Novation

What is '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.

RELATED TERMS
  1. Assignment

    1. The transfer of an individual's rights or property to another ...
  2. Debt Instrument

    A paper or electronic obligation that enables the issuing party ...
  3. Obligation

    The responsibility to meet the terms of a contract. If an obligation ...
  4. Assignable Contract

    A futures contract with a provision permitting the contract holder ...
  5. Performance Bond

    A bond issued to one party of a contract as a guarantee against ...
  6. Bilateral Contract

    A bilateral contract is a reciprocal arrangement between two ...
Related Articles
  1. Savings

    Is There a Way to Get Out of Your Car Lease Early?

    For those who no longer want their car for whatever reason, transferring the lease to an interested party can be a particularly appealing choice.
  2. Home & Auto

    Rent-To-Own Homes: How The Process Works

    Here's what to watch for when negotiating a contract for a rent-to-own home – and who is a good candidate for this option.
  3. Investing

    How Do Futures Contracts Work?

    Futures contracts are one of the most important financial innovations in history, but they are often misunderstood. Find out this contract is used to transfer risk between different parties. ...
  4. Economics

    How Does an Operating Lease Work?

    Operating lease is a term used mostly in accounting to denote a lease that gives the lessee rights to use and operate an asset without ownership.
  5. Savings

    When Is Leasing A Car Your Best Bet?

    Leasing a car isn't right for everyone. But it's attractive for those who want low initial payments and the ability to get a new vehicle every few years.
  6. Savings

    Why You Should Buy A Car Instead Of Leasing

    While leasing has certain advantages, buying a car tends to save you money in the long run and offers greater flexibility.
  7. Home & Auto

    When Is Buying A Car Better Than Leasing?

    People who lease a car are often more concerned with the short-term picture.
  8. Options & Futures

    Futures, Derivatives and Liquidity: More or Less Risky?

    Futures and derivatives get a bad rap after the 2008 financial crisis, but these instruments are meant to mitigate market risk.
  9. Savings

    Your Lease Is Up: When Should You Buy The Car?

    In general, the fact that you know the car is to your benefit. Before deciding, compare the buyback price to what the car would go for on the open market.
  10. Saving and Spending

    How to Value Art and Dodge the IRS on Death Taxes

    Appraising artwork can be a very inexact process, and an estate could face penalties from the IRS for undervalued works. Here's how to best price art.
RELATED FAQS
  1. What are some types of financial netting?

    Read about the different types of financial netting, which is a critical concept when competing claims exist between different ... Read Answer >>
  2. How can a futures trader exit a position prior to expiration?

    A futures contract is an agreement to buy or sell a commodity at a pre-determined price and quantity at a future date in ... Read Answer >>
  3. Why might a bond agreement limit the amount of assets that the firm can lease?

    Bond covenants can limit the amount of leases a company can have because leasing contracts are a form of debt. Taking on ... Read Answer >>
  4. How are arm's-length transactions determined by law?

    Determine if transactions are conducted at arm's length by checking if the parties to a contract are independent and transact ... Read Answer >>
  5. How do you make working capital adjustments in transfer pricing?

    Understand how working capital adjustments are applicable to transfer pricing. Learn about the arm's length standard and ... Read Answer >>
  6. What is the default risk of a derivative?

    Learn about default and counterparty risk for derivatives, and understand why derivatives traded over the counter have significant ... Read Answer >>
Hot Definitions
  1. Demand Curve

    The demand curve is a graphical representation of the relationship between the price of a good or service and the quantity ...
  2. Goldilocks Economy

    An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. This term is used to ...
  3. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
  4. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  5. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  6. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
Trading Center