Reviewed by Jan 05, 2021| Updated on
Novation is the act of replacing a legitimate existing contract with a new contract, where the transfer is mutually agreed by both parties concerned. One of the two initial contracting parties is replaced by an entirely new party in most novation cases, where the original party voluntarily decides to revoke any rights originally given to them. The most common use of novations is in company takeovers and business sales.
A novation is similar to an allocation, which is the act of one party transferring to a third party interest in a property or a company, as opposed to the transfer of the whole entity. But while novations pass on both benefits and possible liabilities to the new party, assignments merely pass along the benefits, and any future responsibilities remain with the original holder of the properties.
Notably, novelties must be consented by both parties involved, which is not true of assignments. Finally, although novations essentially annul the former contract, assignments do not extinguish the initial contracts in favour of the replacement contract.
A novation isn't a unilateral contract mechanism; therefore, all parties involved can negotiate the terms of the replacement contract before reaching consensus.
In derivatives markets, novation refers to an arrangement whereby bilateral transactions are made through a clearinghouse which functions essentially as a middleman. In this case, sellers pass their securities to the clearinghouse, which in effect sells the securities to the buyers rather than transacting directly with buyers. The clearinghouse assumes a one-party defaulting counterparty risk.
Clearinghouse practice simplifies procedures for participants who do not have the ability to screen for their creditworthiness from any possible counterparty. The buying and selling parties, however, bear the moderate risk of being insolvent in clearinghouses, although this is regarded as a very unlikely possibility.