If you’re new to the world of contracts and agreements, you might have heard of the term novation or the phrase “novating contracts.” So, what is a novation? Furthermore, what does it mean when you’re novating a contract?
What is a novation?
Novation refers to replacing an old obligation with a newly created one. Therefore, in the world of contracts, novation is a process that involves replacing an existing contract with a new one.
For example, this could involve removing one of the two parties involved a contract and replacing them with a third party. Once the third party replaces any of the two parties in the two-party agreement, the exiting party will hand over all their responsibilities and benefits to the third party.
How Does a Novation Work?
Now that your question, “what is novation?” is answered, it’s time to understand how novations work. Simply put, novating contracts means transferring a contract’s benefits and responsibilities to a different party.
An example of a benefit includes the money a party receives, while the responsibility or burden could be the tasks needed to be accomplished to receive the benefit.
Once a novation occurs, the original contract becomes void and gets replaced with a new one. However, all parties must provide their consent to make the novation happen.
Furthermore, a novation isn’t a type of unilateral contract mechanism. This means that all parties involved can negotiate before reaching an agreement.
For a clearer picture of how novations work, let’s say party A is currently providing their services to party B as the supplier of their goods.
Party A decides to give up being party B’s supplier but promises to find party B a different source for their goods. Party A manages to get a new supplier (party C) for party B and wishes to transfer service contracts with party B.
That said, party A decides to hand over all benefits and burdens to party C. If all three parties agree, the old contract is disregarded, and a new one is created to replace the old one.
The only difference between the old and new contract is that party C now has all the obligations that were originally party A’s.
Different Types of Novations
There are three different types of novations:
In this type of novation, only two parties are involved. A standard novation happens when two parties both consent to adding new terms to a contract. This results in the creation of a new contract where the newly added terms are present.
An expromissio consists of three parties, which involves the entry of a third party. The third party is the party that will assume one of the two parties’ benefits and obligations. In an expromissio novation, all parties involved must consent to the new terms and create a new contract.
A delegation is a type of novation where one of the parties involved in a contract hands over their obligations to a different party. Once that happens, the new party becomes legally bound to the terms present in the contract.
Where Is a Novation Used?
A novation is present and used in different types of industries. From finance to real estate, novation is widely used by any market or business as long as contracts are involved. Generally, novations are used to:
- Replace an existing obligation with a new one.
- Replace one party with a different party through an agreement.
- Add an obligation to perform.
Here are good examples of how novations are used in different industries below:
Use of novations in banking
In banking, banks and lenders also enter agreements in the form of contracts. Banks can use novations to hand over loans or debts to other lenders.
The bank will have the original contract canceled. Upon cancellation of the old contract, a new one containing the same terms and conditions will be created.
Use of novations in real estate
Contracts are also crucial in real estate, making novations just as essential. For instance, novations in real estate can be used by tenants who wish to hand over the lease of their commercial space to a different party.
Novations can also be used by homeowners who want to sell their home to a different buyer and ensure that the buyer shoulders all the unpaid mortgage.
And as stated in the beginning, novations aren’t just made to transfer obligations to another party. Novations can also be used to make revisions or additions, creating a new contract as a result.
For example, suppose a buyer finds out that a property has a problem during its inspection. In that case, the buyer and seller can both agree to lower the property’s purchase price to cover expenses for the necessary repairs.
Use of novations in the construction industry
Novations are also widely used in the construction industry. Often, contractors will decide to hand over their job to a different contractor.
Of course, the contractor must get their client’s permission before transferring the obligations and benefits to a different contractor.
Understanding the Difference Between Novation and Assignment
Besides the term novation, there’s also a chance that you may have heard of the word assignment when talking about contracts.
That said, novation and assignment are methods where a party or individual can hand over their benefits and burdens to a different party. However, you shouldn’t confuse novations and assignments as the same thing.
After all, even though an assignment also transfers the responsibilities and benefits to a different party, like a novation, the burdens that occurred in the contract don’t get passed to the new party.
Therefore, in an assignment, the original party is still responsible for the burdens before the assignment, even if they have already exited the contract. Moreover, unlike novations, assignments don’t need the third party’s consent.
Novations are essential in any industry or market where contracts are involved. Since parties involved in an agreement might eventually leave for various reasons, novations ensure that the benefits and burdens are smoothly transferred to the incoming parties involved.
As long as all parties have no objections to the novation, the novation can proceed. As a result, the benefits and burdens will get passed on to the third party.