Novating a contract

Sometimes business enter into agreements, which they later need to give up, be it because of internal restructuring or following an asset purchase. In these type of cases, termination may not always be the most appropriate or possible solution. However, they may be able to transfer both their rights and obligations to a third party. Read this Quick Guide to find out how.

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Novation is the process by which the original contract is extinguished and replaced with another, under which a third party takes up rights and obligations duplicating those of one of the parties to the original contract.

This means that the original party transfer both the benefits and burdens under the contract. The benefits could be in the form of money or the benefit of a service, while burdens are what the party is obliged to do in order to receive the benefits, for example, payment for a service or goods, or the performance of a service. 

Novation is a complex process, as all the parties involved (the original parties and the incoming party) have to sign the novation agreement.

This is because while the benefits under a contract can be assigned without the other party’s consent, contractual obligations cannot be assigned. This means that the original party can only achieve this if both the buyer (the new party) and the third party agree to a novation. 

This may be difficult in some cases, for example when there is a change of supplier of services. The other original party may find it difficult to agree, if they don’t see a benefit of novating the contract or ask for further assurances that they won’t be worse off as a result of the novation.

In these kind of situations the party wishing to novate the contract should be prepared to negotiate with the other party. Ask a lawyer if you need advice based on your specific circumstances.

Parties wishing to novate their contract should carefully check its terms as sometimes, there may be a provision in a contract which will ban all purported transfers of the rights and obligations under the contract or it may specify how consent is to be acquired.

A novation agreement is essentially notice to the remaining party, and therefore the requirements for serving notice should be followed.

After the contract is novated, the outgoing party and the remaining party usually release each other from any liability and claims in respect of the original agreement on or after the date the agreement was signed. 

They might also agree to indemnify (promise each other to compensate the loss incurred to the other party due to the acts of the first party or any other party). For example, the outgoing party can agree to indemnify the incoming party in respect of any liabilities and obligations the incoming party agrees to take over and the incoming party can agree to indemnify the outgoing party in respect of any liabilities that the outgoing party retains.

A novation agreement transfers both the benefits and the obligations of a contract to a third party. In contrast an assignment does not transfer the burden of a contract. This means the outgoing party remains liable for any past liabilities incurred before the assignment.

For more information read Assigning a contract

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