Novation (vs. Assignment)

Novation is how a party gets out of a contract and puts someone else in its place. The Supreme Court of Canada, in National Trust Co. v. Mead, [1990] 2 S.C.R. 410, described it as a trilateral agreement by which an existing contract is extinguished and a new contract is brought into being in its place.

The doctrine exists because of a basic rule of contract law. A party is generally free to assign the benefits of a contract, such as the right to be paid, to a third party. It cannot assign its obligations. Two principles combine to produce that result: people may choose whom they contract with, and people are not bound by obligations they had no part in creating. A creditor who agreed to be paid by one company cannot be forced to accept a different company in its place.

Novation is the exception, and it turns on the counterparty's consent. In practice, the outgoing party, the incoming party and the counterparty all sign an agreement that the old contract ends and a new one with the incoming party takes its place. Once that happens, the counterparty can no longer look to the original party if the new party fails to perform. That release is what makes novation valuable to a seller, and why counterparties are cautious about giving it.

The two are often confused because both move a contract from one party to another. The legal effect is very different.

In Ontario, section 53 of the Conveyancing and Law of Property Act lets an absolute written assignment of a debt pass the legal right to the assignee once express written notice is given to the debtor, subject to prior equities, such as defences the debtor had against the original creditor. That is the statutory route for transferring receivables, not a release of anyone's obligations.

In a typical asset deal, the buyer signs an assignment and assumption agreement promising the seller it will perform the assigned contracts. The counterparty is not a party to that promise, so it can still sue the seller if the buyer fails. The seller's main protection is the buyer's indemnity under the purchase agreement. Where the contract restricts assignment altogether, the counterparty's consent is needed before even the assignment can happen; see change of control and anti-assignment clauses.

In Mead, the Supreme Court of Canada adopted a three-part test from Polson v. Wulffsohn (1890), 2 B.C.R. 39. For a novation:

1. The new debtor must assume the complete liability.
2. The creditor must accept the new debtor as principal debtor and not merely as an agent or guarantor.
3. The creditor must accept the new contract in full satisfaction and substitution for the old contract.

The court stressed that assent is the crux of novation. It cannot be forced on an unwilling creditor, and without an express agreement a court should be loath to find one unless the circumstances are really compelling. Courts may consider the parties' conduct, but the burden of proving novation is not easily met. Signing an assumption agreement does not by itself create a novation.

The facts show how this plays out. Mead bought a property subject to an existing mortgage and signed an assumption agreement with the lender. The agreement said the lender could release the original borrower at any time; that was an option for the future, not a present release. The lender later discontinued a lawsuit against the original borrower, but the court held that this conduct was equivocal and found no novation.

The lesson for business owners is simple. If you need to be released, get the release in writing, signed by the counterparty. Do not rely on the counterparty accepting payments from the buyer.

Novation comes up wherever a party wants to leave a relationship cleanly:

• Asset sales: a seller transferring a business under an asset purchase agreement may want releases on major customer, supplier or equipment contracts. Buyers usually limit novation to the contracts that matter most, because each one requires the counterparty's cooperation. The checklist for buying a business in Ontario places these consents in the wider closing process.
• Commercial leases: assigning a lease does not release the original tenant. Only the landlord's agreement does, which is a novation in substance. See lease assignment vs. sublease.
• Loans and guarantees: a lender may agree to substitute a buyer as borrower. A guarantee given for the old obligation may not extend to the new one, so lenders usually require guarantors to confirm or sign a fresh personal guarantee.
• Government contracts: federal procurement guidance requires a contractor to obtain Canada's written permission before assigning a contract, with integrity documentation for the assignee, so a sale of a government contracting business has its own consent track.

A well-drafted novation agreement names all three parties, sets an effective date, states that the incoming party assumes all obligations from that date, releases the outgoing party, and says who remains responsible for breaches that occurred before the effective date.

Not every change in a business requires contracts to be moved. In a share purchase, the corporation that signed the contracts remains the party, so nothing is assigned or novated; generally only a change of control clause can be engaged. Asset purchase vs. share purchase explains how buyers choose between the two structures.

Amalgamation also avoids novation. Under section 179 of Ontario's Business Corporations Act, the amalgamating corporations continue as one corporation, which possesses all of their property and rights and is subject to all of their liabilities and contracts. Section 186 of the Canada Business Corporations Act has a similar effect for federal corporations: the property of each amalgamating corporation continues as property of the amalgamated corporation, which continues to be liable for their obligations. Contracts carry on with the amalgamated corporation without any assignment or new agreement, as the guide to corporate amalgamation in Canada explains.

Two cautions apply. A contract can expressly treat an amalgamation as a change of control or a deemed assignment, so key agreements still need to be read. And counterparties need to be told the amalgamated corporation's name and details so invoices, payments and notices go to the right entity; the post-amalgamation checklist covers that clean-up.

Vikram Desai's Vaughan IT company sells its managed services division to Claire Dubois's corporation for $2.4 million under an asset purchase agreement. The division has 40 client contracts. The largest is a three-year agreement worth $480,000 a year with a Brampton logistics firm, carrying service-level credits and data-breach exposure.

For the other 39 client contracts, which allow assignment on notice, the parties use an assignment and assumption agreement, with Claire's corporation indemnifying Vikram's company. For the logistics contract, Vikram insists on a novation. The client agrees after reviewing Claire's security certifications and financial statements. The three-party novation agreement makes Claire's corporation the service provider from the closing date, releases Vikram's company from performance after that date, and leaves Vikram's company responsible for $18,000 of service credits already earned before closing.

The equipment lessor consents to an assignment of a $95,000 server lease but refuses to novate it, so Vikram's company remains liable on it. The purchase agreement protects it with an indemnity from Claire's corporation and a $50,000 purchase price holdback until the lease ends.