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”).
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”.
Under an assignment and assumption the outgoing party assigns its rights against the remainer to the incoming party, while at the same time the incoming party assumes the outgoing party’s obligations to the remainer, 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. Somehow, as a result, the Transaction is is not terminated and reconstituted as such, as would happen in a novation, but granted perpetual existence through the whole surgical procedure: the Transaction is transferred as a live, palpitating organ from the breast of the retiring counterparty and into the ribcage of the incoming one.
This is a lovely, imaginative solution to a technical tax risk. It is bold, elegant, endlessly fascinating and superficially attractive — rather like one of those Penrose triangles. Like a Penrose triangle, you can easily commit it to paper, and it pleases the easily gulled. Also like a Penrose triangle, it is conceptually impossible and cannot work.
Perhaps the “duck rabbit” is the better philosophical metaphor. You call it a “rabbit”, but it quacks like a duck, looks like a duck, and lays eggs. An assignment and assumption is just a novation by another name.
A bilateral contract is not a “material thing”, in the Cartesian sense: it is not res extensa. It has no life independent of the minds of the people who entered it. A contract is A’s personal obligation to B, and B’s personal obligation to A. Those obligations are defined by reference to their obligor: they do not — cannot float free of the person must see to it that they are carried out. Obligations have no separate legal personality and no independent existence.
Now a merchant who has agreed something with one customer may come to wish she hadn’t. She may find another merchant willing to step into her shoes and carry out the services required. This may all even happen with the customer’s agreement — even its encouragement.
Now Merchant A may transfer its rights to enjoy performance of customer’s personal obligations to Merchant B, easily enough, and without interrupting the customer’s personal obligations themselves. But Merchant A cannot transfer its personal obligations to anyone else without destroying the contract which have legal force to those obligations and replacing it with a new one.
Thus, the novation, which preserves for the remaining party the economic effect of the old transaction whilst simultaneously cancelling it and replacing it with a new one.
Look: if an assignment and assumption agreement worked as intended, then this is how we would always transfer derivative contracts, as clearly the intention would always be to preserve the ontological integrity of one’s existing transactions as totally as one could. But yet the ISDA’s crack drafting squad™ — I grant you, an organisation given to gratuitous abstrusity, but not generally where it would imperil one’s tax burden — went with the novation. That there is no published ISDA standard form assignment and assumption agreement should tell what whatever the foregoing cannot.
Trick for young players
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.