There may be times when you want to substitute an old contract for a new one, without drafting one from scratch.
This is where novation is useful.
If you’re looking to substitute or assign your contract, a novation can save you a lot of time and effort and is common in commercial arrangements.
Some examples include leasing arrangements, corporate takeovers or transferring business risks.
In this post, we’ll explain what novation is and provide some tips to do it successfully.
Read along!
What is Novation?
A novation refers to an arrangement where parties substitute an existing contract and replace one party to the agreement. As a result, a new, third party enters the picture. The rights and obligations of the original contract are transferred over to a new contract. The third party will hence incur liability for breaches of the contract.
In this way it is different to assignment, where only the rights under a contract are transferred over. For more information on what an assignment is, check out our article on assignments.
Example
Company X has a contract with Company Y. Company X wants to change the other party to Company Z and cease contracting with Company Y. This is because Company Y cannot pay their debts, but their parent company, Company Z, can. Company X can only doing this if both Company Y and Company Z agree to novation. After both agree, Company X’s contract continues with Company Z, with all outstanding debts paid.
How Does Novation Work?
For novation to be effective, all three parties must consent. Novation is usually formalised in a deed. This deed works as a formal contract which must be “signed, sealed and delivered” to the parties. You must ensure that your novated contract is in writing. The new agreement can also carry over obligations under the old contract.
Novations should include:
A Release Clause
It is essential that a clause in the novation deed outline the discharge of both rights and obligations from the outgoing party. It is important that you ensure the clause is clear and concise, so that there is no room for confusion.
Representations and Warranty Provisions
The deed should also outline that both the outgoing and continuing party have full legal capacity to proceed with business, including relevant authorisation. It should also evidence that both parties have taken all actions to the best of their abilities to finalise the novation deed.
Insurance/Indemnity Clause
If you are the incoming third party, you may want to have an indemnity clause. This can protect you from being liable for work completed before the novation date. This a gain can help to reduce the likelihood of conflict.
Costs
For various transactions such as novated leases, parties should calculate and include agreed costs.
Due Diligence
As with entering any sort of business contract, you should always conduct any necessary background checks on new parties.
In particular, a thorough examination of factors such as their:
- Management capabilities and skills;
- Financial status; and
- Level of access to resources to facilitate completion and performance of obligations.
Conclusion
Since novation involves renewed acceptance from an incoming third party, the resulting contract and implications may be quite complex to finalise. However, when executed effectively, they may be an appropriate means to exit unwanted contracts or to sell existing businesses. As a small business, it is best to seek legal advice before choosing to novate rights and obligations.
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