Novation In Mergers And Acquisitions: Out With The Old, Deal With The New

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SimmonsCooper Partners

Contributor

SimmonsCooper Partners (“SCP”) is a full service law firm in Nigeria with offices in Lagos and Abuja. SCP is one of Nigeria’s leading practices for transactions relating to all aspects of competition law, commercial litigation, regulatory compliance, project finance and energy. Our team has gained extensive experience in advising both local and international clients.
In mergers and acquisitions (M&A), effectively transferring rights and obligations between parties is critical. For instance, the acquiring company often aims to assume the existing contracts of the target company.
Nigeria Corporate/Commercial Law

Introduction

In mergers and acquisitions (M&A), effectively transferring rights and obligations between parties is critical. For instance, the acquiring company often aims to assume the existing contracts of the target company. Novation, being a legal tool that replaces one party in a contract with another, plays a key role in facilitating the transfer of contractual rights and obligations to the acquiring entity. This ensures the continuity of business relationships throughout the process. This article provides practical guidance for clients navigating novation in M&A transactions, focusing on key legal considerations and best practices to ensure your transactions are handled efficiently and with minimal risk.

Novation Decoded

Novation is a legal mechanism that allows an existing contract to be replaced by a new one, with the consent of all parties involved. This process typically involves substituting a new party into the contract, effectively stepping into the shoes of the original party while releasing the original party from their obligations under the old contract.1 Novation contracts are used in the sale of businesses, takeover transactions, and M&A deals.

Although similar to an assignment, a novation is fundamentally distinct from an assignment. Unlike a simple assignment, a novation contract transfers the entire contractual relationship, not just ownership of an entity or property. In a novation, both the benefits and liabilities are transferred to a new party, whereas, in an assignment, only the benefits are transferred, leaving the original party responsible for the obligations. This makes novation essential when a full transfer of contractual duties is needed.

Consider the following scenario: Sarah enters into a contract with XYZ Ltd. to provide IT consulting services for a year. However, shortly after the contract is signed, Sarah receives an attractive job offer abroad and realizes she can no longer fulfill her obligations to XYZ Ltd. To resolve this, she identifies another consultant, David, who is willing to take over the contract under the same terms. Recognizing her obligations to XYZ Ltd., Sarah proposes a novation to both XYZ Ltd. and David. All parties agree, and through the novation agreement, David steps into Sarah's role, assuming all her obligations to XYZ Ltd. while continuing to provide the services as initially agreed.

This process of novation is however not automatic2; and requires clear agreement from all parties to ensure that the new contract is distinct from the old one, with all rights and obligations fully transferred to the new party.

In the context of mergers and acquisitions, novation becomes particularly important when a company being acquired or merged has existing contracts that must be transferred to the acquiring entity. Through novation, these contracts are smoothly transitioned to the new company, allowing the acquiring entity to assume the benefits and responsibilities of the original party. This ensures business continuity and that all contractual obligations are met under the new ownership, making novation an essential process for maintaining stability during such transitions.

Knowing When to Novate vs. Assign

Deciding between novation and assignment depends on the specific circumstances and objectives of the contractual relationship. Here's a guide to help to determine which option is best suited for your situation:

When to Novate:

  • Complete Release: Choose novation if the original party wants to be fully released from all obligations and liabilities. This is common in M&A scenarios.
  • Complex or Long-Term Contracts: Novation is ideal for contracts with long-term or complex obligations, ensuring continuity and compliance with the original contract's intent.
  • Regulatory or Contractual Requirements: Some contracts or industries may require novation due to regulatory needs or specific clauses, ensuring all parties are properly vetted.
  • Consent of All Parties: If the contract requires consent from all parties to transfer obligations, novation is necessary.

When to Assign:

  • Retaining Liability: Opt for assignment if the original party wants to keep responsibility for obligations but transfer benefits, such as payments, to another party.
  • Simple Contracts: Use assignment for simpler contracts, like payment agreements, where only the rights need to be transferred.
  • Contractual Flexibility: If the contract allows for assignment and the original party is comfortable retaining obligations, assignment offers a flexible, less burdensome option.

When deciding between a novation and assignment, begin by examining the contract for any clauses that specify whether novation or assignment is permitted or required. If the contract carries significant risk or liability, novation might be the better choice, as it fully transfers both responsibilities and benefits to the new party. Moreover, if preserving a strong relationship with the counterparty is a priority, novation can offer a clean break, ensuring that the original party is completely removed from ongoing obligations, which can help maintain goodwill and trust.

Must-Knows for a Smooth Novation Process

To guarantee the validity and enforceability of a novation, certain legal requirements must be meticulously followed. These requisites are particularly vital in M&A transactions, where the stakes are high, and the smooth transition of contracts is essential. Below are the key legal elements required for a successful novation:

(a) Mutual Agreement of All Parties: For a novation to be legally binding, there must be a clear and mutual agreement among all parties involved. This includes not only the original parties to the contract but also the new party who will assume the obligations. In the context of M&A, this typically involves the acquired company, the acquiring company, and the contract's counterparty. This requirement aligns with the doctrine of privity of contract, which maintains that contractual rights and obligations are confined to the parties involved in the original agreement.3

(b) Discharge of the Original Contract:

  • Releasing Old Obligations: A successful novation leads to the discharge of the original contract, effectively releasing the original party from its obligations. The new party then assumes these obligations under a new contract, ensuring continuity without the original party's involvement.
  • Avoiding Hidden Liabilities: In M&A transactions, it's particularly important that the acquiring company does not inherit any undisclosed liabilities from the that the novation effectively extinguishes all prior obligations and that no residual liabilities remain.4

(c) Documentation and Formalities: Proper documentation is essential for the enforceability of a novation agreement. The agreement must be in writing and clearly outline the terms of the new contract, including the rights and obligations being transferred.5 Well-drafted novation agreements ensure that all parties are aware of their rights and responsibilities, significantly reducing the risk of future litigation. This formal approach to documentation is crucial for maintaining the integrity of the M&A transaction.

(d) Regulatory Approvals: In certain industries, regulatory approval is required for novation agreements to take effect. For example, in Nigeria's oil and gas sector, the transfer of licenses and contracts often requires approval from regulatory bodies such as the Nigerian Upstream Petroleum Regulatory Commission (NUPRC). Failure to obtain these approvals can render the novation agreements void or unenforceable, potentially jeopardizing the entire transaction.

Risk Mitigation Strategies in Novation

Navigating the novation process in mergers and acquisitions requires careful planning and proactive risk management. Here are some key strategies to mitigate risks during novation:

  • Comprehensive Contract Review: Before moving forward with an M&A transaction, conduct a detailed review of all contracts that may require novation. During this due diligence process, identify and proactively address any clauses that could present challenges, such as change of control provisions or anti-assignment clauses.
  • Obtain Consent Early: Obtaining consent from all parties involved in the novation can be time-consuming. To prevent delays, it's advisable to start this process as early as possible in the transaction. If a full novation is not feasible due to lack of consent, consider a partial novation where only specific aspects of the contract are transferred while others remain with the original party. Alternatively, explore whether assigning rights (without transferring obligations) could be a viable solution, as this might still achieve the desired outcome.
  • Early Engagement with Counterparties: Initiate discussions with all relevant counterparties early in the transaction process. Early engagement allows ample time to address concerns and reduces the risk of last-minute objections that could delay or complicate the novation. If the new party is concerned about potential risks or liabilities, consider offering financial guarantees or security measures, such as establishing an escrow account, providing a performance bond, or offering indemnities.
  • Clear and Comprehensive Novation Agreements: Draft the novation agreement clearly and comprehensively to avoid any ambiguity.
  • Regulatory Approval: Ensure that all necessary regulatory approvals are obtained.
  • Documentation and Record-Keeping: Keep detailed records of all actions taken during and after the novation process. This documentation will be invaluable in the event of a dispute or if regulatory inquiries arise.

Novation—A Tool for Smooth M&A Transactions

Novation plays a critical role in mergers and acquisitions, ensuring the continuity of contracts and the transfer of liabilities. While the doctrine of novation is well established, companies must carefully navigate the requirements for consent, documentation, and regulatory approval.

By following best practices, companies can effectively implement novation in M&A transactions, minimizing risks and ensuring a smooth transition. As the Nigerian business environment continues to evolve, the importance of novation in M&A transactions is likely to grow, making it an essential tool for companies looking to expand and restructure their operations.

Navigating the intricacies of novation in M&A transactions can be complex, but with careful planning and expert guidance, it can be a smooth process. For further guidance on how to manage these challenges and ensure transactions are successful, please reach out to Love Adeniji or Oluwadara Omoyele.

Footnotes

1. Phillips V. Arco Ltd (1971) LPELR-2918 (SC)

2. Polak Investment & Leasing Co. Ltd V. Sterling Capital Market Ltd (2018) LPELR-46830 (CA)

3. NOSPETCO Oil & Gas Ltd v. Olounnimbe & Sons (2021) LPELR-55630 (SC)

4. Polak Investment v. Sterling Capital (Supra)

5. Philips v. Arco Ltd (Supra)

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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