Novation
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Negotiation Anatomy™
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In layperson’s terms a novation is the transfer in full of one party’s rights and obligations under a contract to another person. The transferor steps out of the contract and is no longer bound by it. The transferee steps in to the contract and assumes all the transferor’s obligations. The remaining party stays put, but must perform to, and may expect performance from, the transferee and not the transferor.
Bizarre love triangle
Unlike an assignment, a novation requires all three parties to agree. A party to an English law contract may “assign” its rights to a third person without its counterparty’s permission (as long as the contract does not forbid it); however, it cannot unilaterally assign its obligations.
There are pretty obvious economic reasons why that should be so: the creditworthiness of the party with whom you have contracted is a fundamental part of the bargain you have made: that party should not be able to substitute itself without your permission.
Therefore a novation is, in effect, the consensual termination of the existing contract (between “transferor” and the “remaining party”) and the creation of a new contract on identical terms between “remaining party” and the incoming party (known often as the “transferee”).
Consideration
The consideration given for terminating one contract and creating the other are related: In effect, there will be a MTM value payable to or from the transferor under the first, and an equal payment to or from the remaining party under the second, so transferor and transferee settle these payments directly between each other. Remaining party’s obligation to discharge transferor of its liabilities under the terminating contract is conditional on transferee’s agreement to accept the identical liabilities under the new contract.
Assignment and assumption agreement
Counterparties to equity derivatives worry a lot about tax. When reorganising their derivatives portfollios between their prime brokers, they are given to the concern that a standard ISDA novation may be a “taxable event” by terminating the existing in-the-money transactions at a profit, thereby realising a taxable gain that might not (yet) have arisen had the Transaction just carried on as it was.
Whether this is true or not is a matter for local tax attorneys — fools rush in where they fear to tread — but, the battle of form over substance being what it is, you would like to think one could mount a sensible argument that seeing as a fund’s net market exposure before and after a novation doesn’t change, the novation should be tax neutral, but — chicken licken and all that.
Anyhow, one hopeful — but, to these cynical eyes, foolish — solution is to document the transfer not as a novation but an “assignment and assumption”, where the outgoing party assigns its rights, the incoming party assumes its obligations, and an infinitesimal moment later the outgoing party gracefully steps away into the night, propelled by the good wishes, respect, discharges and hold harmlesses of those remaining, and somehow the Transaction is is not terminated but granted perpetual existence through this whole surgical procedure transferred as a live organism from the heart of the retiring counterparty into the rib cage of the incoming one.
This is a lovely, imaginative solution. It is bold, hearty, superficially attractive, and endlessly fascinating, rather like one of those M. C. Esher tuning forks. Like an Esher tuning fork, you can easily commit it to paper, and it can please the easily gulled. For the same reason — because it is conceptually impossible — it cannot work.
But is a novation different from an assignment and assumption agreement?
Trick for young players
This is where one where unless you are careful, you may need to rely, more heavily that you would like, on the legal eagle’s old friend mutatis mutandis.
Many service contracts allow service-providing parties to delegate, sub-contract or otherwise outsource the substantive meat and drink of what they have promised to do for their clients (alas — such is the obsession of our mildewed times, with rentier behaviour). Now that is all well and good, but the client’s juridical birds of prey, bridling at what they (rightly) see as an inclination towards outright dereliction of duty, will insist some limits on this right to subcontract. You may only sub-contract, they will say, to your own affiliates.