Contract Law
Novation: What You Need to Know
Author
Colin Lambertus
Author
Colin Lambertus
July 9, 2024
Contract Law
Do you want to replace a party to a contract? If so, you need to consider the rules and process around “novation”.
In this article, we explain:
- what is novation
- when is novation used: common uses and examples
- how do you novate an agreement
- key considerations
What is novation?
Novation is a legal term that describes the process by which the rights and obligations of a party to a contract are transferred to another.
The party transferring its rights and obligations effectively walks away, and has their contract transferred with a new party taking over. The other original party to the contract carries on with the same rights and obligations but they stop dealing with the party walking away and start dealing with the new party coming in.
Novation requires a mutual agreement across at least 3 parties: the original party walking away, the new party coming in and the other original party staying on.
Novation is not to be confused with “assignment”. An assignment is the process by which a party transfers their rights under a contract to another party but not their obligations. Obligations cannot be “assigned” they can only be novated.
When is novation used: common uses and examples
Novation is normally used in the context of corporate restructuring or business acquisitions.
For example, a UK headquartered company may be doing business in Australia. What started out as an exploratory venture has turned into a significant business stream with a growing client base. The UK entity now wishes to create a subsidiary in Australia to look after those customers, attract future work and hire local staff. The UK entity will want to novate its contracts with its Australian customers over to the new Australian subsidiary. In this case, the parties agree on a novation to transfer responsibilities to the new entity.
Or, the reverse could happen – if for whatever reason a parent company decides to shut down its subsidiary it may want to take over the subsidiary’s contracts. Again, a novation agreement would be needed with the subsidiary’s counterparties having to agree to the parent company taking over from the subsidiary.
Alternatively, in an acquisition context, if company A is buying the business of company B through an asset purchase arrangement (rather than a share purchase arrangement), certain contracts will probably need to be novated to A. These usually include B’s supplier and customer contracts.
Novation is also used in the context of financing agreements or mortgages – lead banks may be part of a consortium and participant lenders drop in and out when they lend money to borrowers. Novation can be a tool to facilitate this participation without having to negotiate a new contract agreement with the borrower each time.
Can you novate your contract?
Before considering whether you can, or how to novate a contract you should first look at the contract to see what it says.
This is because the contract may contain provisions restricting novation or allowing it as long as the contracting parties follow a certain process.
Note: if a written contract doesn’t say anything about novation, or if it doesn’t properly deal with it, novation can still happen.
Novation rights or restrictions are often fully or partially addressed in the boilerplate clauses of a contract and, more specifically, the “assignment” clause.
The “assignment” clause usually reads something along the lines of: “neither party will assign, transfer, or otherwise deal with its rights under the contract.” But does this do enough to prevent novation?
On the one hand, the courts have previously held that such a clause could operate to prevent novation because a restriction on “dealing” could be interpreted to mean novation – Musst Holdings Ltd v Astra Asset Management UK Ltd [2023] EWCA Civ 128.
On the other hand, the courts in the recent case of Magee v Crocker [2024] EWHC 1723 (Ch) concluded that contractual controls on transfers or dealings would not apply to a novation.
So question marks around how a novation may be effected can often arise, despite or because of the drafting in the relevant contract. As a result, the safest course of action will always be to have the remaining party, the departing party and the incoming party sign a novation agreement.
How do you novate a contract: forms of novation
There are different ways that novation occurs:
In writing
In principle, a novation does not need to be in writing unless:
- the underlying contract is one that has to be in writing e.g. for the transfer of land;
- the underlying contract does not allow an implied or informal novation; or
- if the parties use a deed to record the novation.
However it is best practice to use a written agreement for a novation for reasons of certainty and for clarity around the release of legal rights. For example, it is common in novation agreements for there to be wording dealing with the pre-novation position. Parties can agree to release the departing party from all liability prior to novation, or, more commonly, state that they are not doing so. Specific indemnities may also need to be drafted.
Having the liability position set out clearly in writing at the time of novation reduces the risk of there being debate between the parties or gaps in liability found down the line if things go wrong.
Oral novation or novation by conduct
As flagged above, novation does not necessarily have to be in writing and can, instead, be made by an oral agreement. But can novation be implied?
Yes, parties may, knowingly or unknowingly, agree to novate an agreement by their conduct.
Novation by conduct can be boiled down to a party acting in such a way that it substitutes another party in its place (or in the place of its counterparty). The other parties would have to accept this conduct – usually by continuing to act in such a way that accords with the first party’s actions that have the effect of novating the agreement.
In the case of Gama Aviation (UK) Ltd v MWWMMWM Ltd [2022] 4 WLUK 364 International Jet Club (IJC) entered into a contract to provide maintenance and repair services for an aircraft owned by MWWMMWM (M). The group of companies in which IJC was a member undertook a re-organisation and another member of its group – Gama – serviced the aircraft, dealt with M and invoiced M. Later, M stopped paying Gama’s invoices and Gama sued M for non-payment. The court held that as a result of the parties’ conduct, the service agreement had been novated to Gama and Gama could therefore sue M for non-payment. The fact that the parties were in negotiations in relation to a revised written agreement was not inconsistent with a finding that the original agreement was novated (following Evans v SMG Television Ltd [2003] EWHC 1423 (Ch))
Key Considerations
The main points to consider around novation are:
- How will pre-novation rights and liabilities be dealt with?
- How will post-novation rights and liabilities be dealt with?
Unless the novation agreement provides otherwise, novation will stop the outgoing party and the continuing party from incurring further liabilities to each other. As to pre-novation liabilities, the novation agreement will usually make express provision dealing with one of the following alternatives:
- The outgoing party will remain liable for all its pre-novation liabilities under the original contract (most common position).
- The outgoing party will remain liable for certain identified liabilities only.
- The incoming party will assume the outgoing party’s liabilities under the original contract with retrospective effect (least common position unless another member of the outgoing party’s group is taking over).
If the outgoing party retains any pre-novation liabilities, the incoming party should consider taking indemnities from the outgoing party to cover those liabilities. Conversely, the outgoing party should consider asking for indemnities from the incoming party for any pre-novation liabilities the incoming party agrees to take over.
The parties should also make it clear in the novation agreement whether they are releasing only past breaches that they know about or whether they are releasing all past breaches, even those that are unknown.
The novation agreement should also be clear on post-novation rights. For example, if the outgoing supplier has not been paid for work done before novation, the agreement should make it clear as to how the outgoing supplier should be paid and by whom.
Finally, we should highlight a particular issue to consider with public sector contracts. Even though, on the face of it, there is no reason why the parties to a public sector contract cannot agree to novate a contract, public procurement rules may prevent the novation from happening. This is because once a contract has been awarded to a supplier, only very specific variations may be made to it without another procurement procedure being followed. It may be possible, for example, for a supplier’s subcontractor to take over from the supplier in certain circumstances. Particular care, therefore, must be taken when dealing with public sector contracts.
Conclusion
At EM Law, we are experts in contract law. If you need assistance with novating your agreements, or ascertaining whether an agreement has been properly novated, please contact Neil Williamson or Colin Lambertus here, or feel free to reach out to either of them directly.
