Novation by conduct - Use it or lose it

This article is written by our business partners at Ashfords Solicitors

Written terms of a contract can be overridden by subsequent conduct.

The recent case of Rolls-Royce Holdings plc v Goodrich Corp demonstrates that conduct inconsistent with the express terms of a contract can override those written terms. In this case the court had to decide whether a contract had been effectively novated by conduct.

This article explains the definition of novation and explores this case in detail.

What is novation?

Novation is the process by which one party to a contract (A) is discharged and replaced by a new party (B) who takes on A’s rights and obligations with the other existing party (C). The consent of all three parties is a key requirement for an effective novation and this can either be provided expressly in a written contract or inferred from conduct.

Background of the Rolls-Royce Holdings plc v Goodrich Corp case

Rolls-Royce Group plc and Goodrich entered into an option agreement that gave RR Group the right to buy out part of the Goodrich operations in specified circumstances. The option agreement had a no oral modification clause, which said that neither party could transfer rights or obligations without the prior written consent of the other party.

A few years later, RR Group and another group company, RR Holdings, executed a share transfer. RR Group became directors of RR Holdings, and the two companies agreed between themselves that RR Holdings took the benefit of the option agreement. No novation was executed with Goodrich, nor did RR Group give written notice to Goodrich as required by the no oral modification clause, so there was no written consent from Goodrich.

Over the years, Goodrich appeared to accept that RR Holdings had effectively taken over RR Group’s role as party to the option agreement. Eventually, RR Holdings served a notice exercising the option. Goodrich challenged the call, relying on the no oral modification clause, claiming that only RR Group could validly exercise the option under their agreement. RR Holdings responded by claiming novation by conduct.

The judgment

The judge concluded there was a novation by conduct, RR Holdings’ service of its call option notice was valid. Foxton J said the test for novation by conduct is whether an inference is necessary to provide a lawful explanation or basis for the parties’ conduct. The test is objective. On the evidence it was ‘perfectly clear’ that Goodrich and RR Holdings had conducted themselves over many years on the basis that RR Holdings and not RR Group was party to the option agreement. There was no other explanation for the parties’ conduct other than novation.

Goodrich argued that the no oral modification clause prevented novation by conduct, relying on the Supreme Court decision in MWB Business Exchange Centres Ltd v Rock Advertising [2019] AC 119. The Supreme Court said that no oral modification clauses are designed to protect the original agreement and promote certainty if later changes are agreed: ‘the law should and does give effect to a contractual provision requiring specified formalities to be observed for a variation’.

Despite that, Foxton J held that the evidence supporting a tripartite consensual arrangement between RR Group, RR Holdings and Goodrich was clear and the necessary consents could be found in the various documents and contractual arrangements entered into over the course of many years by the three parties.

What can we take away from this?

Over the years Goodrich had the opportunity to protest at RR Holdings acting like a novated contracting party, but acquiesced. The case serves as a warning to contracting parties - if contract protections are to be effective, they must be asserted, or they could be overridden.