Novation Agreement

The Novation Agreement is intended to be used in cases where two parties have entered into one or more Transactions and one of those parties subsequently transfers its rights, liabilities, duties and obligations to a new counterparty.

Novations under English law

From Linklaters (2004):

Meaning of “novation”

The classic definition of the meaning of the term ” novation” was given by Lord Selborne LC in
Scarf v Jardine (1882) 7 App Cas 345, 351, who considered the term to mean “that there being a contract in existence, some new contract is substituted for it, either between the same parties (for that might be) or between different parties; the consideration mutually being the discharge of the old contract” .

A novation usually involves one of the parties to the original contract having identical rights and
obligations under the new one, except that they are enforceable against or owed to a third party instead (ie the third party, in effect, takes over the rights and obligations of one of the parties).

However, the term is wide enough to encompass an arrangement under which both parties to
the original contract are substituted, so that the new contract is between two completely
different parties (see, for example, Exhibit C to the Novation Definitions).

An arrangement under which a new contract is substituted for only some of the rights and
obligations under another contract, so that the original contract remains in existence but the
rights and obligations are reduced in equal measure to those created under the new one
(sometimes described as a “partial novation” ) strictly falls outside Lord Selborne’s definition.

… it is clear that this would not affect the enforceability of the arrangements. Provided that it is clear what the parties intended to achieve, the terminology they use to describe them is immaterial. It follows that there is no reason to believe that arrangements … could be attacked on this ground.

It is a matter of construction whether the novation extends to any rights and obligations that
were due to have been performed prior to the novation date but remain outstanding, or whether it only includes rights and obligations which fall due after the novation date. It is also a matter of construction whether a remedy for any prior breach of contract is novated or whether it remains with the original party.

Novations: Enforceability under English law

Enforceability of the underlying transaction

For a novation to be effective, the underlying transaction probably has to be valid and binding as, in the absence of this, there would be no rights or obligations to be transferred. The agreement of the counterparties to the new contract to undertake equivalent obligations towards each other would therefore be devoid of content unless the novation transaction contemplates that these obligations will be assumed without regard to their enforceability prior to the novation.

Enforceability of the novation transaction

Since a novation involves the termination or (in the case of a partial novation) variation of one contract and the creation of another, the consent of each of the parties must be obtained. Any formalities that are required for the new contract to be effective must be observed (for example, the novation of a guarantee must be evidenced in writing containing the guarantor’s name or signature). However, in the context of derivatives transactions it is rare for any formalities to be required. A novation transaction itself does not have to be in any particular form.

Unless a novation transaction is executed by deed, it must be supported by consideration. Under the Contracts (Rights of Third Parties) Act 1999, a third party may enforce a term of a contract that is made for its benefit. However, this is unlikely to be of assistance in the context of a novation as it does not avoid the need for that contract itself to be made by deed or be supported by consideration.

Consideration must be provided both for the release by a party from its obligations under the original contract (or a reduction of those obligations) and for the acquisition by a party of any rights under the new one. Where the novation involves obligations owed by each party to the original contract, the consideration will be the mutual surrender of these obligations and the acquisition by each party to the new contract of obligations to each other.

If only one party to the original contract has any outstanding obligations, whether any
consideration is provided by it for the release of those obligations will depend on the
circumstances. If the novation involves it incurring obligations in favour of a third party
(ie the counterparty to the new contract), the consideration will generally be its
agreement to acquire those obligations as they will be acquired at the request of the
original counterparty.

On the other hand, if the party that is released acquires no further obligations as a result of the novation (as where its obligations are novated to a third party or the new contract is between two different entities), consideration may be absent unless the release is effected in return for a payment. Similarly, there may be no consideration for the agreement of the new counterparty to incur the obligations that are novated to it unless it receives a payment in return. The payment requirements would not, however, have to be set out in the novation agreement itself: they could be contained in a separate document that is entered into (or comes into effect) at the same time.

Where it unclear whether a party is providing consideration for the release or reduction
of its obligations, or for its agreement to assume new obligations, it would be advisable
for the novation transaction to be executed as a deed. This constitutes an exception to
the requirement for consideration.