Novation

Novation is the replacement of a contract, or of one party to it, by a new contract with the agreement of everyone involved. The original obligations are extinguished and new, identical or amended obligations take their place, usually with a new party stepping into the position of one of the old ones. Because the departing party is released, novation needs the consent of the remaining party as well as the incoming one.

Novation is the standard way to transfer both the rights and the obligations under a contract. It differs from assignment of contract, which transfers rights alone and leaves the assignor bound. In finance it underpins central clearing of trades, the transfer of derivatives between dealers, loan trading through transfer certificates and the movement of contracts when businesses are sold.

Imagine you rent a flat and want to move out early, and a friend wants to take over the lease. If the landlord agrees, the old lease with you is torn up and a new one is signed with your friend on the same terms. From that moment you owe the landlord nothing, and your friend owes the rent.

That is novation. All three people must agree, because the landlord is swapping one tenant for another. If you simply let your friend live there and pay you, you would still owe the landlord, which is closer to subletting than to novation.

A novation is typically a three-way agreement among the outgoing party (the transferor), the incoming party (the transferee) and the remaining party. Its key elements are:

• Consent of all parties, given expressly or, in some legal systems, inferred from conduct.
• Release of the outgoing party from future performance, and from past liabilities if the parties agree.
• Assumption of the obligations by the incoming party, on the same or revised terms.
• Consideration, or execution as a deed, where the governing law requires it.

Because a new contract comes into being, the parties must check whether guarantees, security and collateral attached to the old contract carry over or need to be granted again.

The most important financial use of novation is central clearing. When two firms agree a trade that is cleared, the contract between them is replaced by two contracts with a central counterparty (CCP), one between the buyer and the CCP and one between the CCP and the seller. Each firm then faces the CCP rather than the other, which concentrates counterparty risk in an institution backed by initial margin and default funds and allows positions to be offset through netting. After the 2008 financial crisis, G20 leaders agreed that standardized over-the-counter (OTC) derivatives should be centrally cleared, a commitment implemented in the United States through the Dodd-Frank Act and in the European Union through the European Market Infrastructure Regulation.

Outside clearing, dealers use novation to transfer existing contracts such as interest rate swaps and credit default swaps to another dealer. The International Swaps and Derivatives Association (ISDA) published a Novation Protocol in 2005 after supervisors raised concerns that trades were being passed on without the remaining party's consent being obtained promptly.

• Syndicated loans. Lenders often sell their share of a loan by novation using a transfer certificate set out in the facility agreement, so the buyer takes on funding commitments as well as the right to repayment.
• Business sales and outsourcing. When a business or a portfolio of contracts is sold, customer and supplier agreements are often novated to the buyer.
• Payment partnerships. When a payment firm sells its business or leaves a market, agreements with partners such as a correspondent bank may be novated so the buyer takes over obligations as well as income.
• Payment routing. In the proposed tradable remittance contract model, novating each customer transfer to the winning provider would move full responsibility to that provider. In practice it would need the customer's consent and would sit uneasily with consumer rules that hold the original firm liable under the remittance contract, so assignment or subcontracting is the more likely structure.

Novation gives a clean break, but it takes time and depends on the remaining party saying yes. Until consent is given the transfer is incomplete, and both firms may be uncertain about who carries the credit risk. The remaining party will usually run know your business (KYB) and credit checks on the newcomer before agreeing. Novation can also reset rights that depended on the old contract, such as limitation periods, the priority of security or transitional regulatory treatment. For these reasons standard documentation in derivatives, lending and capital market settlements sets out in advance how novation works, and firms usually take legal advice before relying on it.

• CPMI-IOSCO: Principles for financial market infrastructures (2012)
• International Swaps and Derivatives Association (ISDA)