CHAPTER 4.09. Novation

• Jurisdiction: United States

4.09. Novation

When entering into an amendment to a loan document, especially when that amendment also restates the amended document, one issue to be kept in mind is whether the parties intend the new document to operate as a novation of the original document being amended and restated. Although there may be circumstances under which novation is desirable and intended, usually the parties do not intend a novation, but rather that the original contract apply with respect to the time period during which the original contract was operative, with the amended and restated terms applying to the period during which the amended and restated contract is in force. An aspect of this issue that is of particular interest arises if the original agreement granted a security interest in the debtor's collateral. If the amended and restated agreement effects a novation and therefore the creation of a new security interest, this can have important implications for the priority of the secured creditor's security interest.

Delaware law is straightforward when it comes to novations. A novation requires four elements: (i) a valid pre-existing contract, (ii) a valid new contract, (iii) extinguishment of the old contract, and (iv) the consent of all parties to the novation transaction.¹²⁹ As can be seen by those four elements, generally a novation will only be found by a court in circumstances where it is clear that the parties have intended novation to occur. Although a novation can be implied from circumstances, there is a presumption against novation and therefore the burden is on proving that a novation has occurred.¹³⁰ In Berg v. Liberty Federal, for example, a borrower claimed that the mortgage lender suing on the note could not enforce the note against that original borrower because the borrower had transferred, and a third party had assumed, the original note. Among other arguments, the original borrower apparently claimed as a defense that the assignment and assumption, coupled with the mortgage lender's acceptance of the assignee's payments on the mortgage loan, resulted in a novation of the original note. The Delaware Supreme Court disagreed, holding that a mere debt assumption and the lender's acceptance of payments from that assuming party were not sufficient to establish a novation that would relieve the original borrower from liability under that note.¹³¹

A case from the Sixth Circuit Court of Appeals, In re Fair Finance Company,¹³² is illustrative of the need to...