If you were to ask a number of people whether a particular covenant in a contract was a financial covenant, you might get a wide variety of answers. Some might say that only the covenants that required the borrower to comply with financial ratios or metrics were financial covenants. Others might expand this to refer also to covenants that gave the borrower exceptions measured by monetary amount to general prohibitions against the payment of dividends, the incurrence of indebtedness or the making of acquisitions or other investments. Others might have different answers.
In GDI, LLC, et al. v. Cole Taylor Bank, N.A.,1 an Illinois appellate court was asked to determine whether the borrower's failure to make a required principal payment under a loan agreement constituted a breach of a financial covenant under such loan agreement. The court held that such failure was not such a breach.
Background
In 2008, GDI and Cole Taylor Bank executed an amended and restated loan and security agreement. This agreement provided for a secured line of credit where availability was subject to a borrowing base consisting of accounts receivable and inventory.
GDI fell into financial difficulty. The loan agreement was amended to permit GDI to have an overadvance of $1,000,000 until March 31, 2009. GDI did not repay the overadvance on such day; on the same day it also failed to meet its payroll. On April 2, 2009, GDI informed the bank that it had stopped operating. On April 3, 2009, the bank sent a notice to GDI that GDI was in default; that notice referred only to the failure to repay the overadvance.
Among the events of default listed in the loan agreement were (i) an event of default for nonpayment of amounts owing to the bank under the loan agreement, which was subject to a five day cure period (the "Payment Default"), and (ii) an event of default for nonperformance of "any of the . . . financial covenants" in the loan agreement, which was not subject to any cure period (the "Financial Covenant Default"). The Financial Covenant Default listed some specific sections of the loan agreement as examples of what would be considered "financial covenants," but the loan agreement did not further define what a "financial covenant" was. Importantly, the section of the loan agreement that imposed the requirement to repay the overadvance was not specifically listed as a "financial covenant" in the text of the Financial Covenant Default.
After sending the notice of default (but apparently before five days had lapsed since the repayment of the overadvance was due), the bank accelerated and commenced exercising remedies against its collateral, including imposing a freeze on GDI's bank accounts, instructing GDI's account debtors to pay the bank directly and attempting to dispose of the inventory. GDI sued, claiming that the bank had not given GDI the benefit of the cure period applicable to the Payment Default prior to exercising remedies. The bank argued that the obligation to repay the overadvance was a "financial covenant" not subject to a cure period. The trial court agreed with this analysis.
The appellate court disagreed that the covenant to repay the overadvance was a financial covenant, but held that other events – including the cessation of GDI's operations and the failure to make payroll-- constituted a separate event of default that justified the bank's actions, even though such events were not specified by the bank in its notice of default, and even though such events had not been relied upon by the trial court.
Analysis
In general, a lender needs to have an actual matured default before it can exercise remedies. If it acts before it has such a default, it risks liability for wrongful action, including the potential for damages under Section 9-625 of the Uniform Commercial Code.2
The appellate court found that the term "financial covenant" as used in the Financial Covenant Default was "[a]t best . . . ambiguous." The court undertook what it referred to as a "survey of case law and commercial lending industry resources" from which it concluded that "[f]inancial covenants are, in general, not affirmative obligations to make payments, but instead 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."
The court noted that the Payment Default was "a separate default provision for failing to timely make payments." While the court did not say so expressly in its analysis, it is a fundamental principle of contract interpretation that a specific term should be given greater weight than general language,3 and here the Payment Default provision, which clearly covered all payment defaults, was more specifically applicable to the failure to repay the overadvance than the Financial Covenant Default provision (which, if it applied at all, only did so in a general sense).
Although the trial court had based its decision on its conclusion that there had been a breach of a financial covenant, the appellate court held that it could affirm the trial court's ruling "for any reason supported by the record, regardless of whether the trial court relied upon that basis."4 The appellate court found that the record showed that GDI's failure to meet payroll and cessation of operations constituted an "incontrovertible event of default."
The loan agreement had a separate event of default if GDI failed to pay, or admitted in writing its failure to pay, its "debts as they come due." This separate event of default apparently was not subject to a cure period. The appellate court cited the failure to make payroll as a failure to pay a debt that was due. The court also stated that the failure to repay the overadvance as "another example" of GDI's failure to pay its debts.5
Debt instruments often contain an event of default for failure to pay debts generally as they become due.6 The language in the loan agreement here did not appear to have contained the word "generally." However, the language could be read, in a manner adverse to the bank, to mean that the provision would only be triggered upon GDI's failure to pay all of its debts, not just its debts generally. The court's opinion does not contain much analysis of whether the debtor was not paying its debts, other than a conclusory statement that the failure to make payroll and the failure to repay the overadvance satisfied the standard set by the default.
The loan agreement also contained an event of default if GDI breached a covenant to give the bank prompt written notice of a material adverse change. The bank alleged that GDI had breached this obligation despite GDI's notice to the bank that it had stopped operating. The appellate court's opinion contains no reference to whether the loan agreement contained an event of default based on the occurrence of a material adverse change or a provision allowing the bank to accelerate if it deemed itself insecure. However, the court concluded that the cessation of operations and the failure to pay debts constituted an event of default.
The appellate court also expressed its view that payment default was inevitable, even if GDI had been given the benefit of the cure period, due to GDI lacking the capital necessary to meet its obligations and continue its operations. The court noted that, while not "outcome determinative," GDI had not argued that it could have cured the default and that "the events that followed confirmed that GDI could not have performed." Since the court had concluded that a default existed other than the Payment Default, for it to suggest that the cure period did not have practical importance was unnecessary.
Final Observations
The appellate court's determination that the failure to timely repay the overadvance was not a "financial covenant" was correct. Such failure was more specifically covered by the text of the Payment Default, and as such the cure period applicable to that type of default was applicable here. In a case such as this, a lender should not expect a court to bless an interpretation of the loan agreement that would effectively result in the loss of a cure period negotiated with respect to an event of default that is specifically applicable to failures to make payment on the grounds that such failures are also covered by a more general default that has no cure period. Lenders should also avoid using phrases that have no commonly understood meaning in their loan documents, particularly in provisions as important as the events of default.
The term "financial covenant" does not have a commonly understood meaning. Although the bank ultimately prevailed in this case, it might have been able to avoid litigation if it had not used that term in the Financial Covenant Default, and instead specified clearly those breaches of covenants that were subject to a cure period, and those that were not.
The court may have bailed out the bank in its determination that the trial court record supported the "incontrovertible" conclusion that a separate event of default existed. The court's analysis on this point is rather cursory. The opinion contains no analysis of whether the payment failures that did exist were material (even though one might reasonably expect them to have been, given the borrower's situation).7
In general, the content of the events of default in a loan agreement –including which events are to be defaults and whether any cure period applies to a particular default-- are a matter of contract between the borrower and the lender.8 Lenders should make sure that the language in their loan agreements relating to events of default is drafted as clearly as possible. Otherwise, their ability to enforce their rights may be compromised, particularly in the event that they wish to act quickly in a deteriorating situation, as was the case here. In this case, if the bank wanted no cure period to apply to the requirement to repay the overadvance, it would have been better if the loan agreement had said so expressly.
Footnotes
1 2015 IL App (1st) 132310-U (Ill. App. 1st Dist. June 9, 2015). The GDI decision was filed under Illinois Supreme Court Rule 23, which means that the decision may not be cited as precedent except in very limited circumstances.
2 See Margolin v. Franklin, 132 Ill. App. 2d 527 (Ill. App. 1971). Section 9-625(a) of the Uniform Commercial Code also expressly contemplates the possibility of injunctive relief if the secured party does not comply with Article 9.
3 See Restatement (Second) Contracts §203(c); Alberto–Culver Co. v. Aon Corp., 812 N.E.2d 369 (Ill. App. 2004); Faith v. Martoccio, 316 N.E.2d 164 (Ill. App.. 1974).
4 Nichols v. City of Chicago Heights, 2015 IL App (1st) 122994 (Ill. App. 1st Dist. April 30, 2015).
5 There is an argument that the court's inclusion of the loan agreement debt within this provision's general reference to "debts" violates the principle of contractual interpretation cited above in that the Payment Default includes a failure to make the overadvance payment more specifically than this provision's general reference. We believe that in an appropriate case nonpayment of debt to the lender may be included in a determination of whether the debtor is paying its debts generally (even if the nonpayment of the lender's debt is separately covered by a payment default), but the case may be more difficult to make if, for example, the only debt owed was to the lender.
6 There do not seem to be many cases that have construed this language in the context of an event of default under a loan agreement. This language, with the "generally" included, is similar to language in Section 303(h)(1) of the Bankruptcy Code, which relates to when a bankruptcy court is to issue an order for relief in an involuntary case, as well as to language defining whether a debtor is "insolvent' in Section 2(b) of the Uniform Fraudulent Transfer Act and in Section 1-201(a)(23) of the Uniform Commercial Code. In cases examining Section 303(h), courts have looked to several factors. In some cases, courts have found that the nonpayment of a single, material debt could be enough to satisfy the requirement. Whether a debtor that is a business entity has terminated business may also be a factor. See generally 73 A.L.R. Fed. 763; 8A C.J.S. Bankruptcy § 383.
Official Comment 2 to Section 2(b) of the Uniform Fraudulent Transfer Act states:
In determining whether a debtor is paying its debts generally as they become due, the court should look at more than the amount and due dates of the indebtedness. The court should also take into account such factors as the number of the debtor's debts, the proportion of those debts not being paid, the duration of the nonpayment, and the existence of bona fide disputes or other special circumstances alleged to constitute an explanation for the stoppage of payments. The court's determination may be affected by a consideration of the debtor's payment practices prior to the period of alleged nonpayment and the payment practices of the trade or industry in which the debtor is engaged. The case law that has developed under §303(h)(1) of the Bankruptcy Code has not required a showing that a debtor has failed or refused to pay a majority in number and amount of his or her debts in order to prove general nonpayment of debts as they become due. [citations omitted].
7 As noted above, there is an argument that as a matter of contract interpretation the nonpayment of the overadvance should have been disregarded for this purpose.
8 For example, in setting forth the rights of a secured party that may be exercised after default, Article 9 of the Uniform Commercial Code does not specify when a default arises, leaving that for the debtor and secured party to negotiate. See Official Comment 3 to UCC §9-601 (" . . . [T]his Article leaves to the agreement of the parties the circumstances giving rise to a default.")
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