Novation is a means of transferring one party’s rights and obligations under a contract to a third party. In effect, it extinguishes the existing contract and substitutes it with a new one under which a third party (incoming party) agrees to perform the outstanding obligations of the outgoing party. The incoming party is therefore directly liable to the continuing party for performance of the contract. As discussed earlier in this series, contractual obligations (as opposed to rights) cannot be transferred through assignment and can only be transferred by novation.
As novation extinguishes a contract and replaces it with another, the new contract must satisfy the legal requirement of consideration. Generally, the promises agreed between the parties in the novation agreement will be considered adequate consideration but to avoid any argument most novation agreements are in the form of a deed.
All parties to the original contract (the outgoing and continuing parties) and the incoming party must consent to the novation in order for it to be considered valid. This can be an issue where the continuing party is reluctant to agree to novation, for example, where the incoming party is of inferior financial standing to that of the outgoing party.
The novation agreement will generally release the outgoing party from any future liabilities arising under the contract being novated but in order to avoid doubt it should also state who is responsible for the pre-novation liabilities. If silent on this point, these liabilities will generally stay with the outgoing party.
If the requirements of novation (i.e. consent of all parties and consideration) are not satisfied, the novation may be considered invalid and the transfer ineffective. Alternatively, an assignment of the benefit of the contract may be held to have occurred (assuming the original contract does not prohibit assignment and is not a contract that is non-assignable as a matter of law) instead of a novation of the benefit and burden of the contract. In such a situation, the outgoing party will remain liable for the incoming party’s defaults.
For more information, please contact any member of the commercial contracts team at Stevens & Bolton LLP.
Beverley Flynn