This article is by Shivi Khanna, a student of School of Law, Sushant University, Gurugram. This article is an attempt to examine the concept of novation covered under Section 62 of the Indian Contract, 1872 and to look at the kinds of novation, and elaborating on how novation as a means of discharging a contract works. Some real-life applications of the same have been explained through case laws and important clauses.

This article has been published by Sneha Mahawar.

Introduction

According to Section 2(h) of the Indian Contract Act, 1872, (hence referred to as the Act), any agreement which is enforceable by law is a contract. A contract is formed between two or more parties with the intention to enter into a legal relationship, in exchange for a certain consideration, and with their free consent. Free consent means that the parties must be competent to contract; there must be a lawful object and consideration; and the contract must not be expressly declared to be void under the law. After a contract has been made, the contracting parties must each fulfil their respective obligations as mentioned in the contract. Once the parties carry out their obligations, the object of the contract is fulfilled and thus their liability comes to an end. When the object of the contract is completed, the contract is then said to be discharged. However, the parties fulfilling their contractual obligations and discharging the contract is not the only way to discharge a contract. Other methods of discharging a contract include:-

  • Performance (Section 3167 of the Act)
  • Impossibility of Performance (Section 56 of the Act);
  • By Agreement (Section 6267); and
  • Breach (Section 39 and 73).

Section 62 of the Indian Contract Act, 1872, covers the concept of novation. When the parties to the contract decide that they want to discharge the contract through novation, it means that they want to substitute the existing contract with a new one.

Novation under Section 62 of the Indian Contract Act, 1872

Section 62 is based on the principle – those who create something can also put an end to it. Section 62 of the Indian Contract Act, 1872, states that when the contracting parties want to discharge a contract, then they can: substitute a new contract in place of the old one; or rescind it or alter it. Lord Selborne has expanded on what the novation of a contract entailed in the case of Scarf v. Jardine (1882). According to him, novation is when a new contract replaces an already existing one, either between the same parties or between different parties. The key point is that a new contract takes the place of the old one, and as a result, the old contract is discharged.

Lord Selborne gives the example of novation in the case of the dissolution of a partnership firm. The partners intending to continue the business and the partners wanting to leave come to an agreement regarding wholly discharging the liabilities of the business. If the continuing partners want to take over the assets as well then they need to notify the creditor. The creditor must consent to accept the new liability in place of the old one and in exchange the partners will pay him for that consideration.

The following scenarios are examples of novation:-

  1. In the case of loan: For example, there is a contract between ‘X’ and ‘Y’, where ‘X’ is supposed to pay a certain amount of interest on the money loaned to him by ‘Y’ within a stipulated time period. Consequently, ‘X’, ‘Y’ and ‘Z’ enter into a new agreement, whereby, ‘Z’ will pay off the interest that ‘X’ owes to ‘Y.’ Here, a new debt is contracted between ‘Z’ and ‘Y’ in place of the old contract.
  2. In the case of mortgage: For example, ‘P’ owes 50 lakh rupees to ‘Q.’ Subsequently, ‘P’ and ‘Q’ make a new agreement, where ‘P’ mortgages his flat to worth about 25 lakhs in place of the original 50 lakhs he owed in debt. This new arrangement becomes a new contract and discharges the old one.

However, it should be noted that there should not have been a breach of contract in the existing original contract. Moreover, the contract must be valid and enforceable. For instance, in the case of Shanker Lal Damodhar v. Ambalal Ajaipal (1964) AIR 1946 Nag 260, an old mortgage agreement was substituted with a new one. However, due to the fact that the new mortgage was unenforceable because it was not registered, the parties were still bound by the original mortgage agreement.

It is also important to note that there must be mutual consent between the parties to substitute the old contract with a new one. For example, ‘A’ owes Rs. 300 to ‘B.’ On the other hand, ‘B’ owes Rs. 300 to ‘C.’ ‘B’ decides to make an arrangement where ‘A’ would pay the Rs. 300 he owes directly to ‘C’ instead of ‘B.’ However, ‘C’ does not consent to this arrangement. Therefore, a new contract is not made because in the existing contract between ‘B’ and ‘C’, the latter has not agreed to substitute the old contract with the new one. Thus, ‘B’ continues to owe Rs. 300 to ‘C.’

What constitutes a good novation

The following was held in the case of Lata Construction v. Rameshchandra Ramniklal (2000).

Facts – The defendants resided in Libya and commissioned the appellants to construct a flat in India for the defendants to settle in. They entered into an agreement for the same. The defendants made the due payment and asked for possession of the flat, however, the appellants did not comply on the ground that the flat was not ready. When the defendants returned from Libya they found that the flat was locked and had a plaque on it which read ‘Indira Joshi.’ Consequently they entered into a fresh agreement where the appellants would compensate the defendants through monetary means. However, the appellants did not honour either of the agreements.

Issue – Were the old rights in the old contract completely extinguished and substituted by a new contract?

Decision –  It was held that when only a part of the contract is changed, and the new contract is so inconsistent with the old contract such that they cannot stand together, then there is no good novation.

Can novation be brought about unilaterally

The following was held in the case of CITI Bank N.A. v. Standard Chartered Bank (2004).

Facts of the case – The Reserve Bank of India found that there was a collusion between brokers and certain banks and financial institutions – amounting to malpractice and irregularity in the securities market. The three main parties involved were – CitiBank, Standard Chartered Bank, and Canbank Financial Services Ltd.

Issue involved in the case – Whom does the liability fall on?

Judgment of the Supreme Court– There was no evidence to show that there was a tripartite agreement under which the liability was to fall on a third party. It was held that both the contracting parties must consent to substituting the old contract with a new one. Where only one of the parties tries to unilaterally bring about novation, there is no good novation.

Elements of novation

Novation has the following elements:-

  1. There must be mutual consent between the parties.
  2. There must not have been a breach in the original contract.
  3. The new contract must be valid and enforceable.
  4. After novation the old contract gets discharged and no longer binds the parties.

Purpose of a novation agreement

Novation entails the replacement of an old contract with a new contract, or the replacement of the original parties with a new third party. Generally, novation is carried out because going through the discharge procedure for the original contract and going on to draw up a new contract is quite cumbersome and time-consuming. Novation allows one to edit or modify the original agreement to suit the needs of the parties by adding or subtracting the previous terms and conditions. When one of the original parties wants to leave and have their respective liabilities discharged, bringing in a third party to replace them becomes more convenient. 

Therefore, in the case of debts or loans, novation becomes a suitable option. For example, the original debtor can pass on the debt to a third party with the creditor’s consent. And all three parties have to be in agreement and sign the novated agreement. Another case is when a partnership firm dissolves. The departing partner can extricate himself relatively easily through novation, and his rights and responsibilities can be taken over by a new incoming partner or by the remaining original partners. However, even in the case of a partnership firm’s dissolution obtaining the consent of the firm’s creditors is a mandatory step.

It should be noted that there is a certain degree of risk associated with novation. The creditor in the aforementioned examples needs to be relatively sure that the third or new party who is undertaking the liabilities of the original party will be able to complete them. The risk is attached to the part where the creditor will no longer be able to hold the original party liable once the contract is novated.

Who should sign a novation agreement

There are three parties that sign a novation agreement:-

  1. The original party whose liabilities will be discharged after the novation.
  2. The third party or new party who undertakes the liabilities of the original party after the novation is complete.
  3. The creditor or counterparty whose consent is also necessary to go through with the novation, whether it is with respect to the replacement of parties or modification of terms.

Parties usually opt for novation in the following scenarios

  • Debt – ‘X’ owes a certain amount of money in debt to ‘Y.’ ‘X’ is ultimately unable to repay the debt. As a result, a third party ‘Z’ agrees to replace ‘X’ as the debtor and pay the debt to ‘Y.’ ‘Y’ as the creditor gives his consent. Thus, the three opt for novation and ‘X’ is absolved of his liability of paying the debt. Meanwhile, ‘Z’ takes on the liability of paying off the debt to ‘Y.’
  • Takeovers in business deals – a takeover is when one company acquires the majority stake in another company. Novation is used in takeovers when the parties need to be replaced.
  • Sales in the context of business – when the parties need to be replaced novation is used.
  • Dealing in securities in financial markets – when dealing with derivatives in the securities market novation is used in the purchase of securities through an intermediary.

How does novation work

Novation involves the transfer of contractual liability from the original party to a third party. Mutual consent between the parties to go through with the novation is an essential ingredient. Generally, novation takes place when the performance of the contract is impossible and is one of the methods to discharge a contract. Therefore, once a contract is novated, the original parties can no longer be held liable to carry out the obligations stipulated by the original contract. The third party takes on the contractual duties in the novated contract and cannot implicate the original party whose liabilities have been discharged.

One key principle has been established in the landmark judgment of Commercial Bank of Tasmania v. Jones (1893). In this case, the late James Boney had provided a guarantee to the appellants to pay back a sum of money advanced to George Andrews Wakeham. The appellants wanted the executors of James Boney to pay off the sum he had guaranteed for George. It was held that just because the original party cannot be held accountable for his contractual obligations with respect to the novated contract, it does not mean that there is a covenant not to sue him at all.

The aftermath of novation may also bring in an indemnity clause where the parties agree to indemnify each other with respect to losses caused by the actions of the other party in relation to the agreement.

Kinds of novation

There can be two kinds of novation in contract law:-

Change of parties

The concept of change of parties can be seen in the scenario where there is a creditor ‘A’ and a debtor ‘B.’ The original contract between ‘A’ and ‘B’ is substituted with a new contract where ‘A’ as the creditor agrees to have ‘C’ pay off the debt in place of ‘B.’ In this way the old contract between ‘A’ and ‘B’ comes to an end, replaced by the new contract between ‘A’ and ‘C.’ This kind of novation is seen the most frequently when a new partner is introduced to an existing firm. Another case is when a partner retires, the liabilities of the old firm are done away with, and with the approval of creditors a new firm is established. Once again it is very important that parties to the original contract consent to the substitution of a new one in its place. In the novated contract, at least one or more parties must be new and they must undertake the relevant obligations under the new contract.

Substitution of new agreement

In a novated contract, by the mutual consent of the parties, an old contract is substituted by a new one. Once the novation is complete, the old contract is discharged and requires no performance. However, this is on the condition that the original contract must be unbroken i.e. there should not have been any breach.

A new contract cannot be substituted in a case where the old contract has already been breached. This principle was highlighted in the landmark case of Koyal v. Thakur Das Naskar (1887). Here, the plaintiff had lent out Rs. 1173 on a bond, and wanted to recover the amount. However, the stipulated time for repaying the bond passed. As a result, the plaintiff compromised and agreed to receive Rs. 400 in cash and the balance Rs. 700 through instalments. Ultimately, the defendant failed to pay back the amount in the original bond or Rs. 400. The plaintiff then sought recourse in approaching the court for recovering his money based on the original bond. The Calcutta High Court observed that the contract was indeed discharged, but not by novation. The plaintiff had the right to sue for breach of the original contract.

Novation and financial markets

Novation also takes place during the buying and selling of securities in the derivatives market. When selling securities in the derivatives market, the owners prefer to transfer their securities to the buyers via an intermediary i.e. the clearinghouse. Therefore, to understand it in simple terms, the securities pass from the hands of the owner (seller) to the intermediary and finally to the buyer. The intermediary acts as the middleman and takes the role of the counterparty. Therefore, the intermediary also bears the risk of one of the parties defaulting on their obligations.

This novation ensures that the process of buying and selling securities is both simpler and more secure. The parties do not have to face hurdles such as determining the creditworthiness of the other party as  long as the intermediary bears the counterparty risk. The only danger in this type of transaction is if some problem comes up with the intermediary, such as insolvency, fraud etc. However, these types of problems cropping up with intermediaries is not a common occurrence and they are usually reliable.

Novation and mergers and acquisitions

Novation also finds application in mergers and acquisitions. For example, two companies ‘A’ and ‘B’ sign an agreement together to buy and sell certain goods, respectively, and therefore, develop a buyer and supplier relationship. They can have a novation that stipulates that if ‘B’ sells, merges or transfers its business to another company or sells, merges or transfers away part of its business to another company, then the newly emerging company after the merger or acquisition will fulfil the contractual obligations of company ‘B’. Here, it means that the new company will continue to supply goods to company ‘A’ as per the original contract.

Case Laws

Dadri Cement Co v. Bird and Co (P) Ltd (1974)

Facts  of the case – In this case, there was a contract of sale of property. The parties intended to enter into a new arrangement by substituting the agreement, deed of pledge, and the power of attorney. The substitution allowed the old arrangement to be replaced by the new one.

Issue involved in the case – Would this amount to novation?

Judgement of the Court – The Delhi High Court was of the opinion that this amounted to novation. Therefore, the old arrangement became inoperative and the old contract was discharged (not enforceable).

Andheri Bridge View Coop Housing Society v. Krishnakant Anandrao Deo (1991)

Facts of the case – In this case, a contract was made concerning a housing project. The contract stipulated that the land had to be free of encumbrances. However, a problem cropped up as the parties were unable to remove hutment occupations on the land. Therefore, they had to leave the old site and move to a new site where the price rate was higher.

Issue involved in the case– Would the previous contract with respect to the old site be discharged?

Judgement of the Court – The Bombay High Court applied the principle of novation to this case. It was held that replacing the old site with the new site amounted to novating the old contract with a new one.

Narendra Kumar Brijraj Singh v. Hindustan Salts Limited (2001)

Facts of the case – In this case, the petitioner applied for a job of a certain pay scale on the basis of an advertisement. He was hired but at a lower pay scale than the proposed price in the advertisement. The petitioner did not raise any objection at the time and accepted the post. Later, he tried to claim the original pay scale.

Issue involved in the case – Can the petitioner avail the old pay scale?

Judgement of the Court – The petitioner’s attempt failed and he was not allowed to do so by Gujarat High Court. The principle of novation was applied – the old payscale had been substituted by the appointment and acceptance of the new (lower) pay scale.

BGR Mining and Infra (P) Limited v. Singareni Collieries Co. Limited (2012)

Facts of the case – In this case, the occurrence of major landslides obstructed the extraction operation of coal, and this adversely affected a contract of engineering relevant to the same. Therefore, in light of the disaster, the petitioner was allotted a new area for coal extraction. Even though the new area was smaller than what he was allotted before the landslide, the petitioner accepted it and did not raise any objection.

Issue involved in the case – Was the previous contract with respect to the old area discharged?

Judgement of the Court – The Court held that the original contract was discharged, thus, valid tenders could be offered for the original area.

Important clauses with respect to contract of novation

The following clauses are important elements of a contract of novation:-

  • Definitions – defining the terms in a contract that the parties must adhere to while interpreting the contract.
  • Name of the parties – the particulars of the contracting parties.
  • Details of the third party – the third party’s rights and obligations.
  • Effective Date clause – novation essentially means the substitution of an old contract with a new one. Therefore, the ‘Effective Date’ clause specifies the date from which the new contract will be coming into effect i.e. the date from which the new contract will become binding on the parties.
  • Release Clause – once the agreement has been novated, the new contract takes effect and becomes binding and enforceable on the contracting parties. The old contract gets discharged and the parties are no longer under the obligation of performance. The Release Clause specifies the date from which the original contracting parties are released from the old contract.
  • Obligations, duties, liabilities of the parties – liabilities that the parties must fulfil as per the terms of the contract.
  • Representations – any representations or warranties made by the parties.
  • Any arising costs/fees – costs or fees arising during the judicial/court process.
  • Effects of novation agreement – the substituting of a new contract would undoubtedly bring changes in terms of the parties or the contract itself which would have an impact on the transaction.
  • Jurisdiction – which law and courts will apply to the contracting parties.
  • Counterparts – the party which continues to be part of the agreement, for instance, creditors.

How to draft a novated contract

Drafting a novated contract is not that different from drafting a standard contract. The new contract which is taking the place of the original contract must be valid and enforceable. Moreover, there must not have been a breach of the original contract before the novation was made. The contract of novation has the generic clauses of a standard contract, such as, details of the contracting parties (name, address etc), jurisdiction, definitions, and arising fees/costs. The important clauses to take note of are the effective date clause, release clause, effect of novation agreement.

The main advantages of novation are:-

  • Instead of terminating the original contract and then going through the process of making a new one, through novation even if the parties change the content of the contract remains the same. Novation makes changing the parties more convenient.
  • When two parties want to change or modify some terms of the agreement, they can accomplish this through novation.

Effect of novation upon arbitration

In S.K Sharma v. Union of India (2009), the contracting party was forced to sign the agreement under coercion. However, the arbitration clause under the original agreement did not become invalid. The settlement agreement between the parties was inconsequential, as the nature of dispute was such between the parties that it could be solved through arbitration.

Novation vs Assignment

The following characteristics distinguish novation from the assignment:-

Factors NovationAssignment
ValidityOn the other hand, novation requires mutual consent of all parties to the agreement.Assignment is possible as long as a notice is sent to the other party.
Accountability In a novation, all the rights and obligations of the original party are transferred to the third party.Hence, as has already been mentioned, the third party cannot compel the original party to perform contractual duties as stipulated by the agreement. This is because in novation the original party is absolved of all liabilities and the third party is the one who agrees to bear said liabilities in the former’s place.In an assignment there is only a partial transfer i.e. only the rights and benefits are transferred to the third party.

Pros and cons of novation

Pros Cons 
More convenient than discharging the original contract and then going about drawing up a fresh contract.Frequently used in debts, mortgages, loans and dissolution of partnerships.Requires the consent of all parties, therefore, it cannot be imposed unilaterally.There is a certain risk factor for the creditor as he needs to be certain that the incoming party/third party will fulfil the liabilities he undertakes. The creditor cannot hold the original party responsible after the novation is complete.

Pros and cons of assignment

Pros Cons 
Assignment is less cumbersome than novation. Assignment does not stipulate that there must be consent from all parties. As long as a notice is sent the assignment is valid.The third-party only gains the benefits through assignment. Therefore, the original party can still be held accountable to fulfil his contractual obligations.

Novation vs Rescission

Rescission Novation
In simple terms, rescission is when the contract is terminated or cancelled by the parties. This means that the parties are no longer bound by their respective contractual obligations.On the other hand, novation is when an old contract is replaced by a new one. Novation is a convenient way of modifying or editing the previous contract, by changing some of its terms or the parties involved. One of the original parties might be absolved of their obligations but a third party would replace them and take up said obligations.

In Unikol Bottlers Ltd v. Dhillon Kool Drinks (1995), the original contract had a clause that allowed the parties to terminate the contract. The parties then made a supplementary contract to postpone the termination. It was held that this did not amount to the novation of contract.

Novation vs Alteration

Alteration Novation 
Alteration is when some terms of the original contract are modified or changed with the consent of all the parties. Novation is the substitution of an old contract with a new contract. In alteration, the parties to a contract do not change. Novation has the scope to have the original party replaced with a new third party.

In Union of India v. Tantia Construction (P) Ltd (2011), there was a contract to construct a rail overbridge. However, an alteration was made to the overbridge’s design which was equivalent to a substantial alteration in the original plan itself. The alteration was significant enough to convert the entire plan into an entirely new project. The alteration did not fall within the increase or decrease clause of the original contract. It was held that the government was not entitled to invite new tenders for the same, and also had to pay the contractor for the work already done. The contractor could not be compelled to do a new project at the old rates.

Conclusion

Novation is covered under Section 62 of the Indian Contract Act, 1872. It is a convenient and simplified process that allows contracting parties to modify the terms of the original agreement and replace the old contract with a new one. Novation also allows the parties the option of keeping the terms of the contract the same while changing the parties by binding a third party to the original contract. Novation is one of the methods for discharging the original contract. Novation is most frequently found in cases of debt, loan, mortgage, merger and acquisitions, and business transactions. Novation is also seen in the financial and derivatives market.

References


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