In construction, as in life, change happens. When one party to a contract needs to be replaced by another, a novation agreement is the legal document that enables such replacement to take effect. This insight outlines what novation is in the context of a construction project, how it differs from assignment, the most common forms of novation, and the key requirements for a novation agreement to be legally enforceable.

What is novation?

Novation is the substitution of a new contract in place of an old one. The process involves the rights and obligations of one of the original parties to the contract being transferred ('novated') to a third party.

In the context of construction, novation most commonly occurs in design and build projects, where the employer may engage consultants in the pre-construction design process. The building contract between the employer and contractor will provide for the contractor to take full responsibility for completing the design and construction of the project. The employer’s appointments with the pre-construction design team will be novated to the contractor, typically at the time of entering into the building contract, to enable design continuity and promote cost and time savings.

Other scenarios where novation may feature include:

• contractor insolvency (e.g., if a contractor enters into administration, the building contract may be novated to a new contractor so that the works can continue);
• corporate restructure (when contracts may be novated from one group company to another, including to a special purpose vehicle (SPV) company specifically set up for delivery of the project);
• local government reorganisation (e.g., if an existing council is merged or dissolved, contracts may be novated from the outgoing authority to a successor); and
• sale of the site (when contracts may be novated from the original owner to the new owner of the site).

How does novation differ from assignment?

An assignment transfers only the benefit of a contract (such as the right to receive payment) from one party to another. The original party remains responsible for performing its obligations under the contract (typically known as the burden). The other party's consent is not required to assign, unless the contract prohibits or restricts assignment.

By contrast, novation transfers both the benefit and the burden of the contract. The incoming party takes on both the rights and the obligations of the outgoing party (such as the obligation to pay), and the outgoing party is released. As it alters legal obligations, novation requires the consent of all parties.

Common forms of novation

In the context of construction, novation generally takes one of two forms.

The most common form of novation is novation “ab initio”. It creates a legal fiction that the in-coming party has been a party to the contract from the beginning. In a design and build scenario where the employer novates its interest in a design consultant's appointment to the contractor ab initio (from the beginning), the contractor steps into the shoes of the employer and is treated as if it were always a party to the appointment and was the consultant’s client from the outset. The consultant becomes liable to the contractor for design services it carried out for the employer prior to the novation. Employers often prefer this model, because it creates a single point of design responsibility and enables them to hold the contactor responsible for all design defects.

The other form of novation, sometimes called a 'switch,' is not a novation in the strict legal sense. Instead, it acknowledges that the consultant initially works for the employer and then works for the incoming party. The incoming party agrees to step into the shoes of the employer only from the time of the novation. In the context of a design and build project with a ‘switch” novation to the contractor, at the point of novation, the consultant’s liability to the employer switches to the contractor, who becomes the consultant’s client on novation. The consultant remains responsible to the employer for pre-novation design services, with the contractor responsible to the employer for post-novation design services. This model tends to be less attractive to employers, because if there is a design issue, the employer must determine whether that issue stems from pre-or post-novation design and pursue either the consultant or contractor accordingly for redress.

Understanding a Novation Agreement

A novation agreement is an essential legal tool for transferring contractual obligations from one party to another. By formally replacing one party with another and releasing the outgoing party from liability, a novation agreement provides legal continuity, and protection for the parties. It also ensures that all parties are clear about their respective roles going forward.

The specific impact of the novation will differ depending on the form (i.e., whether it is “ab initio” or a “switch”). The precise wording of the novation agreement will also be of relevance. For example, it is possible for the novation agreement to include amendments to the original terms of contract or to otherwise vary the obligations of the parties, resulting in the parties having slightly different rights and obligations under the contract going forward than the original parties had.

Formalities

For a novation agreement to be valid and enforceable, certain legal requirements must be met. Key requirements include:

Consent – Fundamentally, novation involves three parties: the outgoing party transferring its rights and obligations, the incoming party taking on those rights and obligations, and the remaining original party. All three parties must consent for novation to take effect.

Consideration - Novation extinguishes one contract and replaces it with another. The new contract must satisfy the legal requirement of consideration (something given in exchange for a promise), to be legally binding and provide the incoming party with enforceable rights under the original contract. The mutual promises agreed between the parties in the novation agreement may be considered adequate consideration, but for the sake of certainty most novation agreements are in the form of a deed. Unlike a simple contract signed underhand, which requires consideration from each party, a deed derives its legal force from the strict formal steps taken to sign, witness, and deliver it properly.

Clarity - The novation must clearly identify the parties involved, the original contract being novated, and the effective date of the change. It must also state that the in-coming party is taking over the rights and obligations of the original party, and the extent to which the original party is released from any further obligations.

How Capsticks Can Help

While the intent of a novation agreement may be simple, its drafting and execution can give rise to a number of practical and legal issues. The process must be approached carefully. A poorly drafted novation agreement or invalidly executed deed may lead to uncertainty, disputes, and/or unenforceable obligations.

Our construction team advises clients across public and private sector projects on novation agreements. We can assist with drafting, reviewing and negotiating novation agreements, to ensure that all legal, commercial, and regulatory issues are properly addressed, and to ensure consistency between the novation agreement and other project documents. We can also advise whether novation is the best approach under your circumstances, or whether an alternative (such as assignment, termination, or renegotiation), would better meet your business needs.

If you have any queries around the issues discussed in this article, and the impact on your organisation, please speak to Partner Catherine Kay or Principal Associate Eileen Leonard.