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Contracts/Novation
- This article is on the legal term. For the keyboard company, see Novation Digital Music Systems; for the former modem manufacturer, see Novation CAT, for the webdesign firm visit Novation.
Novation is a term used in contract law and business law to describe the act of either replacing an obligation to perform with a new obligation, or replacing a party to an agreement with a new party. In contrast to an assignment, which is valid so long as the obligee (person receiving the benefit of the bargain) is given notice, a novation is valid only with the consent of all parties to the original agreement: the obligee must consent to the replacement of the original obligor with the new obligor.[1] A contract transferred by the novation process transfers all duties and obligations from the original obligor to the new obligor.
For example, if there exists a contract where Dan will give a TV to Alex, and another contract where Alex will give a TV to Becky, then, it is possible to novate both contracts and replace them with a single contract wherein Dan agrees to give a TV to Becky. Contrary to assignment, novation requires the consent of all parties. Consideration is still required for the new contract, but it is usually assumed to be the discharge of the former contract.
The criteria for novation comprise the obligee's acceptance of the new obligor, the new obligor's acceptance of the liability, and the old obligor's acceptance of the new contract as full performance of the old contract.[2]
Application in Financial Markets
Novation is also used in futures/options trading markets to describe a special situation where the clearing house interposes between buyers and sellers as a legal counter party, i.e., the clearing house becomes buyer to every seller and vice versa. This obviates the need for ascertaining credit-worthiness of each counter party and the only credit risk that the participants face is the risk of clearing house committing a default. Clearing House puts in place a sound risk-management system to be able to discharge its role as a counter party to all participants. The term is also used in markets that lack a centralized clearing system (such as the swap market), where "novation" is used to refer to the process where one party to a contract may assign its role to another, who is described as "stepping into" the contract. This is analogous to selling a futures contract.
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