What is Novation of Contract?

Introduction

A contract is broadly understood as an agreement that is legally enforceable. According to the Indian Contract Act, 1872, the concept of "novation" refers to the substitution of an existing contract with a new one, wherein identical obligations are carried out by different parties or modified between the same parties. Novation effectively terminates the obligations under the original contract and replaces them with those under the new contract.

The Indian Contract Act of 1872 recognizes the notion of novation in Section 62. Any contract may be novated, but it can only take effect when a new contract—not a new agreement—is in place. Therefore, merely agreeing to replace the current contract will not be enforceable unless both parties have mutually agreed to and executed it. When two parties novate a contract, a new contractual obligation is created. 

Definition and Legal Framework

The Section 62 of the Indian Contract Act, 1872 depends on the concept that people who create something have the ability to destroy it. When a contract is novated, the parties are required to abide by the new agreement, and the old contract expires. According to Section 62 of the Act, “the original contract needs not to be performed if the parties to the deal agree to substitute a new contract for it or to repudiate it or change it.”[1] 

Essentials of Section 62 of the Indian Contract Act

The essentials of Section 62 of the Indian Contract Act, 1872 are as follows: 

1. Existing Valid Contract: There must be an original contract between two or more parties.

2. Mutual Consent: The parties must agree to novate the contract, substituting either a new party or new terms.

In the case of Ramdayal v. Maji Devdiji[2], the Court clarified that novation can occur not only when new parties are introduced but also when the terms of the existing contract are substantially altered. Novation is only valid when all parties involved consent to the change.

In the case of CITI Bank N.A. v. Standard Chartered Bank[3], according to the Reserve Bank of India, there was misconduct and irregularity in the securities market due to collaboration between brokers and specific banks and financial organizations. CitiBank, Standard Chartered Bank, and Canabank Financial Services Ltd. were the three principal players. So, the question arose on whom the liability will fall. On which the Supreme Court stated that there was no proof to support the existence of a tripartite agreement designating a third party for obligation. It was decided that in order to replace the previous contract with a new one, both parties had to provide their agreement. There cannot be good novation when only one party attempts to bring about novation unilaterally.

3. Substitution or Alteration: The old contract must be entirely replaced by a new one, either through a change in obligations or the introduction of a new party.

In case of Lata Construction &amp, Ors v. Dr. Rameshchandra Ramniklal Shah[4], the Supreme Court held that novation requires the complete substitution of the old contract. The new contract must replace the previous one entirely, and until such replacement is complete, the original contract remains in force. Specifically, it stated that novation necessitates the complete replacement of the previous contract with the new one, and only under those circumstances is the original contract exempt from performance requirements. The conditions of the previous contract should be nullified or entirely changed in the new substituted agreement.

4. Discharge of the Old Contract: Upon novation, the original contract is discharged and the obligations arising out of it are extinguished.

5. New Contract: The new contract must be valid and enforceable, meeting all the essentials of a legally binding agreement. 

Kinds of Novation

1. Substitution of a New Party

In the instance of a novation agreement, the terms of the agreement may allow for the replacement of one party with another. As a result, one party becomes obligated instead of another. This type of contract transfers all of the liabilities to the new party, and the party who assigned his obligations to the other party will not be responsible for any damages in the future.

For example, if A and B are parties to a contract and A decides to take C's place in lieu of B, then the current contract between A and B will be terminated.

In this case of Godan Namboothiripad v. Kerala Financial Corporation[5], the respondent (Kerala Financial Corporation) approved a loan to one Gopinath for the purchase of a transportation vehicle, which was to be paid in installments. He failed to make his payments, and as a result, the respondent confiscated the automobile. Following that, the appellants executed an equitable mortgage that guaranteed their obligation to repay the balance. The court determined that it was a novation of contract since the appellants assumed obligation for the debts and the original debtor (Gopinath Menon) ceased to be the debtor.

2. Substitution of a New Obligation

It is open to the parties to a contract to engage into one and change its terms by mutual agreement. When both parties mutually agree to amend the terms of an existing contract, the new agreement becomes binding on them. However, if the contract has a clause specifying that one party may unilaterally amend the terms of the contract, such changes will be regarded as legal. As a result, a party cannot unilaterally impose requirements that were not included in the original contract.

The Apex Court held in the Ramji Dayawala & Sons (P) Ltd v. Invest Import[6]case that a multi-part contract ought to have had consensus ad idem, or the assent of the contractual parties in an identical way and sense.

If there has already been a breach of the prior agreement, the new one cannot be replaced. In the famous case of Koyal v. Thakur Das Naskar (1887)[7], this idea was emphasized. In this case, the plaintiff sought to recoup the Rs. 1173 that they had loaned out on a bond. But the deadline for paying back the bond has past. Consequently, the plaintiff made a compromise and consented to accept Rs. 400 as cash and the remaining Rs. 700 as installments. In the end, the accused neglected to return the Rs. 400 or the amount specified in the initial bond. The plaintiff subsequently took legal action and petitioned the court to get his money back under the terms of the initial bond. The Calcutta High Court observed that the contract was actually discharged, but not via novation. The plaintiff was entitled to sue for breach of the original contract. 

Purpose of Novation Agreement

Novation refers to the replacement of an old contract with a new one, or the replacement of the original parties by a third party. In general, novation is used since going through the discharge procedure for the previous contract and then drawing up a new contract is time-consuming and inefficient. Novation allows you to amend or modify the original agreement to meet the demands of the parties by adding or removing earlier terms and conditions. When one of the original parties want to resign and have their respective liabilities discharged, hiring a third party to replace them becomes more convenient. Therefore, novation becomes a viable alternative when it comes to debts or loans. For instance, with the creditor's approval, the initial debtor may transfer the debt to a different party. Additionally, the novated agreement must be signed by all three parties with consent.

The dissolution of a partnership firm is another scenario. Through novation, the departing partner can fairly easily get out of the situation and transfer his rights and responsibilities to either the remaining original partners or to a new partner who joins the partnership. Nonetheless, getting the approval of the company's creditors is a requirement even in the event of a partnership firm's dissolution. It is important to realize that novation carries some danger. In the aforementioned cases, the creditor must have a reasonable level of confidence that the third or new party taking on the original party's obligations would be able to fulfill them. The point where the creditor will no longer be able to hold the original party accountable after the contract is novated carries the danger. 

Applications of Novation

1. Debt and Loan Restructuring

Novation is frequently used in the restructuring of debts and loans. In such cases, a new debtor may take over the liabilities of the original debtor, provided the creditor agrees to the substitution. The creditor’s consent is vital, as novation releases the original debtor from their obligations, transferring them entirely to the new party. 

2. Partnership Firms

Novation is also common in the dissolution of partnership firms. When a partner wishes to leave the partnership, their rights and obligations may be transferred to a new or existing partner through a novation agreement. This allows the partnership to continue without disruption.

3. Mergers and Acquisitions

Novation is also used in mergers and acquisitions. For example, two organizations, 'A' and 'B', sign an agreement to acquire and sell specific items, establishing a buyer-supplier relationship. They can have a novation that states that if 'B' sells, merges, or transfers its business to another company, or sells, merges, or transfers a portion of its business to another company, the newly formed company will fulfill 'B''s contractual obligations. Here, it signifies that the new firm will continue to supply items to company 'A' in accordance with the existing contract.

4. Financial Markets

Novation is commonly used in financial markets, particularly in derivatives trading. In these cases, clearinghouses act as intermediaries, ensuring the transfer of obligations between buyers and sellers. The clearinghouse effectively novates the contract by assuming the counterparty risk. In the case of securities transactions, novation ensures that the buyer and seller need not worry about each other’s creditworthiness, as the clearinghouse takes on the responsibility of fulfilling the contract. 

Effect of Novation on Arbitration

In S. K Sharma v. Union of India[8], the contracting party was coerced into signing the agreement. However, the original agreement's arbitration clause remained effective. The settlement agreement between the parties was insignificant because the nature of the dispute was such that it could be resolved by arbitration.

In the recent case of B.L. Kashyap and Sons Limited vs. Mist Avenue Private Limited[9], the Delhi High Court ruled that when a new contract replaces the existing contract, the arbitration clause is also canceled by the new agreement. This conclusion is founded on the idea of contract novation, as established in Section 62 of the Indian Contract Act of 1872. According to the subsection, "if the parties to a contract agree to substitute a new contract for it, or to rescind or alter it, the original contract, need not be performed."[10] 

Novation v/s Assignment

• All parties to the agreement must agree on novation. Assignment is permitted as long as notification is made to the opposing party.
• A novation transfers all of the original party's rights and liabilities to a third party. As previously stated, the third party cannot compel the original party to undertake contractual duties as defined in the agreement. This is because in novation, the original party is released from all liabilities, and the third party agrees to bear those liabilities in the former's place. An assignment is just a partial transfer, in which the rights and benefits are passed to a third party. 

Novation v/s Rescission

• Novation occurs when an old contract is replaced with a new one. Novation is a straightforward approach to change or edit an existing contract by changing some of its terms or the parties involved. One of the original parties may be relieved of their obligations, but a third party would replace them and assume those obligations.
• Rescission occurs when the contract is terminated or cancelled by the parties. This implies that the parties are no longer bound by their respective contractual commitments. 

Novation v/s Alteration

• Novation is the replacement of an existing contract with a new one. In a modification, the parties to a contract remain unchanged. Novation has the ability to replace the original party with a new third party.
• Alteration occurs when some conditions of the original contract are updated or changed with the agreement of all parties.

Conclusion

Novation is governed by Section 62 of the Indian Contract Act of 1872. It is a convenient and simple method that allows contractual parties to change the terms of the original agreement and replace it with a new one. Novation also gives the parties the option of maintaining the contract's provisions the same while replacing the parties by binding a third party to the original agreement. Novation is one of the options for terminating the original contract. Novation is most commonly used in debt, loan, mortgage, merger & acquisition, and commercial transactions. Novation is also prevalent in the financial and derivatives markets.

[1] Indian Contract Act, 1872, s. 62.

[2] AIR 1956 RAJ 12.

[3] AIR 2003 SCC 4630.

[4] AIR 2000 SCC 380

[5] AIR 1998 KER 31

[6] AIR 1981 SCC 2085.

[7] (1888) ILR 15 CAL 319.

[8] AIRONLINE 2021 DEL 136

[9] 2023 SCC Online Del 3518

[10] Ibid.

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