If a borrower sells its business and the buyer agrees to assume the related indebtedness, does the lender of that indebtedness have to accept the buyer as its debtor in place of the original borrower? The answer is “yes” if there has been a “novation” created by the assumption of indebtedness, and that may be an unfavourable result for the lender. Fortunately for lenders, the threshold for proving novation is high, as confirmed in the recent judgment of the Supreme Court of British Columbia in Dore River.1
In that case, the defendant borrower sold its business to a buyer who agreed to assume the obligations for two loans owing to the plaintiff lender. There were discussions with the lender about agreeing to the assignment and assumption of the loans, but no final agreement was reached on that issue and no written agreement was entered into. The buyer made two small payments on the loans, but the loans then fell into arrears. One of the loans was paid out, and the lender sued its original borrower and a guarantor for payment of the remaining loan [Loan B]. The original borrower and guarantor defended the claim by alleging that there had been a novation of Loan B, such that the lender had accepted the buyer as its debtor in place of the original obligants. Thus, they claimed they were released from their covenants to pay Loan B.
The court, however, found on the facts that there was no novation, and the original borrower and guarantor remained liable to pay Loan B. A novation can occur if a lender expressly agrees to accept a new debtor in place of its original borrower. However, novation can also occur by other conduct of a lender if three conditions are met:
- the new debtor assumes the complete liability of the original borrower
- the lender accepts the new debtor as principal debtor, and not merely as an agent or a guarantor of the original borrower, and
- the lender accepts the new contract in full satisfaction and substitution for the old contract.
On the facts in Dore River, the court concluded that there was no express agreement to accept the new debtor, and there was insufficient evidence to support the borrower’s contention that the three conditions for proving novation were met. The judgment confirms that the threshold to establish that a novation has occurred is high, and it would be difficult for a lender to inadvertently agree to a novation, such that it would lose the covenant of its original borrower. Despite that, if a borrower is selling its business or assets and purports also to assign the related indebtedness, the affected lender should be aware of the danger that novation could occur (with the buyer replacing the original debtor), if the lender expressly agrees to that result in writing or the conditions for novation by conduct referred to above are met.
The circumstances surrounding the sale of a business and the assumption of indebtedness by the buyer may be such that a lender is willing to accept the buyer as its new debtor in place of the original debtor following a full review of all applicable financial reports and a consideration of other circumstances. However, a lender will always want to have control of that outcome. Newer is not necessarily better. It is simple math that two covenants are better than one, and in many cases retaining the covenant of the original debtor to supplement that of the new borrower is in the lender’s best interests.