pay no amount.
Novation can also allow for modified payment terms if all parties agree. Take the case of Person A, B and C mentioned above. Person C might agree to accept Person A’s jewelry as payment which has a value of $100–the debt amount. This transfer of jewelry can still constitute as repayment and resolution of all debt between the three parties.
Novation in mergers and acquisitions is common. A classic example is when a company, X, enters into a contract with another Company, Y. A novation can be included to ensure that if company Y sells, merges or transfers their business or parts of their business to another company, the new company that merges with or acquires company Y or parts of it, will assume obligations and liabilities of company Y in the contract with Company X. In this contract, a purchaser, merging party or transferee of Company Y will step into the role of Company Y in respect to their contract with Company X.
Novation is also used in financial markets. A bilateral transaction done through a clearinghouse intermediary in the derivatives markets is called novation. Here, sellers transfer securities to the intermediary or the clearinghouse which then sells the securities to buyers. The clearinghouse assumes the obligations and counterparty risk in case of a party defaulting. The clearinghouse also becomes responsible for vetting buyers based on creditworthiness.
Here is an article with more examples of novation .
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Who Should Sign a Novation Agreement?
A novation must be signed by all parties involved–the transferee, transferor and counterparty. The transferor transfers the obligations to the transferee in an agreement with the counterparty. One might consider signing a novation agreement in the following scenarios:
- Unable to repay debt: If party A borrows money from party B, but is unable to repay the debt and has a third party, C, come in an offer to repay the debt, all parties can consider novation. Here party A would transfer all debt obligations to party C and walk away. Party B will receive the debt from Party C instead of Party A. In case of default, Party B will not be able to hold party A responsible.
- Takeover transactions: In business transactions or corporate takeover, novation can be used to replace parties as per new takeover roles.
- Sale of business: Novation during sale of a business is often used to replace or transfer business obligations between parties.
- Financial Markets: Novation allows derivatives market to use bilateral transactions through an intermediary.
If you are looking to draw up a novation agreement, here is an example of a novation agreement .
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