What Is Novation?

What Is Novation?

Let me explain novation directly: it's when you replace one party in a two-party agreement with a third party, and all three of you have to consent to it. Essentially, to novate means you're swapping out an old obligation for a new one.

Take this example—suppose a supplier wants to hand off a business customer to someone else. If you, as the customer, the old supplier, and the new one all agree, we tear up the old contract and create a new one that's identical except for the supplier's name. The old supplier walks away from all rights and obligations, passing them fully to the new one.

Key Takeaways

Remember, novating means replacing an old obligation with a new one. In contract law, it swaps out one party in a two-party deal with a third party, but only if all three agree. Once done, the original contract is void, and the exiting party gives up all benefits and duties.

In financial markets, think of a clearinghouse vetting a transaction between two parties—that's a form of novation. And don't confuse it with assignment: in assignment, the original party keeps ultimate responsibility, so the old contract stays intact.

How Novation Works

In legal terms, novation transfers both the benefits and burdens of a contract to another party. Benefits could be something like payments for services, while burdens are the obligations you take on to earn those payments, such as delivering the services. With novation, one party agrees to give up the benefits and drop the duties.

Canceling a contract outright can get messy, costly, and harm your reputation. It's smarter to arrange for another party to step in and fulfill the same terms, as long as everyone agrees. You see this often in construction, where subcontractors juggle multiple jobs and might transfer one to another contractor with the client's okay.

Novations happen a lot when a business is sold or a corporation is taken over. The new owner wants to keep the existing contractual obligations, and the other parties want continuity without disruption. Novation makes that transition smooth.

Types of Novations

There are three types you should know about. Standard novation happens when two parties decide to add new terms to their contract, which results in an entirely new agreement.

Expromissio involves three parties: a transferor, a counterparty, and a transferee. All three must agree to the new terms and form a new contract. Delegation is when one party passes its responsibilities to a new party, binding that new party to the contract's terms.

Novation vs. Assignment

Novation is an alternative to assignment. In assignment, one person or business transfers rights or property to another, but only the benefits move over—the obligations stay with the original party. Novation, however, transfers both benefits and liabilities to the new party.

For instance, a sub-lease is typically an assignment. The original rental contract remains, and the landlord can still hold the primary leaseholder accountable for damage or missed payments by the subletter.

With novation, the new party gets the rights and obligations, and the old party exits completely—the original contract is nullified. In property law, if a tenant signs over a lease to another party via novation, the new tenant takes on rent responsibility and liability for damages as per the original lease.

Both assignment and novation generally need approval from all three parties. Keep in mind, a sub-lease is usually an assignment, not a novation, so the primary leaseholder stays responsible for issues like non-payment or damage.

Novation Uses

Since novation replaces a contract, you can use it in any business, industry, or market that relies on contracts.

Financial Markets

In financial markets, novations are common for credit default swaps, options, or futures when transferring contracts to a derivatives clearinghouse. A bilateral transaction goes through the clearinghouse as an intermediary. Sellers transfer their securities' rights and obligations to the clearinghouse, which then sells to buyers. The transferor, transferee, and clearinghouse all must agree by a deadline; if not, you book a new trade and start over.

Real Estate

Contracts are key in real estate, so novation is a useful tool. If buyers and sellers have a contract but issues come up during due diligence, inspection, or closing, novation lets you adjust it. For commercial or residential rentals, novation can change contracts if tenants face shifts affecting their needs or payment ability.

Government Contracting

Contracts matter for companies bidding on government work at federal, state, or local levels. If a contractor can't deliver or faces issues, they can ask the government to recognize another party to finish the project.

Banking

Banks use novation to transfer loans or debts to different lenders, which means canceling the old contract and making a new one with the same terms.

Example of Novation

Novation can happen between any two parties. Here's an example: Maria contracts with Chris to buy cryptocurrency for $200. Chris has a similar contract with Uni for $200. To simplify, all three agree to a novation where Chris transfers the debt and obligations to Maria. Maria pays Uni $200 in crypto, and Chris gets nothing but is out of the deal.

Novations also allow payment term revisions if everyone agrees. If Uni wants cash instead of crypto and Maria consents, a novation happens with new terms on the contract.

What Does Novation Mean?

In novation, one party in a two-party agreement surrenders all rights and obligations in the contract to a third party, canceling the original contract.

What Is the Meaning of Novation Agreement?

It means transferring the rights and obligations of one party in a two-party contract to a third party, with all three agreeing.

Is Novation a New Contract?

Yes, it creates a new contract, invalidating the old one upon signing.

The Bottom Line

To wrap this up, in a novation, if all parties agree, one party in a two-party agreement hands over all rights and obligations to a third party, canceling the original contract. This differs from assignment, where the original party gives up rights but stays responsible for terms—the old contract persists, but novation builds a new one.