This article is written by Arushi Agarwal, pursuing Diploma in Advanced Contract Drafting, Negotiation, and Dispute Resolution from LawSikho. The article has been edited by Prashant Baviskar (Associate, LawSikho) and Smriti Katiyar (Associate, LawSikho).
When a dispute arises, one is faced with the choice of initiating legal proceedings before a court. The state machinery has established the courts to decide criminal disputes, disputes against the government, and commercial disputes between private entities. Arbitration is typically used to resolve disputes between private entities outside the court machinery.
In common law, the assignment of an agreement results in novation when there is the replacement of the agreement entirely with a new agreement. If the original contract is extinguished, there is the need for consent of both the contracting parties, which implies that the consent of the assignee to the arbitration agreement is required. A novation agreement is a replacement to an already existing agreement. As per the mutual agreement between the parties to the contract, an existing agreement is terminated and a new agreement comes in its place which redefines the roles and obligations of the contracting parties. The Indian Contract Act, 1972 provides for novation under Section 62 of the Act.
An example of a novation agreement is if, in the existence of a distribution agreement of sound recordings, “B” is bound to distribute the sound recordings through the distribution channel provided by “A” and the responsibility of “B” can be replaced by “C”. Now, in the agreement instead of “B” being liable towards “A”, by novation of an agreement “C” will be liable towards “A”.
A transaction may be argued to be novation when there is;
(i) a contract in subsistence,
(ii) the latest contract is substituted for it, either between the same parties or between different parties, where the consideration is the mutual discharge of the old contract. Novation happens only when there is an absolute substitution of a new contract in lieu of the old agreement. An arbitration clause in an agreement is incapable of surviving if the agreement containing the arbitration clause has been superseded/ novated by a later agreement.
The aim of this article is to examine whether an arbitration clause in an agreement survives if the agreement containing the arbitration clause gets superseded/ novated by a later agreement.
Novation can be acknowledged to mean an act whereby parties to contract reciprocally agree to replace terms of obligation with a new set of terms or where contracting parties are restored with a new party. The cardinal principle of novation is that it is an act done in mutual harmony of the contracting parties concerned; which includes the new parties where the new party has replaced the preceding one.
A novation agreement must take effect before the time of execution of an agreement expires. If it is not given an effect, then there will be a breach of the agreement and if the new agreement is replaced with the old one, it will adjust the remedial rights arising on the violation of the agreement. Furthermore, if the new agreement cannot be given any effect, the contracting parties can continue their obligations as per the old agreement.
It is entrenched that an arbitration clause survives the contract, and the parties remain bound by the arbitration for the dispute resolution mechanism. The challenge before the Supreme Court was whether the arbitration clause in a preceding contract, concerning the corresponding transaction survives, in the event of parties replacing the preceding contract with a new one.
What are the principles of a valid novation?
The following should be complied with for a legitimate novation agreement:
- An old contractual agreement must exist so that it may be replaced with a new one.
- The new agreement must comply with the requisites of an agreement that is mentioned under Section 10 of the Indian Contract Act.
What are the essentials for the termination of an agreement by novation?
- The new agreement must be wholly replaced with the original or old agreements
- The original agreements will have existence and enforceability until a new agreement is established
- The original agreement must not be breached, that is, novation agreement should have come into effect before the breach of an agreement
- The spirit of novation lies in the objective to replace the original agreement with the new one and not in the similarities and differences in the terms of an old and the new agreement.
Courts are suspicious of a novation agreement unless they are convinced the parties have complied with the principles of the agreement, and hence, the parties are required to prove the validity of the same in the court about the existence of a new agreement and the discharge of the previous agreements and all its obligations through a novation. The idea behind this provision is to allow freedom to the contracting parties to an agreement to modify and alter the terms and conditions as it deems fit to them.
Landmark case laws
There are two circumstances mentioned below in which a novation may be affected:
- If a new contract, stated with new terms of the agreement is replaced with an existing agreement among the same contracting parties
In the case of R.S. Amarnath vs. Union of India, if an agreement consists of multiple terms and conditions then referring to every term as a separate agreement will be wrong. Likewise, fresh rates, royalties, or compensations would not be quantified as a new agreement. Furthermore, minor and small changes in an agreement without an intention to draw a new agreement do not amount to novation.
- If there is a change in parties to the agreement, however, the agreement remains the same.
In the case of Satish Chandra vs. National Small Industries Corporation, the petitioner stood as a warrantor for the investment done in his proprietary business enterprise. Later, the son of the warrantor converted the proprietary business into a private company. It was held in the case that due to the following changes which led to novation, the petitioner’s warranty stands terminated or discharged.
In the case of Sasan Power Ltd. vs. North American Coal Corporation (India) Pvt. Ltd., the court opined that the novation is not concluded unless it results in substitution, rescission or extinguishment of the previous contract by the new contract. Mere variation of some terms of a contract does not account for novation.
The court appraised the scope of Section 8 of the Arbitration Act and cited the Supreme Court decision in Vidya Drolia v. Durga Trading Corpn. , wherein the Bench noted that for non-acceptance of a Section 8 application, a party has to make out a prima facie case of non-existence of valid arbitration agreement, by promptly depicting a strong case. The court herein opined that the court should refer the matter if the validity of the arbitration agreement cannot be determined on a prima facie basis.
In the case of Young Achievers vs. IMS Learning Resources (P) Limited, the Supreme Court, in this case, held that, if the contract is superseded by another contract, then the arbitration clause, being an integral part of the preceding contract will fall with it. Where the parties entered into a new contract by novation/substitution of the original agreement and there was no provision in the new agreement in respect of any disputes arising under the original agreement nor did it contain an arbitration clause to resolve disputes, then the new agreement was pure and simple novation of original contract. Therefore, the court opined that the dispute cannot be referred to arbitration.
The Supreme Court in the case of Lata Construction vs Dr Ramesh Chandra Ramnikalal Shah held that a novation takes place only when there is an absolute substitution of a new contract in lieu of the old contract. The bench has further examined the scope of Section 8 of the Arbitration Act and referred to the Supreme Court decision in Vidha Drolia v. Durga Trading Corpn. wherein the court reiterated that for rejection of a Section 8 application, a party has to make out a prima facie case of non-existence of valid arbitration agreement, by depicting a strong case and court should refer the matter if the validity of the arbitration agreement cannot be determined on a prima facie basis.
In the case of Dadri Cement Company v. Bird and Co. Pvt Ltd., the question arose as to whether the original agreement which contained an arbitration clause, did or did not survive to govern the subsequent agreement whereby the parties entered into a fresh agreement. It was held that the new agreement operated to bring about a novation of the original contract. According to Section 62 of the Contract Act, if the parties to a contract agree to substitute a new contract for it, or to rescind it or alter it, the original contract need not be performed. The original contract of sale, therefore, necessarily became inoperative and unenforceable and ceased to exist.
In the case Larsen and Toubro Ltd. vs Mohan Lal Harbans Lal Bhayana, There was novation of contract, which resulted in non-survival of the arbitration clause in the original agreement, when the said clause was modified by subsequent agreements. The court held that if the arbitration clause and procedure for the appointment of an arbitrator in the original agreement is novated and parties acted accordingly, the clause in the original agreement for the appointment of arbitration cannot be invoked.
The legal position, as asserted by the Court in various decisions is that once a fresh contract supersedes the former contract containing an arbitration clause, the operative effect of said arbitration ends with the end of the former contract. The parties deciding to enter into a new agreement, and while doing so mutually agree upon the mode and manner of settlement of the dispute, if anything arises in the future and there is no reference to previously executed contract vis-a-vis settlement of disputes arising therefrom, is clearly indicative of novation of contract. The Courts have clearly laid down the implications of novation of a contract on the arbitration clause contained in it in various decisions as mentioned above.
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