Novation is also used in derivative markets where bilateral transactions occur by an intermediary essentially functioning as a clearinghouse. For example, there is an arrangement in which the security holders transfer securities to a clearinghouse from where the securities are transferred then sold to the buyers. Here the clearinghouse acts as the new party, and the risks relating to the party defaulting their obligation are assumed by the clearinghouse. The process of novation simplifies for those parties in the market who are not required for ascertaining the creditworthiness of such other party in the transaction. However, credit risk is the only risk faced by the participant in the market in which there is a risk of insolvency of the clearinghouse. Therefore, the insolvency of the clearinghouse is unlikely event to occur. Even if there is no centralized system of clearing in place for swap trading (another party is assigned the function of contractual party), a novation can occur in which the seller delegates no clearinghouse and the rights and duties of a derivative party to another party.
Working Process of Novation
There is a consensual replacement in the novation of the contract where the new party undertakes the rights and obligations from the original party to the contract, thereby relinquishing the rights and obligations of the original part. There is no transfer of the property or the entire entity as the transfer by the original party is concerning the interest in the contract to such other party. In a circumstance where there is no possibility for implementation concerning the terms of the existing contract, the process of novation plays an important role. There is the transfer of benefits and burden in the novation, including benefits such as payments and obligations such as obliged to earn the payment. The burden and the benefits are relinquished on behalf of the original party to the contract willing to do so. As the original party rights are relinquished and given to the new party, the new party cannot hold the original party accountable to any obligations concerning the contract terms. After completing the novation agreement, there is also an agreement between the parties to indemnify each other if any loss has occurred on the act of other parts. There must be an arrangement of a new party to conduct a better business and fulfill the terms of the contract already existing rather than canceling the contract, which results in proving a bad reputation of the organization and incurring the cost. Instances of novation can be found in the construction industry in which there is a juggle of different jobs at one time by the subcontractors. The contractor transfers certain jobs to different contractors with the permission of his or her client. Novation is also found when there is the takeover of an organization or sale of any business. The new party or owner retains obligations concerning the terms of the contract.
Novation and Assignment
Apart from the similar nature, novation differs fundamentally from the assignment. There is the transfer of rights or the property from one individual or business to another in the assignment and transfer of benefits. However, there is no transfer of obligation of the original party to the contract to the new party. In contrast, there is the transfer of both benefits and obligations or liabilities to the new party’s contract from the existing original party. In the assignment, consent of the new party is not required for completing the assignment. At the same time, novation is an agreement between the contracting parties for transferring rights and obligations to the new party. Novation will not be completed unless the parties have not reached a consensus on the contract terms. On completing the process of novation, the existing contract becomes nullified. An example of an assignment is a sublease where the original contract of the rent remains intact. Here, the primary leaseholder can be held responsible by the landlord for any damage to his or her property or if the sub-letter fails to pay rent. However, in case of a lease in property law, which falls under the example of novation, a lease is signed by the tenant to another party, and such party takes over the responsibility for the payment of rent as well as the liability for any damage to the property mentioned in the lease agreement.
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