Novation is a variation of a contract in which the parties agree to substitute a new contract for the old one. Novation can be either voluntary or involuntary. Voluntary novation occurs when the parties agree to change their bargain. Involuntary novation occurs when a third party intervenes and substitutes its own terms for those of the original parties.
There are three forms of novation:
Substituted Contract: A new contract agreed on by the parties. By mutual consent, their rights and obligations under their original contract are canceled and replaced by a new one. Often this is done to avoid an illegal or undesirable clause in the original contract.
Contract of Indemnity: The intervening party agrees to accept all liability on itself, taking over all of the original party’s contractual obligations, thus becoming liable for both sides of the original contract.
Contract of Guaranty: The intervening party agrees to stand as guarantor for another party (usually with better credit) so that the latter will be able to fulfill its contractual obligations.
A novation means that the contract is completely replaced by a new one, with a new set of obligations. In other words, it is as if the old contract never existed. Thus, there is no need to have any obligation from the old contract carried forward. An alteration, on the other hand, is a modification of a contract without replacing it altogether. The obligations that arise from the original contract remain in force, with additions or deletions.
For example, an alteration might occur when one party wants to change the delivery date for a requirement due in three months. Under a novation, a whole new contract would be formed because of this change to the delivery date; if the old contract were still in effect, it would be meaningless because there would be no delivery date at all. Alteration allows only changes in the existing obligations associated with the original agreement and adds additional ones if necessary to reflect these changes.
Novation vs Alteration
Novation and Alteration are two different types of contracts in which the parties agree to change the terms of a contract. However, the main difference between these two is that in novation, the original contract is terminated and a new one is created whereas in alteration, only the terms of the contract are changed but not its termination.
The term novation comes from the Latin word novatio which means substitution or interchange. Novation is a legal concept that may or may not involve a new agreement entered into by all parties to replace an existing one, i.e., the original contract. In many cases of novation, such as a substitution of one obligor for another or substitution of collateral, there is no real substitution at all, but rather only a re-description or re-characterization of something that already exists. The most common example of novation occurs when an existing debt held by one creditor is replaced by a new debt owed to another creditor. This would be accomplished by an assignment (transfer) to the new creditor under powers contained in the original contract between debtor and initial creditor.
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