If you have signed a contract for a loan, you may have come across a legal term—confession of judgment. While it may look like just another paragraph of the ‘fine print’, you should still know what this legal term is all about.
Every borrower should be able to make an informed decision.
What is a Confession of Judgment?
Per the Legal Information Institute, a confession of judgment is essentially a waiver of objections if you default on a debt. If it’s a business debt, the lender can seize assets. If you’ve provided a personal guarantee, the lender can also seize a debtor’s personal property.
It may require you to waive your right to defense at trial.
A confession of judgment is generally looked down upon by courts because it is often used in predatory lending practices.
In 1972, the United States Supreme Court affirmed a district court decision and ruled that a cognovit note is not unconstitutional and does not violate a defendant’s due process rights.
A cognovit note is a promissory note that waives the maker’s rights to a trial, hearing, and notice when signed.
The justices ruled that the debtor in the D.H. Overmyer v. Frick (405 U.S. 174, 1972) case received valuable consideration (payment) in exchange for that cognovit.
However, in commercial transactions with adhesion contracts, where bargaining power between parties is significantly uneven, they may be unconstitutional.
New York law only allows a confession of judgment against an out of state borrower. New York courts will throw out a COJ if executed against a New York borrower.
How Does it Work?
Assuming a confession of judgment provision is properly executed, it serves as an immediate judgment once filed in the courts. This is just like a court judgment or filing in civil procedure.
This allows a plaintiff to use all the tools for collection of judgment available as if a full trial had occurred. These include writs of execution, attachment of wages and assets, abstracts of judgment affecting title, etc.
A confessed judgment may contain a judgment provision that includes payment of attorneys fees or legal fees, seizure of property or a commercial lease, etc.
The creditor’s attorney will enter a judgment roll against the debtor or joint debtors (if applicable). At this time, the judgment debtor (the defendant) is obligated to pay the judgment and any damages.
A confession of judgment can also be used to secure the plaintiff against a contingent liability on behalf of the defendant. A contingent liability may occur, depending on the outcome of an upcoming event.
Few states allow a confession of judgment:
- Illinois
- Maryland
- Michigan
- Minnesota
- New Jersey
- Ohio
- Pennsylvania
- Texas
- Virginia
California requires a debtor to have an attorney look over the confession of judgment and offer legal advice before the document’s execution.
Should You Sign a Confession of Judgment?
While an entrepreneur may feel they must sign a confession of judgment, these contractual clauses are not enforceable in most states. Not signing one means a lender must take you to court if you default.
The lender would not have a confessed judgment to rely on. A petition to court costs more. In a cost-benefit analysis, if they believe your business is likely to default, it will not be worthwhile for them to lend you money.
Hence you can be locked out of some forms of business financing, like equipment loans.
A creditor may use a confession of judgment to minimize court costs and speed up the process. They may add it to a loan agreement to test whether a debtor will pay a loan back. A creditor who objects may lose out on the loan or business financing.
The more desperate a business owner is for money, the harder it is to avoid a confession of judgment clause—if it is legal. Desperate business owners who need money are less likely to be able to pay for an attorney to defend them in trial court.
They are even less likely to take a due process case to district court, or appeal it to a circuit court.
Confession of Judgment Example
A confession of judgment is often part of a merchant cash advance agreement. And a business owner seriously considering an MCA is likely to be desperate by definition.
With this combination, the entrepreneur is more likely to encounter a confession of judgment in a business loan agreement and be required to sign it. With few other options, the business owner is between a rock and a hard place.
In the current inflationary economy, as costs continue to soar, a business needs to hold onto as much of its profits as possible. But if it is beholden to paying back an MCA (and its accrued interest), it will drain its bank account, with less money for operations.
If the business raises prices, it could lose customers. If it doesn’t, it must hustle for more sales. It is a situation ripe for a default.
If the business defaults on the merchant cash advance, the confession of judgment kicks in. As a result, a plaintiff can seize assets. If the business loses vital equipment, it could have trouble meeting demand.
Then it would lose customers, no matter what it did with its pricing. If that happens enough times, the business will go under.
How Can a Confession of Judgment Affect Your Business Credit Score?
Since a confession judgment serves as the equivalent of a court case a business has lost, it becomes a public record. This means it will go on a Lexis/Nexis report. It will also end up on business credit reports.
As a result, both a defaulted debt and a confession judgment will show up on a report. This double whammy will hit a PAYDEX score and other business credit scores hard. This will have a cascading effect on a business’s fortunes.
Lowered scores close off means of obtaining business capital. If profits do not keep up, bankruptcy would be imminent.
In addition, many business owners float loans to their failing businesses. As the business continues losing money, there are certain fixed costs which cannot be deferred.
Cost-cutting measures could be layoffs, selling assets, or selling equity in the company. At some point, the company has no more to give. The business owner isn’t an infinite source of funds, either.
If things get really dire, the business owner will have problems paying their own bills, and thereby tank their personal credit. Since Experian includes personal credit in their business credit calculations, this brings business credit scores down even further.
