Novation

Novation, in contract law and business law,^[1] is the act of either:

1. replacing an obligation to perform with another obligation; or
2. adding an obligation to perform; or
3. replacing a party to an agreement with a new party.

Novation vs. Assignment

In contrast to an assignment, which is generally valid as long as the other party is given notice (except where the obligation is specific to the obligor, as in a personal service contract with a specific ballet dancer, or where assignment would place a new and special burden on the counterparty), a novation is valid only with the consent of all parties to the original agreement.^[2] A contract transferred by the novation process transfers all duties and obligations from the original obligor to the new obligor.

Examples of novation

For example, if there exists a contract whereby Dan will give a TV to Alex, and another contract whereby Alex will give a TV to Becky, then, it is possible to novate both contracts and replace them with a single contract wherein Dan agrees to give a TV to Becky. Contrary to assignment, novation requires the consent of all parties. Consideration is still required for the new contract, but it is usually assumed to be the discharge of the former contract.

Another classic example is when Company A enters a contract with Company B and a novation is included to ensure that if Company B sells, merges or transfers the core of their business to another company, the new company assumes the obligations and liabilities that Company B has with Company A under the contract. So in terms of the contract, a purchaser, merging party or transferee of Company B steps into the shoes of Company B with respect to its obligations to Company A. Alternatively, a "novation agreement" may be signed after the original contract^[3] in the event of such a change. This is common in contracts with governmental entities; an example being under the United States Anti-Assignment Act, the governmental entity that originally issued the contract must agree to such a transfer or it is automatically invalid by law.

The criteria for novation comprise the obligee's acceptance of the new obligor, the new obligor's acceptance of the liability, and the old obligor's acceptance of the new contract as full performance of the old contract. Novation is not a unilateral contract mechanism, hence allows room for negotiation on the new T&Cs under the new circumstances. Thus, 'acceptance of the new contract as full performance of the old contract' may be read in conjunction to the phenomenon of 'mutual agreement of the T&Cs.^[2]

Application in financial markets

Novation is also used in futures and options trading to describe a special situation where the central clearing house interposes itself between buyers and sellers as a legal counter party, i.e., the clearing house becomes buyer to every seller and vice versa. This obviates the need for ascertaining credit-worthiness of each counter party and the only credit risk that the participants face is the risk of the clearing house defaulting. In this context, novation is considered a form of risk management.

The term is also used in markets that lack a centralized clearing system, such as swap trading and certain over-the-counter (OTC) derivatives, where "novation" refers to the process where one party to a contract may assign its role to another, who is described as "stepping into" the contract. This is analogous to selling a future contract.

References

1. ↑ Richard Heckinger and David Mengle. "Derivatives Overview" (PDF). Chicago Fed. 
2. 1 2 Duhaime, Lloyd (25 May 2012). "Part 6: Restraint of Trade, Assignment, Novation & Frustration". duhaime.org. Duhaime's Contract Law. Retrieved 30 July 2013. 
3. ↑ Duhaime, Lloyd (2009). "Novation Definition". duhaime.org. Duhaime's Legal Dictionary. Retrieved 30 July 2013. 

Further Reading

• Understanding Derivatives; Markets and Infrastructure Federal Reserve Bank of Chicago, Financial Markets Group