Knowledge Center

Wednesday, June 10, 2015

Illinois Appellate Court Defines "Financial Covenant" for the First Time

HMB convinced the appellate court to affirm the trial court judgments without need for oral argument

June 9, 2015

In the recent, unpublished, Illinois Appellate court decision, GDI v. Cole Taylor Bank, the Court defined the term "financial covenant" when it is not defined in the agreement between a lender and borrower. While the Court conceded that the term does not lend itself to an easy, rigid definition, it said that financial covenants can be negative or affirmative provisions that "concern certain reporting obligations used to measure the financial state of a company." Financial covenants are not monetary or expense covenants for which sums are due, nor do they require an obligation to make payments. However, they do require the borrower to do or not to do certain things that would increase the risk borne by the lender or jeopardize the borrower's financial security.  A negative financial covenant may prohibit the borrower from incurring more debt. An affirmative financial covenant may require maintaining a minimum amount of net worth.

In GDI v. Cole Taylor Bank, GDI overadvanced on a loan by a significant amount, which was prohibited by the loan agreement. The bank declared GDI in default for its failure to reduce the overadvance to $0.00, and the parties disputed whether GDI was entitled to a cure period.

The loan agreement also provided that any breach of a covenant would result in a default. However, it did not articulate whether a failure to pay an overadvance would be considered a breach of a "financial covenant," for which there was no cure period. The loan agreement did state financial covenants concern maintaining certain leverage and coverage ratios and other financial vitality benchmarks. The Court found that GDI's failure to pay the overadvance did not fall within the definition of a breach of a "financial covenant," nor did it fall within the "financial covenant" section of the agreement. Thus, GDI was not in default for a breach of a financial covenant.

However, prior to being declared in default, GDI ceased operations, terminated all but three of its fifty-six employees, did not meet payroll obligations, and admitted a failure to satisfy its financial obligations. The Court found these events justified the bank's declaring GDI in default even though these events were not cited as the bases for default in the bank's default notice to the borrower.

GDI, though unpublished at this time, is a reminder that loan agreements should define financial covenants. Default provisions should likewise be clear, including as to the notice and cure provisions the parties intend should apply, in order for the appropriate notice and cure provisions to be enforced.

 

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