Contract novation – what businesses need to know

As a business owner, you’ll likely be comfortable and confident concerning commercial contracts. The ability to negotiate, agree and adhere to the terms of an agreement will be fundamental to your business’s continued growth and success.

However, you may not be as familiar with the concept of contract novation. Indeed, you may have yet to come across the term before. You’ll probably only have heard the term ‘novation’ if some form of change is happening to your business, such as its sale or the transfer of a specific function to another business, etc.

In these circumstances, you may have to transfer a contract to another business; in doing so, you need the consent of the original contracting party. That’s a contract novation.

In this article, we’ll discuss contract novation so that, as a business owner, you’ll understand what’s involved and how to approach this process.

What’s meant by a contract novation?

A contract novation occurs when the two original parties to a contract, enter into a legal agreement with a third party to transfer the rights and liabilities of that contract over to the third party. Once the novation agreement is signed, the contract will be between the original remaining party and the new third party.

When is a contract novation needed?

Contract novations can be used in various circumstances. Still, the most common scenario is when a business is sold, and the acquiring business purchases the company’s assets instead of its shares. This is known as an asset purchase.

In these circumstances, the company assets must be novated over to them for the acquiring business to benefit from the target business’s contracts.

This is different from a share purchase because, in that case, the focus is on acquiring the actual legal entity itself. As a result, the original contracting parties are still the same, and contract novations aren’t necessary.

Another situation where a novation agreement may be utilised is when a business acquires a specific stand-alone function or contract rather than acquiring the entire company.

What’s the process for a contract novation?

Step 1: Review the contract terms

Begin by thoroughly examining the terms of the relevant contract.

Look for any clauses related to the novation and the process involved. If you are uncertain about any aspect, it’s advisable to consult a commercial lawyer who can provide guidance on understanding the contract terms.

Step 2: Seek agreement with the incoming business

Once you have a clear understanding of the contract, engage in discussions with the incoming business to reach an agreement in principle regarding the novation.

This involves negotiating and finalising the terms of the novation agreement.

Step 3: Obtain consent from the original contracting party

Contact the original contracting party to obtain their consent for the specific novation. Inquire about their requirements and conditions for granting consent.

They may request information about the incoming business, such as its profile, financial standing, and other relevant details.

Step 4: Address legal fees and documentation

The original contracting party will likely expect coverage for their legal expenses incurred in handling the novation request and preparing the necessary documentation. Ensure that arrangements are made to address these fees.

Step 5: Prepare the novation agreement

With the consent of the original contracting party and all necessary information gathered, proceed to draft the novation agreement. This agreement should outline the transfer of rights and obligations from the original party to the incoming business.

Step 6: Execute the novation agreement

Once the novation agreement has been prepared, it should be signed and executed by all relevant parties involved in the contract novation. This step finalises the transfer of rights and obligations and completes the novation process.

It’s important to note that each novation case may have specific nuances and requirements, so consulting with legal professionals experienced in contract law is advisable to ensure compliance and a smooth process.

Can we still be liable once the contract is novated? 

The three parties must agree on how to deal with pre-novation contract liabilities in the novation agreement.

Either the incoming party will assume these liabilities, or you may assume liability for them as the outgoing party. This will all be negotiated as part of the arrangement, and if you have to remain liable for matters happening pre-novation, then you should price this risk into the deal.

Also, as the outgoing party, you may be asked to guarantee the incoming party’s future contract performance in certain circumstances.

This may be a condition of consent for the novation in situations where there is reasonable doubt over the financial standing of the incoming business or a significant lack of trading history on their behalf.

This is more unusual and likely only happens in unequal bargaining positions.

Novation vs assignment 

Both assignment and novation are forms of transferring an interest under a contract from one party to another. However, it’s essential to understand that they have distinct differences.

Contract assignment involves the transfer of the contract’s benefit from one party to another. It allows the new party to enjoy the advantages and rights provided by the contract. However, the burden, which refers to the obligations and responsibilities, remains with the original party. In simpler terms, only the benefits are transferred through assignment, while the burden remains unchanged.

On the other hand, novation goes a step further. It not only transfers the benefits but also transfers the burden of the contract from one party to another. This means that the new party assumes both the rights and obligations of the contract.

In essence, a novation creates a completely new contractual relationship, where the new party is fully responsible for performing, executing, and fulfilling the obligations set forth in the contract.

Understanding the distinction between assignment and novation is crucial, as it determines the extent of rights and responsibilities transferred in the context of a contract.

Wrapping up

Contract novation is an important concept that businesses must understand, especially during change or when transferring contracts to another party. It’s crucial to consult with legal professionals to ensure compliance and appropriately negotiate the allocation of liabilities and guarantees.

Seeking advice from commercial lawyers experienced in contract law can support a smooth contract novation process. If you would like advice and support with regards to a contract novation exercise, whether as part of a business sale or otherwise, you should reach out to a commercial lawyer with appropriate expertise like LawBite.

Ashley Gurr is a commercial and contract lawyer at LawBite. Ashley has over 15 years of experience in private practice helping SMEs and in-house for an international consultancy group advising on commercial contracts and a multi-national utility giant in a contract strategy role.