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What does novation mean in contracts?
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What Is Novation Contract
The term novation in contract refers to the process where the contracting parties agree to replace one or more contracting parties with another.
In the English dictionary, the word “novation” means “the substitution of a new legal obligation for an old one”.
In other words, a new contracting party substitutes another contracting party thereby inheriting the obligations contained in the contract.
For example, Company A and Company B have entered into a contract.
There will be novation when Company A, Company B, and Company C agree that Company B will relinquish all its rights and obligations under the original contract and will be replaced by Company C.
In the end, the contract will continue between Company A and Company C.
Purpose of Novation
Why should you do a novation of your contract instead of simply cancelling it.
There are instances where contracting parties may find that cancelling the contract may not be advantageous and choose to operate novation of their contract.
Terminating a contract can trigger various unwanted and undesirable obligations on the parties, it may be costly, and may even affect the contracting parties’ reputation.
Instead, a party that intends to leave will find another party who is willing to take up the same obligations under the original contract thereby operating a substitution of a party.
When there’s novation, the party leaving the agreement loses are rights under the contract but is also freed from all the obligations as well.
When To Novate
Novation is a type of agreement between three parties where a party agrees to substitute itself to another party who is bound in a contract with another.
There are many situations in business when novation is a preferred approach rather than assigning the agreement or terminating it.
Here are some scenarios when novation may be preferred:
- A party is unable to pay its debt
- In the context of a takeover transaction
- In the context of a business sale
- In financial markets
What is the definition of novation?
In essence, in common English, novation means to replace an old obligation with a new one.
For example, if a person has agreed to perform a certain task and this task is replaced with another, we can refer to this as novation.
Novation Contract Law
What does novation mean in contract law?
In contract law, novation refers to the replacement of a contracting party with another contracting party where all the original contracting parties and the new one agree (tripartite agreement).
What’s important to note is that in the context of a novation, the original agreement between the initial contracting parties is voided.
A new contract is entered into between one of the original contracting parties and a new party.
The exiting contracting party will no longer have any rights or obligations under the original contract once it’s been novated.
To novate, all parties have to agree, including the third party.
If a contract is between Party A and Party B and Party B wants to novate in favor of Party C, all these parties must agree.
Party A must agree that Party B is relinquishing all benefits and duties under the contract and be replaced with Party C.
Party C must agree to accept all the same terms and conditions found in the contract between Party A and Party B.
For this reason, Party A, Party B, and Party C all have to agree to a novation agreement.
Novation Contract Pros And Cons
What are the advantages and disadvantages of novation in contracts?
The main advantage of novation is that a party can “leave” a contract and be “replaced” by another without having to go through the complexities of terminating a contract and possibly risk.
In a novation, you have one party staying in the contract and another party exits.
The advantage for the staying party is that it can continue getting the benefits of the contract without having to go through a complex renegotiation process with a third party and having to deal with possible disputes with the exiting party.
The advantage for the exiting party is that it can exit the contract without important risk or liability.
Also, the exiting party will also be discharged from all liabilities and claims going forward.
The main disadvantage with novation is for an exiting party to find a third party who is willing to accept the “same” terms and conditions under the original contract.
Many companies have different standards and risk tolerance and so they may not be willing to take on the same level of risk under the contract as the exiting party had taken.
Also, the remaining party may contract with another party based on certain specific characteristics of that party that may not be present in a third party.
As such, getting the approval of all parties for a novation may be challenging in certain circumstances.
How Does Novation Contract Work
How does it work to enter into a novation agreement?
To better understand how novation works, let’s look at a practical example.
It’s quite common to see contract novation in the construction industry or in the context of M&A transactions.
Let’s use the construction industry to illustrate our example.
Imagine that a client mandates a general contractor to build an office building.
Considering the project is important, the general contract enters into contracts with subcontractors (original contract) to provide it with specific services allowing it to build the office building.
However, a subcontractor may initially enter into the contract but may then want to leave this project for another.
Instead of cancelling the contract, the subcontractor will find another company to “replace” it under the original contract with the general contractor.
In this case, it would not be feasible for the subcontractor to just cancel the contract with the general contractor as that may result in significant project delays and trigger many penalties that it may be responsible for.
Rather, by novating the contract, the general contractor is able to keep the same contract terms and conditions and have the remainder of the obligations performed by another subcontractor.
Novation Contract FAQs
To better answer the question of what is novation, let’s look at frequently asked questions on this topic.
What is the novation legal definition
How do you define novation in legal terms?
According to the Legal Information Institute, novation is defined as follows:
A novation is an agreement made between two contracting parties to allow for the substitution of a new party for an existing one.
In essence, novation is:
- An agreement
- Between contracting parties
- Allowing the substitution of one party with another
What is novation in real estate
In real estate, novation happens quite often when a party passes on its rights and obligations to another party where the outgoing party is released from all liability and duty under the original contract.
A typical example of novation that you may see in real estate involves the novation of a commercial lease.
In the context of a commercial lease, a commercial tenant having a lease with a landlord finds another tenant to novate the original agreement with the approval of the landlord.
The outgoing tenant is released from all its rights and obligations under the commercial lease and the landlord signs a new commercial lease with a new tenant based on the exact same terms and conditions as the original contract.
What is a novation agreement
What is the difference between a novation agreement and contract assignment?
Novating a contract is the process of having a contracting party replaced by a new one upon the mutual agreement of the original contracting parties.
When a contract is novated, the party leaving the contract relinquishes all its rights under the contract but also all its obligations in favor of the other party.
A contractual assignment is a process where one contracting party transfers the contract to another where only the benefits of the contract are assigned but where the assigning party still remains obligated under the original contract.
So the main difference between novation and assignment is the level of responsibility remaining with the “exiting” party.
However, no matter if you are assigning the contract or novating, you’ll need all three parties to approve.
Novation of Contract Takeaways
So there you have it folks!
What Is A Novation Contract
Novation is the process where a contract is extinguished between two contracting parties and replaced with a new contract, having the same terms and conditions, between one of the original contracting parties and a third party.
In a nutshell, the terms and conditions of the original contract are duplicated between one of the original contracting parties and a third party.
The party leaving the original contract lets go of both the benefits and burdens under the contract to another in favor of another.
Now that you know the novation meaning, good luck with your contract negotiations and management!
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