The novation of a construction contract to new owners of works is commonplace. The result of a novation is that the original contract is discharged and a new contract is created. And commonly, such novations are effected through pro forma or standard form novation deeds which do no more than simply provide for the change in parties.
This practice raises an interesting issue regarding the enforceability of liquidated damages which may be payable by the Contractor under the novated contract. It is well established that, in order to be enforceable, liquidated damages must be a genuine pre-estimate of the loss that the owner will suffer should the promises made by the Contractor not be kept (although recent High Court authority suggests that this test might be wider than previously thought). Liquidated damages usually apply in respect of delays in completion, but can also apply to shortcomings in the performance of the Works, say for instance, in respect of an industrial plant which fails to operate as required. But relevantly to this discussion, the time when the validity of liquidated damages is assessed is at the date the contract was entered into – not when the applicable breach occurred.
Because the effect of a novation is the creation of a new contract, the date for assessing liquidated damages’ validity moves from the date of the original contract to the date of the new contract – the date of novation. This means that the parties are likely to be required to re-assess liquidated damages as of this date, an exercise which also means that the assessment must be conducted through the eyes of the new owner – an entity which may have a totally different loss profile from the original owner.
This position is supported by comments by Owen J in Westpac Banking Corporation v Australian Shipbuilding Industries Pty Ltd (Unreported, Supreme Court of Western Australia, Owen J, 25 September 1996):
“[The arbitrators] held… that there was a novation as a result of which a new Shipbuilding Agreement (solely between Westpac and ASI) came into force on 4 October 1989... It follows (as I have already said) that the date at which the circumstances from which the calculation of possible loss and damage flowing from a breach must be examined is 4 October 1989.”
The risk, therefore, is that if the genuine pre-estimation exercise is not conducted afresh at the time of novation, the liquidated damages may be declared void as a penalty. When a cookie-cutter novation deed is used for this purpose, there is a real risk of this being overlooked. As a result, it is important to consider any liquidated damages provisions prior to giving effect to a novation and, if necessary, adjust the liquidated damages amount to reflect the loss which the owner will suffer if the Contractor’s obligations are not met. Failure to do so creates a real risk that liquated damages provision may be considered to be a penalty, and be unenforceable.
It is also relevant to consider whether you really need a novation to achieve your desired outcome. Instead of a novation, a simple assignment of rights under the construction contract may be sufficient to provide the protections that the new owner needs. An assignment does not operate to create a new contract, and therefore does not give rise to the issue discussed above. The key issue is to adopt a structure that best meets your needs and in doing so, be sure to investigate whether that structure could potentially result in loss or reduction of important contractual remedies.