Novations

April 13, 2006

	Visited: 125
	Not rated
	Rate:

Even though pre-formation contracts can result in one of the contract exceptions to limited liability, not all is lost.

It is possible for a creditor to actually release the owner from liability on a pre-formation contract, through an agreement termed a novation. Do not confuse the novation with the indemnification agreement, where the business makes itself liable for a contract in addition to an owner personally. In a novation, the creditor on the contact signs the release.

This is the key to the novation. Only the creditor, and not the owner's entity, can release the owner from liability. Think about it: Wouldn't it be nice if everyone could form an entity, which would then release him or her from liability on a home mortgage? Obviously, only the bank (i.e., the creditor) can release the homeowner from liability for a mortgage.

More specifically, the novation, signed by the creditor, releases the owner from liability and substitutes the entity in his place. Technically, a novation can take place only after the entity is formed. If there is a pre-formation contract, the owner can approach the creditor and request that the creditor sign a novation, releasing the owner from personal liability and substituting the entity in his place. However, with a newly formed entity that is not exactly overflowing with vulnerable assets, the owner should not usually expect a positive response.

Ultimately, the owner, in anticipation of forming his business entity, can insert a clause in a pre-formation contract wherein the creditor agrees to a novation upon the creation of the entity. Clearly, this is the approach that should be taken.

This may occur, for example, when the owner discovers an unusual bargain that he would like to capitalize on during the exploratory stage of his business formation. Once again, however, the creditor would have to be willing to sign off on this clause. In addition, if the entity, in fact, is not actually created, as sometimes happens with new businesses, the owner will retain personal liability on the contract.

Clearly, the best approach is to avoid a pre-formation contract, and thus the need for an indemnification agreement or a novation.

In one case, an individual, in anticipation of creating a corporation, signed a contract with a large accounting firm for $10,000 of accounting and tax services for the prospective business. Though the corporation was legally created only one month later, the owner had unlimited, personal liability on the contract, because the principal (i.e., the corporation) did not exist at the time the contract was formed.

In addition, the owner argued that he should have no personal liability because the accounting firm knew he intended to create the corporation. However, the court ruled against the owner, because he did not insert a novation clause in the pre-formation contract.