Novation

DEFINITION of 'Novation'

Novation is the act of replacing one party in a contract with another, or of replacing one debt or obligation with another. It extinguishes (cancels) the original contract and replaces it with another, requiring the consent of all parties involved.

BREAKING DOWN 'Novation'

If Angela owes Eric $200, but Eric in turn owes Jorge $200, these obligations could be simplified through novation, so that Angela owes Jorge $200, and Eric owes nothing. Angela and Jorge could then come to an arrangement whereby Angela would give him a piece of artwork they agree is worth $200 (or more, to compensate for lack of liquidity) in lieu of cash. This would also constitute novation, assuming the original contract ($200 cash) is extinguished and replaced by the new contract (the piece of artwork). 

Novation occurs when a tenant signs a lease over to another party, who is then responsible for the rent and liable for damages to the property according to the terms of the original lease. It is also common in the construction industry, allowing a contractor to transfer certain jobs to another contractor with the client’s consent. In Australia, employers will commonly offer a novated lease in lieu of a company car: the company deducts the lease payments from the employee's pre-tax income, while the employee assumes liability for the car.

Novation is similar to the concept of assignment, but there are fundamental differences between the two. Novation can transfer rights and obligations alike; assignment cannot transfer obligations. Assignment does not always require the consent of the party that benefits from the transfer; novation does. Finally, assignment does not extinguish the original contract, which novation does.  

In derivatives markets, novation has a slightly different meaning. It refers to an arrangement whereby bilateral transactions are done through a clearing house: rather than transacting directly with buyers, sellers sell their securities to the clearing house, which in turn sells these to the buyers. The clearing house assumes the counterparty risk for these transactions, that is, the risk that one party or another will default. This practice helps to reduce credit risk for participants, who may be unlikely or unable to vet every other participant for credit worthiness. Instead, the risk to all parties is that the clearing house will become insolvent.

Novation can also refer to a method used to extend the life of debt and obligations, similar to a rollover.

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