‘Novation by conduct’ opens up contractual dispute

Factual background

Musst Holdings Limited (Musst) entered into an Introduction Agreement with an investment fund manager, known as Octave Investment Management Limited (Octave), in which Musst introduced potential investors in exchange for a fee percentage from Octave.

At the time this agreement was entered into, it was understood that the arrangement would eventually be with Astra Asset Management UK Ltd (Astra), rather than Octave, who was undergoing regulatory approval. In time Octave’s employees and clients were transferred to Astra. Musst began to address their invoices to Astra, but did not receive payment in return. No contractual arrangement was in place between Astra and Musst, which gave rise to the question of whether novation by conduct took place.

Novation by conduct

Novation is the termination of one contract and the creation of a new one, with one outgoing party replaced with a new incoming party. It involves the entire or partial (as applicable) transfer of obligations and rights to the new incoming party. In the circumstances, this would include Astra’s obligation to pay Musst in exchange for the right to receive introductions of potential investors.

Referring to earlier case law, it was noted that novation requires the consent of all parties (i.e. the outgoing, incoming and remaining party). Such consent can either be provided expressly (such as by a written agreement) or inferred by conduct.

Deciding whether novation can be inferred by conduct is a question of fact. It had previously been decided that transferring funds from one party to another was sufficient to amount to a novation by conduct. The court determined that the commercial relationship between Musst and Astra started when Musst began addressing invoices to Astra.

However, business efficacy is also required to infer novation by conduct. This means that there must be a lawful explanation or basis for the parties’ conduct. In this case, it was clear that there was a clear intention to novate, on the understanding that Octave was only being used while Astra obtained the regulatory approvals and this transfer was anticipated at the beginning of Musst’s and Octave’s agreement.

Failings of contractual safeguards

What is interesting in this case was that there were two types of contractual clauses that were held to be insufficient to prevent a novation by conduct:

1. Requirement for prior written consent

The contract had an explicit requirement that neither party had the right to assign transfer or deal in any other manner with its rights and obligations under the contract without the prior written consent of the other party. However, the court decided that this was insufficient to prevent a novation by conduct and “…it was clearly open to Musst to waive the requirement for prior consent after that dealing occurred.”

2. No oral modification (“NOM”) clause

A NOM clause was included which provided that any “variation” of the agreement ineffective unless it was in writing and signed by the parties. The court concluded that this did not apply to the novation by conduct as “a novation is not a varied contract”.  With a variation, the original contract remains in place, whereas “in contrast, a novation is the replacement of a contract by a new contract between different parties”.

Learning points

There are other contractual protections that may be sought. Careful consideration should be given to any clause that requires prior written consent and/or NOM clauses, to ensure that they capture the specific circumstances they are intended to apply to and achieve the protections sought. Parties may be interested in including a specific “non-waiver” clause so that if they do not enforce strict compliance with the contract they are not deemed to have waived the rights or obligations of the other party. However, as this case demonstrates, the most effective protection is to adhere to the contract to minimise the potential for disputes.

Written by Gemma Irving.