What is a novation agreement?
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 sale of business transactions. In a sale of 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 to 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
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.
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