Novation

What it means

Novation is an agreement by which the parties replace an existing obligation with a new one. A typical example is turning an unpaid purchase price into a loan with different repayment terms, or replacing several small obligations with a single new one with a common repayment schedule.

In a privative novation the original obligation ends and the new one takes its place. In a cumulative novation only certain terms change, such as the due date or interest, and the original obligation continues in amended form. The contract must make clear which type the parties intended.

Novation is useful when a customer has payment difficulties. Instead of pursuing the debt in court, the parties agree on a new obligation the debtor can manage to repay. The creditor obtains a clear legal basis, often with interest, and the debtor gains time to stabilise.

How it works in practice

In a privative novation, security attached to the original obligation ends with it. A surety or lien provided by a third party generally continues only if that party consents. The creditor should therefore expressly renew the security or obtain the guarantor's consent when novating.

In the books, when a trade receivable is converted into a loan, it is reclassified from trade debtors to loans granted. Nothing changes for VAT; the original invoice remains valid. If the new obligation carries interest, that interest is income recognised on an accruals basis.

The new obligation has its own due date and its own limitation period, which may give the creditor more time to recover the debt. A written acknowledgment of debt by the debtor has a similar effect, but it confirms rather than replaces the original obligation.

What to watch out for

A loosely worded agreement can lead to disputes over whether there was a novation or merely a change of terms. The difference is fundamental for security, limitation and the debtor's defences. The contract should state expressly whether the original obligation ends and what happens to its security.

With a debtor in crisis, the risk of the transaction being challenged must be considered. If the debtor later goes bankrupt, the trustee may examine whether the novation favoured one creditor over others. Agreements with related parties receive particular scrutiny.