Caroline Hayward and Simon Mee discuss processes and considerations when changing contractual relationships by assignment or novation. Read on for the latest in KWM’s inhouse-centred series: From our inhouse to yours.
What happens when the parties in a contractual relationship need to change? Whether a creditor simply wants to pass on the right to receive payment from a debtor, or a supplier has changed following a business sale or internal restructure requiring the update of all of its contracts.
We will discuss the key issues that parties should consider to ensure that the process is managed effectively and reflects the parties’ wishes.
The most common methods for transferring contractual rights and obligations are by assignment or novation. Whilst the words “assignment” and “novation” have strict legal meanings, the words can often be used interchangeably, and the specific meanings and effect can be lost. It is important to consider the specific circumstances and understand which method applies, and how that affects the outcome. We will speak about the legal meanings as they relate to Australian law in this article.
Assignment
Assignment is the transfer of contractual rights or benefits from one party (the assignor) to another (the assignee). Legislation in each state and territory sets out requirements for a legal assignment, including that the assignment must be absolute and the other party to the agreement must be given notice. A legal assignment entitles the assignee to bring proceedings to enforce those contractual rights. An equitable assignment is also possible, for example where the statutory requirements cannot be complied with, but any enforcement requires the assignor to be joined as a party in any action.
The obligations or burden under a contract cannot be assigned, so the contract otherwise remains unchanged, and the assignor having passed on the benefit remains liable to perform any part of the contract that remains unfulfilled. In certain circumstances, the obligations under a contract can be transferred to, or assumed by, a third party with the assigned rights if an assumption clause is included.
In principle, the benefit of a contract may be assigned without the consent of the other party, although this does depend on the terms of the original contract, which may prohibit assignment or require consent. The onus of proving whether consent has been unreasonably withheld is on the party seeking consent and is determined objectively, based on the circumstances at the time.
An assignment provides flexibility by enabling a party to transfer its rights without altering the underlying contract. Depending on the terms of the contract, the continuing party may have limited control over the assignee’s actions.
It is worth noting that some contracts cannot be assigned, where the identity of the party is crucial to the terms. For example, it may be intended that the right to exercise an option is available to a specific person only.
Novation
If a party wishes to pass on both the benefit and burden of a contract it may do so by novation. The novation creates a new contract with duplicate rights and obligations and extinguishes the old contract.
A novation must be agreed by the parties to both the original contract and new contract,
Preferably, both the original and continuing parties would formally agree the terms of a novation agreement to allow a smooth transfer of the responsibilities under the contract. However, if a party objects to the novation, then they need to make their objection clear, consent to the novation can in certain circumstances be inferred.
As a new contract comes into existence, the question of consideration should be considered. Sufficient consideration is usually provided by the mutual assumption of the rights and obligations under the new contract. A deed is often used as consideration is not required under a deed.
Other options
Whilst assignment and novation are the more usual processes for transferring contractual obligations, in certain circumstance other mechanisms are available. On the merger or restructuring of large businesses there may be a significant number of contracts that need to be transferred. Deeds of novation can be used, but this may be impractical, involving substantial work and expense and the potential re-negotiation of contractual terms with many counterparties. In some circumstances, it may be more practical to apply to the Court for it to exercise its powers to facilitate the contractual changes via a scheme of arrangement, minimising risks and delays.
Alternatively, there may be circumstances in which a party to a contract wishing to pass on its obligations may simply subcontract those to a third party. The parties will need to ensure subcontracting is not prohibited by the original agreement or by law and understand that the subcontracting arrangement does not affect the liabilities of the parties in the main contract.
Key considerations
The question of assignment and novation should initially be considered as part of the negotiation and drafting of the initial contract. What impact could the change of party have on the business? Should consent be required, and if so, in what circumstances can it be withheld? It may be that novation or assignment is in fact expected and the parties may agree in advance that a third party may later assume obligations under the contract.
During the term of the agreement, various factors should be considered if the question of assignment or novation arises. The starting point is to review the terms of the existing contract including provisions dealing with assignment or novation and change of control, where relevant. What practically needs to happen to make the change?
Due diligence
The continuing party should carry out its due diligence, in the same way as at the time it entered into the original contract, although additional factors may be relevant. Considerations include:
- Capability: is the new party capable of carrying out its obligations?
- Guarantee: is a guarantee required to guarantee the performance of the new party?
- Jurisdiction: are there any jurisdiction issues arising in relation to new parties
- Regulatory Consideration: are there any regulatory considerations or restrictions, for example licensing requirements?
- Personnel: was the original agreement based on any particular personnel, or expertise?
- Liabilities: who will be responsible for liabilities arising before the novation?
- Indemnities: should the outgoing party provide any indemnities for breaches arising before novation?
If the parties are happy to proceed, they should confirm the agreement in writing. This is a requirement for a legal assignment and is best practice for a novation.
If having considered the change, a continuing party does not wish to give its consent to a novation or assignment (if required), they should make it clear to the other party that consent is refused and should not deal with the incoming party in case such dealings are deemed to amount to consent.
Be prepared
By having a clear understanding of the processes and effect of the transfer of contractual relationships, businesses can better prepare for and manage these changes to protect their interests.
Further information
If you need further guidance on changing contractual relationships, please reach out to your KWM contact or Kirsten Bowe.
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