When you obtain a small business loan, you will need to sign a loan agreement with the lender. Like most contracts, loan agreements can be long and difficult to understand for a layperson. One of the clauses in your loan agreement—one that could significantly impact your business’s future—could be a confession of judgment.
A confession of judgment gives your lender the power to obtain a judgment against you in the event that you default on the loan, without notifying you or following usual court procedures. You can end up losing your business if the lender decides to enforce a confession of judgment.
Although confessions of judgment have been around for decades, most small business owners don’t know how powerful they can be. Confessions of judgment can seriously limit your rights, so it’s important to understand exactly how they work and what you can do if one is used against you.
A confession of judgment is a clause within a loan agreement that allows a lender—if the borrower defaults on the loan—to obtain a judgment against the borrower without following regular court procedures. The lender can use the signed confession to garnish the borrower’s bank account or seize assets. Confessions of judgment—also called a judgment by confession, confessed judgment note, or cognovit note—are most common in merchant cash advances and online loans.
You can think of a confession of judgment as a legal shortcut. The purpose behind confessions of judgment is to facilitate a quick resolution when borrowers default on a loan. Lenders used this legal tool frequently during the 2008 economic crisis. Unfortunately, confessions of judgment can also leave borrowers scrambling.
The process starts when the lender finds that you’re in default of your business loan agreement. Maybe you missed several payments or violated some other term of your contract, such as using loan funds for an unauthorized purpose. The lender will typically notify you in writing that you’re in default of the loan. Some loan agreements will give you a specific amount of time to cure the default. If you don’t remedy the situation in the specified time frame, the lender’s attorney can go to court to enforce the confession of judgment.
The specific way in which a confession of judgment works varies by state. However, signing a confession of judgment can mean:
As you can see, confessions of judgment seriously limit a borrower’s rights in the event of a default. You’re basically saying that you will automatically admit you broke the contract and that the penalty can be imposed on you without you even having the opportunity to explain your side of things.
Also, keep in mind that a confession of judgement may not be clearly labeled in your loan agreement. In some instances, the contract might simply say that the lender can debit your account, sell your assets, or declare the loan due without notice. A confession of judgment might also be included as part of a personal guarantee.
The good news is that many states either prohibit or restrict confessions of judgment. And not all business loans contain confession of judgment clauses. A borrower can also file petitions and motions to attempt to hold off the confession of judgment from being enacted.
Confessions of judgment are only permissible in some states, so depending on where your business is located, you might never have to deal with this burdensome legal tool. Plus, confessions of judgment are more popular with certain kinds of loans than others. They are also more common with financing that’s geared toward or available to borrowers with lower credit scores.
The following types of business loans often include confessions of judgment in states where they are legal:
In each of these cases, you get fast, relatively easy access to capital, making them good options for startups and borrowers with lower credit scores. But, lenders limit their own risks by charging high interest rates and sometimes including confessions of judgment.
It’s also worth noting that while your original loan agreement might not contain a confession of judgment, one could come up later. For instance, let’s say you have a delinquent loan and negotiate a payment plan with the lender. As a condition of the payment plan, the lender might ask you to sign a confession of judgment. If you can’t pay your loan on time in this case, contact your lender right away or hire a business attorney to review your loan agreement.
When you’re shopping around for a business loan, it can be tempting to go with your very first offer, feeling like you can handle any issues later. But you should carefully evaluate the risks of signing a loan agreement that includes a confession of judgment.
By signing a confession of judgment, you’re signing away your right to defend against a lender’s claim that you’ve defaulted on a loan. If a lender enforces a confession of judgment against you, you can file a petition or motion to have it invalidated, but there’s no guarantee you’ll get your money back. Make sure you do the following before signing a loan agreement that has a confession of judgment:
If a confession of judgment clause catches you unaware, you can also try to have it invalidated later. Craig R. Tractenberg, attorney and partner at Fox Rothschild LLP, says that “confession of judgment provisions are frequently challenged in court upon enforcement, and courts are liberal in granting relief, striking, or modifying judgment because of the oppressive nature of the clause. You can ask a court to issue an injunction against the lender in certain circumstances against using the clause.”
The problem is that you might not even know that a lender is using a confession of judgment against you until they’ve debited your bank account or seized your assets. Plus, it’s not enough to claim that you didn’t know what you were signing. You’ll need to show a specific reason—such as duress or fraud—for the court to invalidate the confession of judgment.
If you are seeking a business loan with bad credit, then agreeing to a confession of judgment might be the price you have to pay to obtain some kind of financing. If you’re determined not to sign a confession of judgment, you can improve your credit score and apply for a bank or SBA loan—as these loans typically do not contain confessions of judgment.
Business loans come in many shapes and sizes, and getting the right one for your business is important to your company’s future success. You’ll be comparing business loans along many different factors, including cost, loan amount, and speed.
While loan shopping, don’t forget to read the fine print of any potential business loan agreement. The agreement might contain a confession of judgment or other legal language that could impact you financially later. Make sure you understand what each clause means and consult a lawyer when necessary. The more you know now, the better you can protect yourself and your business in the future.
Priyanka Prakash is a senior contributing writer at Fundera.
Priyanka specializes in small business finance, credit, law, and insurance, helping businesses owners navigate complicated concepts and decisions. Since earning her law degree from the University of Washington, Priyanka has spent half a decade writing on small business financial and legal concerns. Prior to joining Fundera, Priyanka was managing editor at a small business resource site and in-house counsel at a Y Combinator tech startup.