What is a Novation Contract?

Put simply, a novation contract is one that is drawn up when an agreement between two parties is altered by a third party taking the place of one of the original parties.

Tool for change

Novation contracts are used throughout society to put in writing the rights and obligations being transferred when one party to a contract is replaced with another. In real estate, they’re used when one tenant transfers their lease to another, with the consent of the property owner.

In business, they’re used when a vendor or contractor needs, for whatever reason, to back out of their deal with their client and finds another company to take their place in the contract. For example, if a tiling contractor realizes he can’t finish a big job and finds another tiling company to take over, a novation contract would formalize the new arrangement with the client.

A couple of things define a novation contract: informed consent of all three parties and the complete replacement of one of the parties by another, including the transferral of both the benefits and obligations the original party had. In our tiling example, the original contractor walks away, with neither rights nor obligations, and the new company takes its place entirely.

Novation contracts are even drawn up if one party changes substantially. There are pages of federal guidelines, for example, describing the novation contract rules if a government contractor simply changes the name of their company or restructures their business. This is due to the company essentially becoming a new third party, requiring an update to the legal paperwork that details their relationship.

Novation in finance and investing

In the world of investing, novation is most associated with the derivatives market, such as default credit swaps, options or futures, in which investors aren’t trading stocks directly but other financial investments related to stocks or related to the hedges against potential losses in the stock market.

The basic principle remains the same, however, with 3 parties entering into a consensual new contract, such as someone transferring securities to a clearinghouse which then transfers them to a third party.

The International Swaps and Derivatives Association plays a guiding role in standardizing and modernizing novation protocols for investments, most recently for the digital age. It issued a significant revision in 2005, under pressure from regulators, defining the kind of documentation necessary for the full consent of all three parties to make the new contract legally binding.

Novation contracts are also used as banking, typically when a lender wishes to transfer a loan to another lender.

In summary, novation contracts are used when one party removes themselves from a contract, with their obligations and benefits being assumed by a third party. A new agreement is drawn up to remove the original party and have them replaced by the third party. The consent of all three parties is required, and the new agreement must abide by the protocols defined by the International Swaps and Derivatives Association.