Novation

Definition

Novation is the replacement of one party in an existing contract with a third party, with the consent of all parties involved. The original contract is extinguished and replaced by a new contract that transfers both the rights (benefits) and the obligations (burdens) from the original party to the incoming party.

Key takeaways

• Novation replaces one contracting party with a new party and creates a new contract.
• All parties must agree to the novation.
• Novation transfers both benefits and liabilities; assignment typically transfers only benefits.
• Common in business sales, construction, lending, and financial markets (clearinghouse transactions).

How novation works

A novation requires three elements:
1. Agreement of the original parties and the incoming party.
2. Intention to extinguish the original contract and create a new one.
3. Transfer of both rights and duties to the new party.

Novation avoids canceling and renegotiating contracts by formally substituting a party so obligations continue under the same (or revised) terms. It is often preferred to preserve contractual performance and relationships during ownership changes or when a party cannot or does not want to continue.

Types of novation

• Standard novation: Two contracting parties replace their agreement with new terms, creating a new contract.
• Expromissio: A three-party novation where a transferor, transferee, and counterparty all agree to the substitution.
• Delegation (as novation): One party’s responsibilities are passed to a new party who becomes legally bound by the contract terms.

Novation vs. assignment

• Novation: Transfers both rights and obligations; the original party is released and the old contract is voided. Requires consent of all parties.
• Assignment: Transfers only the benefits (e.g., payment rights); the original party usually remains liable for performance or liabilities under the original contract. The original contract remains in effect.

Example distinction: A sublease is typically an assignment (original tenant remains liable); a novation of a lease transfers both rent and liability to the new tenant and releases the original tenant.

Common uses

• Financial markets: Clearinghouses novate bilateral derivatives trades (futures, options, credit default swaps), becoming the counterparty to both sides and reducing counterparty risk.
• Real estate: Novation used to substitute buyers, sellers, or tenants, or to change payment terms during due diligence or closing.
• Construction and contracting: Subcontractor or contractor responsibilities can be transferred to another party with client consent.
• Government contracting: Contractors may seek novation to have a replacement party assume obligations when they cannot perform.
• Banking and lending: Loans or debts can be transferred to a different lender by canceling the old contract and creating a new one with identical terms.

Example

Maria contracts with Chris to buy cryptocurrency for $200. Chris has a separate contract with Uni for the same crypto. With the consent of all three, a novation can substitute Maria directly into Chris’s contract with Uni: Maria pays Uni $200, Uni delivers the crypto to Maria, and Chris is released from the obligations and benefits of the original contract.

FAQs

Q: What does a novation mean in practice?
A: One party in a two-party contract gives up all rights and obligations to a third party; the original contract is replaced.

Q: What is a novation agreement?
A: A novation agreement is the document that records the substitution of a contracting party and the creation of the new contract binding the remaining parties.

Q: Is novation a new contract?
A: Yes. Novation creates a new contract and voids the original.

Conclusion

Novation is a legal mechanism for substituting parties in contracts while preserving contractual performance. Because it transfers both benefits and liabilities and requires the consent of all parties, it is distinct from assignment and commonly used when continuity of agreements is desirable during sales, transfers, or restructurings.