31 Jan 2023
14 May 2021
A novation agreement is a three-way contract, where one original party transfers his/her contractual rights and obligations to a new party, following the consent of the other party in the original contract (the "counterparty"). All parties must consent to the contract. This is different from an assignment, where the obligations of a contract cannot be transferred.
Understanding when to use a novation contract or an assignment is crucial. Since creating novation agreements can be a complex process, business owners must understand what constitutes a valid novation and how it differs from an assignment.
This article will explain what novation is and how to write a novation agreement, and clarify how it differs from an assignment.
Novation is a contract in which a third party takes up the obligations and rights of one of the original parties to the original contract. Through this process, the original contract is extinguished and replaced by a new contract. The obligations of the third party in this new contract will be identical to the rights and obligations of one of the original parties under the original contract.
In a novation, both the rights and obligations of a contract are transferred to a third party. Rights (or benefits) refer to the entitlements of a party under a contract. Common examples of rights include the right to sue and the right to seek compensation. Obligations (or burdens) refer to the duties a party must fulfil under a contract. Common examples of obligations include making payments and delivering goods.
Novation is particularly common in the sale of business transactions. In a sale of a business transaction, the seller transfers the ownership of all its assets to the buyer, including contracts with third parties. Novation is often used to achieve this, as it transfers both the rights and obligations of a contract to the other party.
Another key point to note with novation agreements is that all three parties must agree to the novation. This means that all three parties must sign. The three parties are:
Transferor: The party who is transferring rights and obligations as part of a novation.
Transferee: The party to whom rights and obligations are being transferred as part of a novation.
Counterparty: The party against whom the rights and obligations being transferred are held. The counterparty is the other party to the original contract along with the transferor.
Here is an example of a novation agreement:
Andy enters a contract to sell a motorbike to John. The contract specifies that Andy is to deliver the bike to John in a week and receive John’s payment in a week.
Before John pays Andy, John enters a contract to sell the motorbike to Mary for its purchase price, on the same terms.
Now, John has obligations to both Andy and Mary – he must pay Andy for the motorbike and sell the motorbike to Mary.
John convinces both Andy and Mary to enter into a novation agreement, signed and agreed to by all three of them. As a result of this novation agreement, the contract between Andy and John is extinguished and no longer exists. A new contract between Andy and Mary has been created, where Mary has the same rights and obligations to Andy as John previously had and owed to Andy.
Mary has essentially taken over John’s place in the transaction.
When a novation agreement is agreed to and signed by all three parties, the original contracting parties (i.e. the transferor and the counterparty) are released from liabilities arising from the original agreement before the date that the novation is to become effective.
There are many things to remember when writing a novation agreement. In this section, we will walk you through the key components of every novation agreement.
The preamble of an agreement constitutes the first section of an agreement, which states the names and places of business of the parties.
Unlike typical agreements which have two parties, a novation agreement has three. The three parties include the two original parties to the contract (i.e. the transferor and the counterparty) and the new party to whom the rights and obligations will be novated (i.e. the transferee).
The preamble should include details of all three parties, such as the names and principal places of business.
This clause will effectuate the novation.
This clause will state that the transferee shall become a party to the agreement at issue in the place of the transferor. It will state that the transferee is to be subject to the same obligations as the transferor under the original agreement and is to benefit from the same rights as the transferor under the original agreement.
This is a boilerplate clause that states that all three parties to the novation agreement will do what is necessary to ensure that the novation agreement will be effective.
This clause ensures that even if the parties sign two separate copies of the same agreement, the two copies will be taken together and will constitute one complete agreement.
This is an example of a boilerplate clause. Boilerplate clauses are a set of commonly found clauses in a contract. You can learn more about what boilerplate clauses are here.
Novation agreements often have mutual releases. This means that the transferor and the counterparty will release each other from all liabilities arising from the performance of the original agreement.
A clause is usually included in novation agreements limiting the ability of third parties (persons who are not a party to the contract) to enforce any rights in the contract.
This clause specifies which jurisdiction’s laws the contract is to be subject to and interpreted in accordance with.
You can learn more about governing law and jurisdiction clauses here.
Drafting a novation agreement is challenging and it is easy to miss out on key information. Don’t worry - we have prepared a sample novation agreement for you to use. There are two types of novation agreements - one for a full transfer and release and another for a partial transfer and release.
A novation agreement for full transfer and release involves the transfer of all rights and obligations to a third party. You can find this agreement here.
A novation agreement for partial transfer and release involves the transfer of only some of the rights and obligations to a third party. You can find this agreement here.
An assignment is a process wherein a party transfers its rights under a contract to another third party.
Generally, a party to a contract (i.e. the assignor), can assign its rights under a contract to a third party (i.e. the assignee) without the consent of the party against whom the rights are held (i.e. the counterparty).
This is unless the contract between the assignor and the counterparty prohibits or otherwise limits the assignment of rights. Often, contracts restrict the assignment of rights unless the written consent of the counterparty is obtained. An exemplar clause to this effect looks like this:
“Neither party hereto may assign any of its rights or obligations hereunder to any other person, without the prior written consent of the other party hereto.”
Andy enters a contract to sell a painting to John for $100. The contract states that Andy will give John the painting and will receive payment from John in one week.
Andy also owes $100 to Mary. The last date to repay Mary is also in one week. Andy does not expect to have any money to pay Mary.
To resolve this situation, Andy proceeds to assign his rights under his contract with John to Mary by entering into an assignment agreement with Mary.
Now, Mary is entitled to receive the $100 from John, ensuring that she is fully repaid by Andy.
It is important to remember that only rights can be transferred through an assignment. As such, Andy would still be subject to certain obligations under his agreement with John, which include selling the painting to John in one week.
Novation and assignment are similar concepts and are, therefore, often confused between one another.
Novation involves three parties. All three parties (i.e. the transferor, the transferee, and the counterparty) must agree to the novation. An assignment, on the other hand, only needs to be signed by the assignee and the assignor - it is a two-party agreement. The counterparty does not have to sign.
Furthermore, both rights and obligations can be transferred through a novation, while an assignment only transfers rights.
A novation can be difficult to execute. The difficulty arises from the fact that all three parties involved in a novation must agree to the novation. Generally, it is not very difficult to obtain the consent of the transferor and the transferee.
However, it can be difficult to obtain the consent of the counterparty. This is because the counterparty may think that they will not benefit in any way from such a novation. This may lead to the counterparty renegotiating key points in the agreement to obtain certain concessions in the agreement.
On the other hand, in an assignment, the counterparty’s consent is not necessary. Usually, only consent from the assignor and the assignee is necessary. The assignor simply needs to provide notice to the counterparty to inform them of the assignment.
If you are looking to assign your rights under a contract, you will need to draft an assignment agreement.
We have created one for you to use for any commercial contract. You can find it here.
We have also created a sample assignment agreement specifically for assigning intellectual property rights. You can find it here.
We also have an assignment agreement specifically for assigning patent rights. You can find it here.
Please note that this is a general summary of the position under common law and does not constitute legal advice. As the laws of each jurisdiction may be different, you may wish to consult your lawyer.
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