novation

Definition of novation

Etymology

Latinnovus: new

Noun

novation (uncountable)

1. (law) Replacement of a contract with one or more new contracts, in particular in financial markets the replacement of a contract between a particular buyer and seller with contracts between the clearing house and each party.
   
   Netting by novation will occur immediately upon registration of the transaction in the SCM's name. - London Clearing House submission to the CFTC
   
   
2. (law) A new contract between the original contracting parties whereby the first obligation is extinguished and a new obligation is substituted.
   
   An example of a novation is where an original debt which was payable in two instalments is novated to become payable in five installments.

Further reading

In contract law and business law, novation is 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. 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. Another classic example is where Company A enters a contract with Company B and a novation is included to ensure that if Company B sells, merges or transfers the core of their business to another company, the new company assumes the obligations and liabilities that Company B has with Company A under the contract. So in terms of the contract, a purchaser, merging party or transferee of Company B 'steps into the shoes' of Company B with respect to its obligations to Company A.

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.

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.