Tuesday, March 2, 2010

Novation of Contract

‘P’ Co. Ltd. is a company registered under the Companies Act, 1956. It intends to take over the business of a ‘Partnership Firm’, including its liabilities. The partners of the firm are positive to the idea. The liabilities of the firm also include a loan from Bank.

In this connection, the following Issues arise for consideration:

1. Must the Bank’s consent be obtained to effectuate the transfer of the firm’s business to ‘P’ Co. Ltd.?

2. Whether the Bank is required to enter into a fresh agreement with ‘P’ Co. Ltd.?

3. Is the transfer liable to stamp duty?

“Novation” is defined by the Black’s Law Dictionary, 8th Edn., 2004 as “The act of substituting for an old obligation a new one that either replaces an existing obligation with a new obligation or replaces an original party with a new party.”

In Wharton’s Law Lexicon, 15th Edition, 2009 at p.1174, the meaning of the term ‘Novation’ is stated as “the substitution, with the creditor’s consent, of a new debtor for an old one.”

Section 62 of The Indian Contract Act, 1872 sets out the general parameters for novation. The Section reads in pertinent part as follows:

“Effect of novation, rescission and alteration of contract – If the parties to a contract agree to substitute a new contract for it, or to rescind or alter it, the original contract need not be performed.

Illustration:- (a) A owes money to B under a contract. It is agreed between A, B and C that B shall thenceforth accept C as his debtor, instead of A. The old debt of A to B is at an end, and a new debt from C to B has been contracted.”

It is to be noted that Section 62 speaks of substitution of a new debtor, creditor, contract, etc. in place of an old one. The essential feature of novation of contract is that when a contract is substituted the rights under the original contract are relinquished or replaced by the new contract. Illustration (a) to Section 62 indicates that one of the requisites of such novation is the agreement of all the parties to the new contract.

In every novation there are four essential requisites:

“(1) A previous valid obligation;

(2) the agreement of all the parties to the new contract;

(3) the extinguishment of old contract; and

(4) the validity of the new one.

A novation is new contractual relation. It is based upon a new contract by all the parties interested. See Advanced Law Lexicon, P. Ramanatha Aiyar, 3rd Edition, 2005 at pp. 3253-54.

State Bank of India v. T.R. Seethavarma, AIR 1995 Ker 31 at p. 34. is illustrative:

There, on dissolution of a firm its assets and liabilities were taken over by a third person. He paid part of the debt owed by the firm to a Bank and hypothecated assets with the bank. On filing of the suit by the bank against the firm and the third person for recovery of loan, it was held that in the absence of tripartite agreement between the parties, there was no novation of contract. The liability of the firm continued to exist.

In P.S. Atiyah’s An Introduction to the Law of Contract, 3rd Edition, 1981, at p. 283, it is stated as follows:

“The only way in which it is possible to transfer contractual duties to a third party is by the process of novation, which requires the consent of the other party to the contract. In fact novation really amounts to the extinction of the old obligation, and the creation of a new one, rather than to the transfer of the obligation from one person to another. Thus if B owes A $100, and C owes B the same amount, B cannot transfer to C the legal duty of paying his debt to A without A’s consent. But if A agrees to accept C as a debtor in place of B, and if C agrees to accept A as his creditor in place of B, the three parties may make a tripartite agreement to this effect, known as novation. The effect of this is to extinguish B’s liability to A and create a new liability on the part of C.”

The legal maxim that ‘novatio non praesumitur’ enunciates whether a novation needs to be in writing. The maxim means that “A Novation is not presumed”. See Trayner’s Latin Maxims 4th Edition at p. 403.

In Appukuta Panicker v. Anantha Chettiar, AIR 1996 Ker 303, the Kerala High Court held that it is essential for the principle of novation to apply that there must be mutual consent of all parties concerned.

In T.M. & Co. v. H.I. Trust, AIR 1969 Cal 238, the High Court of Calcutta observed that the liability can be transferred only by a tripartite agreement which will amount to novation.

In view of the above legal position, the consent of the Bank as also the execution of a tripartite agreement, between ‘P’ Co. Ltd., the partnership firm(its partners) and the Bank, is sine qua non in order for it to be a novation of contract.

Accordingly, Issue No.1 and Issue No.2 are addressed.

As regards the levy of stamp duty in respect of the aforesaid transfer of liability from partnership firm to ‘P’ Company Ltd., the law on the subject is as follows:

Sub-section (14) of Section 2 of the Indian Stamp Act, 1899, defines the term “Instrument” as under:

“Instrument” includes every document by which any right or liability is, or purports to be, created, transferred, limited, extended, extinguished or recorded.

A novation arises when a new individual assumes an obligation to pay that was incurred by the original party to the contract. As the same is given effect to by the substitution of a new contract for an old one and the new agreement extinguishes the rights and obligations that were in effect under the old agreement, it falls under the definition of the term “instrument” as defined under the Indian Stamp Act, 1899. A novation agreement is an ‘instrument’ under the Indian Stamp Act, 1899.  Whether such instrument is chargeable to stamp duty needs further analysis.

Section 3 of the Indian Stamp Act, 1899 sets out the instruments chargeable with duty. It provides in relevant part as follows:

“Subject to the provisions of this Act and the exemptions contained in Schedule I, the following instruments shall be chargeable with duty of the amount indicated in that Schedule as the proper duty therefor, respectively, that is to say— (a) every instrument mentioned in that Schedule which, not having been previously executed by any person, is executed in India on or after the first day of July, 1899."

Since in the above case, the novation agreement is being executed for the first time not having been executed previously, it squarely attracts the provisions as contained in Section 3 of the Indian Stamp Act, 1899. Substitution of a new contract is the core of novation. If the new contract suffers from legal flaw such as want of registration, stamps etc., on account of which it becomes unenforceable, the original contract will not be extinguished and there would be no novation. See Vishram Arjun v. Irukulla Shankaraiah, AIR 1957 AP 784 : 1958 (2) An.W.R. 259.

In view of the above stated legal position, it must be said that a novation agreement is an instrument liable to stamp duty under the Indian Stamp Act, 1899.

Accordingly, Issue No. 3 is addressed.
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  1. That's a pretty good write up!

  2. It is very good write up on NOVATION.
    -Mobin Sayed,Mumbai