What Is Novation?

Novation is the act of substituting a valid existing contract with replacement contract, where all concerned parties mutually agree to make the switch. In most novation scenarios, one of the two initial contracting parties is replaced outright by an entirely new party, where the original party willingly agrees to forgo any rights originally afforded to him. Novations are most frequently used in corporate takeovers and the sales of businesses.

How Novation Works

A novation is similar to an assignment, which is the act of one party transferring an interest in a property or a business to a third party, as opposed to transferring the entire entity. But while novations pass along both benefits and potential liabilities to the new party, assignments merely pass along the benefits, therefore any future obligations remain with the original property holder.

Other notable differences: all concerned parties must consent to novations, which is not true with assignments. Finally, while novations effectively nullify the former contract, in favor of the replacement contract, assignments do not extinguish the original contracts.

[Important: A novation is not a unilateral contract mechanism, therefore all concerned parties may negotiate the terms of the replacement contract until a consensus is reached.]

An Example of Novation

Consider the following example of novation. Sally owes David $200, while David, in turn, owes Monica $200. This duo of debt obligations may be simplified through novation. Under the newly designed paradigm, Sally now directly owes Monica $200, while David is effectively carved out of the equation entirely. Novations also allow for payment stipulations to be redrawn, as long as both parties come to a meeting of the minds, regarding the redefined terms.

To continue with our example, in lieu of the cash owed to her, Monica may agree to accept a piece of Sally's original artwork, which has an approximate value of $200 value. This transfer of property constitutes novation and effectively jettisons the original cash obligation.

In property law, novation occurs when a tenant signs a lease over to another party, who assumes both the responsibility for the rent and the liability for any subsequent damages to the property, as indicated in the original lease. Novation is also commonly seen in the construction industry, when contractors transfer certain jobs to other contractors, as long as the clients' consent to such action.

Special Considerations: Novation in Financial Markets

In derivatives markets, novation refers to an arrangement whereby bilateral transactions are done through a clearinghouse, which essentially functions as a middleman. In this case, rather than transacting directly with buyers, sellers transfer their securities to the clearinghouse, which in turn sells the securities to the buyers. The clearinghouse assumes the counterparty risk of one party defaulting.

This practice simplifies processes for participants, who may not have the resources to vet every potential counterparty for their credit-worthiness. However, the buying and selling parties bear the modest risk of clearinghouses becoming insolvent, although this is considered to be a rather unlikely possibility.