(Published in the Summer 2019 edition of The Bankers’ Statement)
Ohio lenders often include cognovits, or confessions of judgment, in promissory notes, guarantees, and other loan instruments. These provisions provide lenders with an efficient, expedited, and inexpensive process to begin debt collection efforts against borrowers in the event of a commercial loan default. While its validity is ingrained in both Ohio and jurisdiction in Ohio and elsewhere (and for decades), critics occasionally denounce cognovits as unfair and contrary to due process, and efforts have been made to change the usage, eliminate or even criminalize cognovits. From a political perspective, while the benefits of cognovits to lenders are obvious, borrowers and third-party stakeholders are also realizing certain benefits. While the Cognovit process has some inherent challenges, it remains a critical driver of both an accessible banking industry and a resilient economy in Ohio.
Known Ohio Law procedure
A Cognovit is a written authorization from a borrower that recognizes the borrower’s liability and authorizes the entry of a judgment against the borrower (without notice or opportunity to be heard) in the event of default. Importantly, Ohio only allows Cognovits related commercial loansinstead of consumer credit (ie debt incurred primarily for personal, family, educational, or household purposes). In order for a Cognovit to be enforceable in Ohio, a lender must ensure that the debt instrument complies with the legal requirements of ORC Section 2323.13.
According to ORC § 2323.13, the debt instrument must state the following warning language in a prominent manner “in such a font size or marking that it appears more clearly and conspicuously than anything else on the document”:
“Warning – By signing this paper you are giving up your right to notice and trial. If you fail to pay on time, you may have been judged by a court without your prior knowledge and the powers of a court may be used to collect from you, regardless of any claims you may have against the creditor, be it for returned goods , defective goods, failure by him or any other reason to comply with the agreement. “1
In addition, immediately before or after the warning, a borrower must issue a “power of attorney” authorizing an attorney appointed by the lender to give judgment on behalf of the borrower in the event of default.
After the parties execute the debt instrument, the lender holds the debt instrument until the borrower repays it or defaults. In the event of a default, the lender may use the Cognovit provisions of the debt security to commence an expedited process to obtain judgment. Assuming that jurisdiction is established, the court will issue a Cognovit judgment if the debt instrument is properly executed in accordance with ORC § 2323.13, which enables the lender to seek all available legal remedies against the defendant debtor without the burden of full proceedings.
Benefits for Lenders, Borrowers, and Third Party Stakeholders
For lenders, the main benefits of Cognovits are speed and risk reduction. Cognovits provide lenders instant access to the courts and debtor’s assets in the event of default. Lenders can quickly get started with the collection efforts to avoid time delays and legal overload. Delays and legal overload can, and often will, adversely affect a lender’s ability to maximize the collection of the underlying debt. The Cognovit process reduces collection time, costs, and most importantly, the likelihood that critical assets of the borrower will dissolve before recovery can occur. This expedited process results in increased collection rates and an important leverage for lenders. In general, Cognovits help mitigate risks and lower the transaction costs associated with commercial loans.
As a result, borrowers and communities will have improved access to credit. Without realizing the benefits of Cognovits, lenders would be forced to tighten their lending standards significantly. Across the industry, lenders would be making fewer, less large loans and raising interest rates to reflect increased risk and higher collection costs. Riskier borrowers may not be able to qualify for a loan at all without the lender’s Cognovit safety net. For those borrowers who qualify, lenders may require additional guarantees or forms of security. The increased risk for lenders directly correlates with increased costs for borrowers. As a result, lenders in Ohio with the ability to apply Cognovit regulations can offer borrowers more favorable terms than in other countries that do not have Cognovit options. The use of Cognovit regulations makes the banking sector much more accessible to commercial borrowers and communities, opening up important growth opportunities and improved job opportunities in construction, manufacturing, and a host of other industries.
Various third-party stakeholders are also realizing the benefits of Cognovits. Cognovits provide banking regulators, accountants and auditors with added collection convenience when assessing credit quality. As mentioned earlier, the Cognovit process supports the collection efforts for commercial loans. Eliminating Cognovits would both increase the risk profile of commercial loans and hinder key collection efforts, resulting in loss performance and a reduction in collection rates. Ultimately, eliminating cognovits would hurt the bottom line of lenders and not maximize shareholder value. In addition, since commercial loans are made up of depositors ‘money, deposits are safer as lenders’ collection rates increase. Cognovits thus protect bank assets for the benefit of both shareholders and depositors, as well as borrowers and the communities in which they operate.
Challenges for Borrowers
The benefits of Cognovits are obvious, but they present certain challenges for commercial borrowers. For example, a borrower incurs costs to ensure that the terms of a debt security are met. During the life of a loan, borrowers must continuously monitor the projects funded by the loan to ensure that they are complying with the underlying loan terms. Even non-monetary defaults can have serious consequences and are often caused by a borrower’s oversight or even a mistake. In addition, borrowers must keep an ongoing line of communication open with their lender.
While Cognovits support lenders in the critical collection process, several constituencies also benefit from their advantages. These benefits include both borrowers and communities affected by economic expansion – an expansion made possible by improved access to credit. The increased accessibility of credit is due in large part to the fact that lenders rely on the protection offered by the Cognovit provisions contained in commercial credit agreements. Therefore, Ohio’s longstanding Cognovit laws continue to facilitate and not hinder the funding of qualifying projects, but rather promote economic development and job growth in the Ohio communities. As a result, Cognovits are and continue to be critical to access to credit in the Ohio banking environment.