Commercial FinancePublications

Cognovit Provisions in Commercial Loan Documents: Enforceability Limited?

September 30, 2013Articles
A recent Ohio Court of Appeals decision sheds some light on the enforcement of confession of judgment (“cognovit”) provisions in commercial loan documents. These provisions remain enforceable in a few states, including Ohio.

A cognovit provision allows a lender to go to court and step into the shoes of its borrower upon a default on the loan and admit on the borrower’s behalf that the borrower breached the agreement. When a lender does this, it may not even tell its borrower that it has appeared in court on its behalf. The court may then enter a judgment against the borrower, which allows the lender to take action — backed by the full power of the court — to recover the money owed to it. The borrower has only limited rights to appeal. The lender can do this because the borrower signed loan documents with a confession of judgment provision.

Lenders and borrowers alike often struggle with whether these provisions are acceptable in a commercial finance transaction. Ohio’s Third District Court of Appeals recently illustrated the importance of understanding the effect of a confession of judgment provision in a loan document in Henry County Bank v. Stimmels, Inc., 2013-Ohio-1607 (2013).

The Henry County Bank opinion reinforces the validity of a cognovit judgment, but it also limits its reach to payment defaults. Henry County Bank’s borrower, Stimmels, Inc., had made its loan payments on time but the Bank believed there were defaults under financial covenants contained in the loan documents. The bank sued the borrower for default, and that same day the bank’s attorney appeared in court to answer on behalf of the borrower that it had defaulted. The court entered judgment against the borrower. Once Stimmels, Inc. learned of the judgment against it, the borrower sought to have the court vacate the order against it. The trial court denied that motion, but the appeals court overturned the trial court’s decision. The appeals court found that because the borrower had not missed any payments, confession of judgment had been improper.

Other Ohio courts have not yet weighed in, but the opinion of a state appellate court in a matter of first impression is usually influential with other courts. The court based its opinion on a warning the legislature has required in loan contracts with confession of judgment provisions. The warning (which must be included in a distinctive way – usually boxed in all capital letters) tells borrowers, “If you do not pay on time, a court judgment may be taken against you without your prior knowledge …” The court reasoned that because the warning does not mention any other potential events of default with the same consequences, the legislature meant for lenders to be able to confess judgment on behalf of borrowers only if the borrower had not paid on time.

This opinion has lessons for everyone involved in commercial loan transactions. For borrowers, it serves as a reminder that if they sign a loan document with a cognovit provision in it, and if they default, their lenders can go to court in their name, and obtain a legally enforceable judgment against their assets. For lenders, it establishes a limitation on the availability of the cognovit judgment process. A non-payment default (such as a failure to meet covenants or requirements of the loan documents) will not be sufficient to allow the entry of a cognovit judgment. For non-payment defaults, a lender should pursue traditional judicial remedies.

While it’s possible that future court decisions may limit the Henry County Bank decision to loan documents containing identical cognovit language, we believe Henry County will have a broader effect. It indicates a trend towards more limited use (and enforceability) of these provisions.

Knowing how a confession of judgment clause will be enforced enables both parties to a loan to make better decisions. When in doubt, consult an experienced commercial finance attorney, who can help you determine the importance of confession of judgment provisions in your loan documents.