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Transferring supply chain contracts

If the assets of a company are taken over or the company merges with another, this will affect its legal identity. When this happens, any contracts which that company is a party to will need to be adjusted so that any rights and obligations it has will transfer to the new company.

This guide looks at some of the issues that can arise when transferring rights and obligations under a contract. For the purposes of this guide, we will assume that the contract's terms permit free assignment. If there are any prohibitions on transfer, these will need to be considered separately. For clarity, we shall refer to the new legal identity formed by acquisition or merger as Newco.

Assignment

The existing company could simply seek to assign the relevant contracts to Newco, assuming that it has this right under its terms and conditions. However under English law an assignment will only transfer the existing company's rights, or benefit, under the contract - for example, the right to receive payment. The obligations, or burden, under the contract will not transfer and will remain with the existing company.

This is often dealt with in one of two ways:

  • where the risk for the outgoing party is mainly a financial risk in relation to any claim brought for non-performance, then it could seek an indemnity from the incoming party against any breach or failure to perform while retaining the obligations; or
  • the existing company could subcontract performance to Newco. This essentially means that the existing company transfers the obligation to perform through a subcontract, but the existing company retains the ultimate responsibility for the obligations.

Novation

An alternative to assignment is a novation. Novating the contracts would transfer the existing company's rights and obligations under each contract to Newco. Strictly speaking, the original rights and obligations are not transferred. The novation will extinguish one contract and replace it with another, under which Newco takes up rights and obligations duplicating those undertaken by the existing company in the original contract.

The parties to the original contract - that is, the existing company and its customer - and the incoming party, Newco, must all consent to the novation for it to validly transfer both the rights and obligations to Newco. This distinguishes a novation from an assignment.

A customer may be reluctant to consent to a novation. It may prefer to be able to pursue the existing company in the event of default, particularly if it perceives (rightly or wrongly) that Newco is an unknown entity with fewer financial resources.

Novation agreement: a novation agreement, or letter, signed by all three parties is the most complete approach. Obviously this is a relatively cumbersome and costly approach as the existing company would have to send out agreements to all its customers. There is also the risk that:

  • customers will not accept or sign the novation;
  • customers will want to negotiate the terms of the novation agreement; and/or
  • customers will want to renegotiate the terms of the original agreement.

If the customer does not sign and return the novation agreement, it may still be possible to establish novation if consent can be inferred from the customer's conduct. For example, consent may be inferred if the customer consistently deals with Newco in place of the existing company over a reasonable period of time. What a court would deem a 'reasonable period of time' is, however, unclear so there would be a risk that the contract had not been transferred.

Deemed acknowledgement of transfer: a novation does not need to take the form of a written agreement. In principle, a novation could occur if Newco writes to customers to tell them that it has taken over the existing company's contracts and that their contract has been transferred to Newco. Provided that they clearly identify the contract in question and the intention to transfer it to Newco, and that the customer acknowledges the communication by starting to deal with Newco, the customer's action could be taken as agreement to the novation. However, there is a risk that a court could decide that the lack of written consent could mean that the novation - and therefore the complete transfer of the contract - is ineffective.

No consent – option to terminate: if the customer does not consent to the novation, the existing company may have the option to terminate the contract. This would be dependant on the terms of each individual contract.

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