What Is A 'Financial Covenant'? An Illinois Court Decides

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...