Novation explained, a plain-English guide for Australian businesses

What novation actually is

Novation is the replacement of one contract with another. In business it almost always means replacing one of the parties: the outgoing party is released and an incoming party steps in to take its place. The High Court put it simply in ALH Group Property Holdings Pty Ltd v Chief Commissioner of State Revenue [2012] HCA 6, describing a novation as a circumstance where a new contract takes the place of the old.

A working definition for Australian businesses is: novation is the substitution of a new contract for an existing one, with the consent of everyone involved, so that the old contract is discharged and the new one governs the relationship from the agreed date.

The effect is what makes novation commercially important. As the New South Wales Court of Appeal confirmed in Fu Tian Fortune Pty Ltd v Park Cho Pty Ltd [2018] NSWCA 282, a novation discharges the original contract between the continuing party and the outgoing party and substitutes a new contract between the continuing party and the incoming party. The incoming party performs the obligations, bears the liabilities and takes the benefits that used to belong to the outgoing party.

This guide covers four things:

The elements: what must be true for a novation to be effective.
A worked example: what a typical small-business novation looks like.
The trap: how novation differs from assignment, and why the difference costs businesses money.
The help: what a lawyer actually does when you novate a contract.

The elements of a valid novation

Three things have to be in place for a novation to work.

Novation requires the agreement of the outgoing party, the incoming party and the party who stays in the contract. That third party is often the customer or client, and its consent is the one most easily overlooked. If the client has not agreed to deal with the new party, there is no novation, and the old contract continues to bind the original parties.

Consent does not have to be written. In Fu Tian Fortune, the Court of Appeal upheld a finding that a vendor had consented to a substituted purchaser on the strength of emails and a telephone conversation, without any further formal document. That cuts both ways: consent can be inferred from conduct, so a business that behaves as though a new party has taken over a contract can find itself treated as having agreed to the change.

The old contract must be discharged

A novation does not simply add a party or tweak a few terms. The old contract must come to an end and a new contract must take its place. In ALH Group, the High Court said the enquiry is whether the parties agreed that a new contract would be substituted for the old and the obligations of the parties under the old agreement discharged.

If any obligation under the original contract survives, the arrangement is not a novation. The High Court made the point directly: if the obligations of the original parties remained after the document was signed, the old contract could not be said to have been discharged, and that discharge is essential to a novation. Where only the price, scope or timing is changing and the parties stay the same, what you have is a variation, not a novation, and it should be documented as such.

Consideration, or a deed

Because a novation is a new contract, it must be supported by consideration to be enforceable unless it is made by deed. A deed is binding without consideration, which is one reason novations are so often documented in a deed of novation rather than a simple agreement. The deed also gives all three parties a single signed record of what was agreed, which matters when the outgoing party is being released from obligations.

A worked example: selling your managed services business

Suppose you run a managed IT services business and you have agreed to sell it to a buyer. Three of your recurring client contracts, each with twelve months to run, are part of the deal. You want to walk away with no ongoing responsibility, and the buyer wants to be the party the clients deal with.

Nothing transfers automatically. The contracts remain contracts between you and the clients, and you remain the party obliged to perform them. If you tried to assign the contracts to the buyer, you would move the benefit of the contracts, mainly the right to be paid, but you would not automatically move the burden. The clients could still look to you for performance and claim against you if the buyer performed badly.

So you novate each contract. You, the buyer and each client sign a deed of novation. From the effective date, the buyer performs the services and invoices the client, and you are released from future obligations to the extent the deed provides. The deed also deals with the grey areas: work performed before the effective date, invoices already issued, defects discovered later and any warranties that survive the changeover.

One client refuses to sign. That contract cannot be novated without its consent, and no amount of drafting fixes that. The deal has to accommodate it, for example by leaving that contract with you and having the buyer subcontract the work, or by adjusting the sale price for the risk. This is the reality of novation: it depends on the consent of people you do not control.

Novation versus assignment: why the difference matters

Assignment and novation are regularly confused, and the confusion is expensive.

An assignment transfers the benefit of a contract, which is to say the rights. In New South Wales, s 12 of the Conveyancing Act 1919 (NSW) gives effect at law to an absolute assignment in writing of a debt or other chose in action, provided the debtor is given express notice in writing. The other states and territories have equivalent provisions in their property law legislation.

What an assignment does not do is transfer the burden. At common law, a party cannot assign its obligations under a contract to someone else without the consent of the other party. The counterparty agreed to deal with you, not with whoever you happen to choose. So after an assignment, you may have handed over the right to be paid while remaining personally responsible for performance.

The High Court drew the line precisely in ALH Group. It said it is not correct to describe novation as the succession of a third party to the rights of a party under the original contract, because that description comes closer to the effect of an assignment. A novation affects the obligations of both parties to the original contract and requires the old contract to be discharged.

The practical rule: if you want to transfer the right to payment or another benefit, an assignment may be enough. If you want to be released from the obligation to perform, you need a novation with the counterparty's consent, or an express release agreed by the counterparty.

Common misconceptions about novation

Several beliefs about novation are widespread and wrong, and each has cost a business money at some point. The ones to watch for are:

A business sale automatically transfers its contracts: It does not. Every contract is between its original parties until the counterparty agrees to a change. A buyer cannot be forced into a contract it does not want, and a seller cannot force itself out.
Novation and assignment are the same thing: They are not. Assignment moves rights; novation replaces the contract itself and is the mechanism by which obligations move.
Changing the terms is a novation: It is not. If the parties stay the same and only the terms change, the original contract continues and what you have is a variation.
The document's title decides what it is: It does not. In ALH Group, the document was called a deed of consent and assignment, but the Court said the legal nature of the arrangement is determined by the terms of the document read as a whole, not its label.
A novation is invalid without a deed: It is not. Consent can be inferred from conduct, as Fu Tian Fortune shows. The reason to use a deed is certainty: it removes arguments about consideration, records the consent of all three parties and fixes the scope of the outgoing party's release.

Where novation shows up in Australian business

Novation is more common than most business owners expect.

Business sales and transfers: customer agreements, supplier contracts, software licences and service agreements all need to move to the buyer, and each counterparty must consent.
Group restructures: contracts are moved between entities within a group for commercial, accounting or risk reasons, which requires the counterparty to agree to the new contracting entity.
Outsourcing changes: a subcontractor's relationship evolves into a direct relationship with the end client, and the contract is novated to make that happen.
Construction and infrastructure: under design, novate and construct arrangements, the design consultant's contract with the principal is novated to the builder at the point of novation. The practice is common in large projects and is reflected in standard-form construction contracts.

If you work in any of these areas, novation documents will eventually be put in front of you, often presented on a take it or leave it basis.

What a lawyer does when you novate a contract

A good novation looks simple and is not. This is where a commercial lawyer earns the fee.

Reviewing the underlying contract: the lawyer checks whether the contract permits a change of party, whether it requires consent, and whether any condition precedent applies, such as a bank, landlord or regulator consent.
Drafting the deed of novation: the deed must identify the parties by their correct legal names, including ACN or ABN, identify the contract being novated by title, date and variations, fix the effective date and allocate liability. The release provisions are usually the heart of the negotiation: past liabilities, future liabilities, surviving warranties and indemnities are dealt with expressly rather than left to implication.
Getting the execution right: a company executes a document under s 127 of the Corporations Act 2001 (Cth) by the signature of two directors, or a director and a company secretary, or, for a proprietary company without a secretary, its sole director. The lawyer confirms the people signing have authority to bind their companies.
Looking beyond the deed: stamp duty, GST and other tax consequences can attach to the transaction, which is a conversation for your accountant or tax adviser, and insurance positions should be checked before the changeover.

The question to answer before anyone signs

The mistake that costs the most in novation is assuming the outgoing party is cleanly out of the contract when the document does not actually say so. If the deed does not release the outgoing party from past liabilities, or leaves warranties alive, or the counterparty's consent was assumed rather than obtained, the old obligations continue to follow you.

Before you sign, ask one question: after the effective date, who answers for the work already done? If the answer is not written in the deed, the parties will argue about it later, and courts will look at the substance of what was agreed, not the label on the document. Get the lawyer to show you, in the deed itself, exactly what the outgoing party remains liable for, and confirm in writing that each counterparty has consented before the deal is done.