David Morse


Where Did My Collateral Go?

It’s Not Just Financial Covenants That Matter — 
A Variation on the Theme of Unintended Consequences as J. Crew Moves Key Collateral Beyond Lenders’ Reach
By David W. Morse, Esq.

In the midst of the competitive lending landscape, the loosening of covenant structures in credit facilities and the resulting increased risk for lenders, coupled with the ongoing pressure on the margins paid for lenders for their risk, is often commented on within the finance industry.

The specifics of this phenomenon takes many forms. It may be as simple as the pervasive use of the covenant lite structure or the increased headroom in the financial covenants for a leverage finance transaction or in the asset-based lending market the low level of excess availability required before the lenders are able to test the single financial covenant or trigger cash dominion or even the relatively benign right to require more frequent reporting of the borrowing base. Or, in both leveraged finance and asset-based lending, it may take the form of speculative addbacks to the definition of EBITDA used for purposes of a leverage ratio, fixed charge coverage ratio or other financial covenant—an occurrence which has attracted the attention of the regulators.

Less often do commentators refer to actions a borrower is permitted to take under the negative covenants of a credit agreement. Negative covenants in a credit agreement are a fundamental element of any financing. They are intended to preserve the expectations of the lender in agreeing to provide the financing and to capture the basis on which the lender set the terms and conditions of the financing. At the same time, the exceptions to the general prohibitions in the negative covenants (or “baskets”) are intended to allow the borrower the flexibility to run its business and execute on its business plan, in a manner consistent with what it has told the lender and in a way that manages the risk to the lender.

Unfortunately, another manifestation of the leverage of the borrower, beyond financial covenant structures and pricing, is the scope of the transactions permitted under the baskets in the negative covenants. Particularly as the market forces many arrangers to abdicate the drafting of the documents to the borrower’s counsel or to allow a sponsor to dictate which counsel the lender must use, the advantages to the borrower are increasingly likely to lead to surprises for the lender, allowing borrowers to take actions that the lenders never contemplated as possible.
The recent controversy around certain actions taken by J. Crew to move its intellectual property to an unrestricted subsidiary so as to be able to restructure its debt illustrates the surprising and unintended consequences to lenders when the baskets under the negative covenants are broadly drafted.

Background of the Case
J. Crew Debt Structure
J. Crew Group currently has three tranches of debt in its capital structure:

  • a $1.567 billion term loan facility provided to J. Crew Group, Inc. and certain of its domestic subsidiaries pursuant to a Credit Agreement dated as of March 5, 2014,
  • a $350 million asset-based revolving credit facility provided to J. Crew Group, Inc. and certain of its domestic subsidiaries pursuant to a Credit Agreement, dated as of March 7, 2011, and
  • $500 million of 7.75%/8.50% unsecured Senior PIK Toggle Notes due May 1, 2019 issued by an indirect parent holding company of J. Crew Group, Chinos Intermediate Holdings A, Inc.

The Categories of J. Crew Companies
To understand how it was able to make the attempt it is necessary to understand the parties to the term loan facility. There are three key groups:

  • the “Loan Parties” consisting of J. Crew Group as the borrower and certain of its wholly owned U.S. subsidiaries as guarantors,
  • the “Restricted Subsidiaries” which are subsidiaries that are not a borrower or guarantor but are subject to the representations and covenants of the loan documents, and
  • the “Unrestricted Subsidiaries” which are subsidiaries of J. Crew Group designated by it subject to satisfying certain conditions but are not subject to any of the terms of the loan documents.

Only the assets of the Loan Parties constitute collateral for the loans.

The “Trap Door” Investment Basket
Most credit agreements include a negative covenant on “investments.” An “investment” is customarily defined to mean, in general, loans or equity contributions of cash or other assets. Like most negative covenants, the negative covenant on investments includes a number of exceptions (or “baskets”). For example, typically, a permitted investment would include allowing loans or equity contributions from one Loan Party to another Loan Party—that is, as an example, intercompany loans among companies that are all obligated on the debt to the lenders and whose assets constitute collateral. Other exceptions to the negative covenant are intended to allow a company to invest in new businesses or to support customers—not to allow valuable collateral to escape the liens of the lender.

In some ways, the J. Crew credit agreement is typical in this regard. There are three baskets that are relevant:

  • First, there is a basket that allows a Loan Party to make an investment in a non-Loan Party that is a Restricted Subsidiary so long as the aggregate amount of such investments outstanding at any time do not exceed the greater of $150 million or 4.0% of “total assets” plus the “Available Amount” (an amount that is tied to earnings).
  • Second, there is a general basket. In the J. Crew credit agreement, the Loan Parties and the Restricted Subsidiaries are permitted to make “other” investments that do not exceed the greater of $100 million or 3.25% of total assets (plus if there is no event of default, the Available Amount). 
  • Third, there is a basket for investments made by a Restricted Subsidiary that is not a Loan Party “to the extent such investments are financed with the proceeds received by such Restricted Subsidiary from an investment in such Restricted Subsidiary.” 

It is this last basket, which when put together with the first two, constitutes the “trap door,” the ability to move assets of any type into--not a new business venture or to support a supplier or customer-- but just another subsidiary and more particularly an Unrestricted Subsidiary, where the assets can be used for any purpose. While the intent of such provision may have been to permit a borrower to make a cash investment in a new business, since it does not limit the types of assets that can be used for the investment (e.g. cash versus intellectual property or other collateral) or the party in which the investment may be made (e.g. a joint venture or third party versus an unrestricted subsidiary), the effect is arguably to allow valuable collateral to go outside of the Loan Parties or even Restricted Subsidiaries.

What Did J. Crew Do?
To take advantage of the “trap door”, J. Crew engaged in a series of transfers of its trademarks. At the end of these transfers, the trademarks that had once been owned by Loan Parties and part of the collateral for the term loans, was owned by an Unrestricted Subsidiary of J. Crew, no longer collateral for the term loans and available to be given as collateral to secure new debt of such Unrestricted Subsidiary, free from any of the limitations in the credit agreement.

Here is an abridged description of the steps taken by J. Crew:

  • J. Crew determined, using a third party evaluation, that its trademarks had a value of $347 million. 72.04% of such amount is $250 million.
  • J. Crew combined the specific basket allowing it to transfer assets to a Restricted Subsidiary that is not a Loan Party of up to $150 million (4.0% of total assets was apparently less than this amount) and the general basket allowing transfers of up to $100 million (again this amount was presumably greater than 3.25% of total assets) as the basis for transferring the 72.04% interest in the trademarks valued at $250 million to J. Crew Cayman, a non-Loan Party, Restricted Subsidiary.
  • J. Crew Cayman then took the trademarks and transferred them to J. Crew Brand Holdings, LLC, a newly formed subsidiary that was designated by J. Crew Group as an Unrestricted Subsidiary, relying for purposes of this transfer on the basket described above which permits a non-Loan Party Restricted Subsidiary (J. Crew Cayman) to make investments without any conditions or limitations “to the extent such investments are financed with proceeds received by such Restricted Subsidiary from an investment in such Restricted Subsidiary.”
  • J. Crew Brand Holdings then transferred the trademarks to other Unrestricted Subsidiaries.
  • The various Unrestricted Subsidiaries as the new owners of the trademarks entered into an exclusive, non-transferable license agreement pursuant to which the borrowers under the term loan facility could continue to use the trademarks, which they had previously owned, for a fee.

Although the requirement for this last step is that J. Crew Cayman, the Restricted Subsidiary, “finance” its investment with “proceeds” received from an investment in such Restricted Subsidiary, there was no “financing” in these transfers—J. Crew Cayman simply transferred the trademarks outright. Are the trademarks “proceeds” and is this a “financing”? The questions have not been raised in the litigation.
If the third basket had been drafted more precisely to refer to “cash proceeds” being used for the investment, then the transfer of the trademarks would not have been permitted. If it had also required that the funds or assets used by the Restricted Subsidiary for the investments had to come from outside the Loan Party group, the adverse impact on the lenders would not have been as significant.

Allowing Transfer of Intellectual Property Just Makes it Worse
For J. Crew, like many businesses, intellectual property is critical to it and its value. In this case, first by splitting the value of the intellectual property and transferring only “72.04%” of the “value” of the trademarks there is an assumption that there is still some value in the remaining percentage. How would this really work? Can the remaining 27.96% be sold or realized on? What would the purchaser really get?

Second, since the intellectual property will continue to be used by the borrowers under the term loan facility under the license agreement with the Unrestricted Subsidiaries, if the operating companies default on the license, it may be terminated or certainly the Unrestricted Subsidiaries as owners of the intellectual property would be able to extract additional rights.

Third, if the Unrestricted Subsidiaries as the new owners of this interest in the intellectual property borrow and secure their debt with the trademark interests, then upon a default under such debt the secured creditor could exercise its rights to take over the trademarks and where does this leave the borrowers under the term loan facility?
Finally, there are a number of courts that have held that a licensee of trademarks do not have the right in a Chapter 11 to assume and/or assign the right to use licensed trademarks without the consent of the owner-licensor. If the Loan Parties under the term loan agreement were to commence a Chapter 11 case, the issues around their right to use the marks would need to be addressed—which would not have been required if intellectual property were not subject to transfer under the baskets in the negative covenants.

And, if the loss of collateral is not enough, now the Loan Parties have to license back the right to use the transferred trademarks which had formerly been the collateral for the term loans and make payments to the Unrestricted Subsidiaries that are the new owners of the trademarks, the proceeds of which could be used to service the new debt incurred by the Unrestricted Subsidiaries—payments that the Loan Parties would not have had to make but for this series of transfers.

J. Crew has taken the position that the license of the trademarks to it by its Unrestricted Subsidiaries is in compliance with the credit agreement because the license arrangements satisfy the requirements of the exception to the general prohibition on transactions with affiliates in the credit agreement that such intercompany arrangements be on terms no less favorable to the Loan Parties than would be obtained in an arms’ length transaction with an unaffiliated party. While technically correct, from a substantive perspective, this misses the point that but for the transfer of the trademarks in the first place, the Loan Parties would not have had to pay anything to use the trademarks, much less pay market rates, and would not have the additional risks noted above.

Why Did J. Crew Do It?
Confronted with deteriorating financial performance in the difficult retail environment pervasive today, coupled with a focus on the 2019 maturity of the parent company’s unsecured Senior PIK Toggle Notes, J. Crew has said that it is looking to engage in a “value maximizing strategy.”

The effect of this focus is the current effort by J. Crew to take unsecured debt that is at a parent holding company level and therefore structurally subordinated to the term loan facility and the asset-based facility and transform it into debt secured by valuable intellectual property at the expense of the current term loan lenders and the asset-based lenders. The benefits of the structure that the term lenders were relying on in making their loans at the operating company level are obviously significantly impaired if J. Crew can now use the trademark assets formerly owned by its borrower and guarantors under the term loan facility to pledge to the holders of the PIK Notes at the parent level.

On March 13, 2017, J. Crew first proposed an exchange offer to certain holders of the PIK Notes pursuant to which outstanding PIK notes would be exchanged for $200 million of new 9% senior secured notes due September 15, 2021 to be issued by J. Crew Brand Holdings, the Unrestricted Subsidiary, and which would be secured by a first priority lien on the trademarks as well as shares of the issuers. The proposed was not accepted by the PIK noteholders.

Then, on June 12, 2017, J. Crew Group announced that two indirect wholly owned subsidiaries commenced an exchange offer pursuant to which holders of the 7.75%/8.50% Senior PIK Toggle Notes could exchange them for a package of securities consisting of 13% Senior Secured Notes due 2021 issued by J. Crew Brand, shares of 7% perpetual preferred stock of the parent company and some shares of the parent’s class A common stock. As part of the exchange consents would be obtained to strip the covenants from the old notes. The new notes would be secured by a first priority lien on the 72.04% undivided interest in the intellectual property that had been transferred. 

The Litigation
J. Crew’s Complaint
On February 1, 2017, J. Crew commenced an action against Wilmington Savings Fund Society, FSB, as successor administrative and collateral agent under the term loan agreement, in the Commercial Division of the New York State Supreme Court. In its complaint, J. Crew is seeking a declaration by the Court that no default or event of default has occurred under the term loan agreement as a result of the transfers of the intellectual property, that the transfers are expressly permitted by the term loan credit agreement and that the company is not liable for the professional fees of Wilmington Savings.

J. Crew’s argument is that under the credit agreement it has the right to transfer up to $277 million of assets as a permitted investment to an Unrestricted Subsidiary based on three baskets in the term loan credit agreement:

  • Up to $150 million based on the basket that allows an investment by Loan Parties in a non-Loan Party that is a Restricted Subsidiary,
  • Up to $100 million based on the general basket that allows the Loan Parties and Restricted Subsidiaries to make any investments, and
  • Up to $27.3 million based on the add-on in the general basket of the “Available Amount” to the dollar limitation on such investments.

The complaint by J. Crew goes on to note that permitted investments are also permitted dispositions under the negative covenant limiting asset dispositions in the credit agreement.

J. Crew also pointed to the provisions of the credit agreement governing transactions between affiliates. J. Crew transferred the intellectual property to a non-Loan Party Restricted Subsidiary using two of the baskets and then from the non-Loan Party Restricted Subsidiary to the Unrestricted Subsidiary using a third basket. The negative covenant in the credit agreement on transactions with affiliates allows transfers between two Restricted Subsidiaries thereby covering the first transfer (but note that this still allows the collateral to escape since a Restricted Subsidiary is not necessarily a Loan Party and only the assets of a Loan Party are collateral).

Two alternative baskets in the covenant on transactions with affiliates permitted the transfer of the intellectual property from a Restricted Subsidiary to an Unrestricted Subsidiary, according to J. Crew. One basket allows a transaction with an affiliate so long as it is on terms substantially as favorable to the applicable Restricted Subsidiary as a comparable arms’ length transaction with a person that is not an affiliate. The other permits the transaction if an “Independent Financial Advisor” states that such transaction is fair to the Restricted Subsidiary. J. Crew obtained a valuation and fairness opinion from Ocean Tomo, LLC, as an Independent Financial Advisor, to satisfy the requirements of this second basket, but took the position that the transfers satisfied the requirements of both baskets.

The Term Lender’s Position
Wilmington Savings, as agent for the term loan lenders, filed it answer to the J. Crew complaint on March 24, 2017. The term loan lenders made a number of counterclaims. The answer filed by the lenders starts with the premise as stated in J. Crew’s Form 10-K from March 21, 2017 that the J. Crew trademark is “integral to our business as well as the implementation of our strategies for expanding our business, “ and that it is “critical to our success.” The lenders argue that the actions of J. Crew are intended to divert the value of this integral and critical asset away from the creditors of J. Crew Group for the benefit of the indirect parent obligated on the PIK notes and the holders of the PIK notes.

As part of the transfer of the intellectual property, J. Crew formed J. Crew Cayman, the Restricted Subsidiary that was the first transferee of the trademarks and J. Crew Brand Holdings, LLC, a newly formed subsidiary that was designated by J. Crew Group as an Unrestricted Subsidiary, the next transferee. Under the term loan agreement in order to be able to designate a subsidiary as an “Unrestricted Subsidiary”, the “Total Leverage Ratio” for the applicable period prior to such designation must be less than or equal to 6.0 to 1.0, on a pro forma basis. The term loan lenders took the position that the company’s calculation of the Total Leverage Ratio was incorrect and therefore this test was not met. Not surprisingly, the term lenders focused on the addbacks to EBITDA used for this purpose related to cost savings and synergies. (And by the way, as the term lenders’ note, the representation as to the Total Leverage Ratio if incorrect constitutes a breach of a representation and therefore an event of default.)

Next, the term lenders turned to the valuation of the trademark assets transferred. The term lenders noted that while Ocean Tomo may have valued a 100% interest in the trademarks at $347 million (which meant that 72.04% of such value was $250 million, within the amount permitted under the investment baskets), Ocean Tomo did not separately value the 72.04% interest so as to reflect the impact on the value of only having a partial interest. The term lenders brief suggests that the value in fact could be more than $250 million permitted under the baskets.

The term lenders argue that the trademark transfers, together with the licensing of the trademarks back to the J. Crew operating companies violates the negative covenant on transactions with affiliates. The argument is that the company cannot show that the transfer and license agreement are on terms substantially as favorable to the company as would be the case in a comparable arm’s-length transaction with a non-affiliate. The premise is that the J. Crew companies went from a position of owning the marks with no payments for the use of them and no risk of losing the right to use them as a result of a default under the license agreement to a situation where it had to pay for the use of the marks and could lose the right to use them—without receiving anything in return.

In particular, the license agreement includes a provision that upon the failure to make a payment of the license fee, the J. Crew companies would have no rights to use the licensed marks and the licensor would have the exclusive right to use them—which renders the remaining interest held by the J. Crew companies (the 27.96% interest) virtually worthless and demonstrates the fallacy of the simple mathematical split of the values used by J. Crew.

The credit agreement includes a prohibition on encumbering the assets of the Loan Parties, subject to certain exceptions. The term lenders point out that the provision of the license agreement that gives the Brand Holdings company the exclusive right to use the licensed trademarks in the event of a default under the license agreement functions as an encumbrance on the remaining interest in the marks held by the Loan Parties in violation of this prohibition in the credit agreement. 

The credit agreement also includes a prohibition on the disposition by a Restricted Subsidiary of “all or substantially all” of its assets. The trademarks constituted all or substantially all of the assets of J. Crew International, a Loan Party and Restricted Subsidiary, which originally owned them, prior to their transfer to J. Crew Cayman. Similarly, the trademarks constituted all or substantially all of the assets of J. Crew Cayman, a Restricted Subsidiary, before it transferred them to J. Crew Brand Holdings, the Unrestricted Subsidiary. Therefore, these transfers breached the credit agreement.

The security agreement for the term loan facility includes a covenant that no Loan Party will do or permit any act whereby any of its intellectual property may be terminated or become invalid or unenforceable. The transfer of a partial interest in the trademarks created a risk that the trademark collateral would become invalid or unenforceable, including as a result of the insolvency of J. Crew, the failure to maintain quality control or otherwise. Under trademark law, joint ownership of trademarks creates a number of risks with respect to preserving the rights to such trademarks.

The other major claim in the answer from the term lenders is that the disposition of the trademarks constituted a fraudulent transfer since it was made with actual intent to hinder, delay or defraud creditors.

On June 22, 2017, more term loan lenders commenced another action in the Supreme Court of the State of New York against J. Crew and Wilmington Savings Fund Society as administrative and collateral agent under the term loan agreement. The complaint essentially repeated the points made in the answer filed by Wilmington to the declaratory judgement action commenced by J. Crew.

This is Not Just a J. Crew Issue
Claire’s Stores, a distressed retailer owned by Apollo Global Management, is another example of a company that used the transfer of its intellectual property to an unrestricted subsidiary in an effort to give it the ability to incur additional debt as it struggles. Claire’s transferred the assets and then used them as collateral for new debt that was issued in an exchange offer for debt held by creditors, other than those holding a first lien on its assets, effectively circumventing the expectations of the first lien lenders that the first lien lenders would receive the proceeds from the disposition of assets subject to their first priority lien.

iHeart Communication, the former Clear Channel, transferred Class B shares of its subsidiary, Clear Channel Outdoor Holdings from a restricted subsidiary that had guaranteed the iHeart debt to an unrestricted, non-guarantor subsidiary. A group of secured noteholders sent the company notices of default on the basis that such transfer constituted a breach of the terms of the indentures governing the notes. iHeart filed suit in the District Court of Bexar County, Texas seeking a temporary restraining order and injunctions against the noteholders in an effort to have the default notices rescinded.

As with J. Crew, the issue was whether the transfer of the stock was a permitted investment. The issue turned on first whether the transfer fit within the definition of an “investment” and second, if so, was it permitted. The Court found that the transfer was an “investment” and therefore subject to the negative covenant limiting investments, but found that there was sufficient room under the applicable baskets. The transferred shares were valued at $516 million, while the basket permitted the transfer of assets with a value of up to $600 million. Therefore, the Court concluded that the transfer was valid and granted the injunction restricting the noteholders from issuing the default notices.
There has also been concern that GNC Holdings, Inc., the health and wellness supplement retailer, which has experienced ratings downgrades in 2016 may seek a debt restructuring using the “trap door” in its credit agreement to transfer assets to an unrestricted subsidiary. In this case, the trap door is widened through the use of foreign subsidiaries that have additional baskets that may be used to transfer assets out from the collateral that secures the obligations under its credit agreement.
Similar issues for Neiman Marcus have been reported.

Lessons to be Learned
The general principle from these situations is for lenders to fully understand the consequences to them of the vague, open-ended drafting of sponsor credit agreements.

  • More specifically, lenders need to consider how multiple, overlapping baskets may be avoided or at least have a total cap on the amounts permitted to be moved under all such baskets, rather than having separate limits under separate baskets. Lenders need to look at the extensive list of permitted transactions that borrowers usually request and understand how they interact, or just resist the request and allow for fewer overlapping baskets.
  • Second, just because it is reasonable to assume that “investments”, whether loans or equity contributions, will be made in cash in fact the baskets as drafted allow the transfer of any category of assets. Categories of assets like intellectual property that may have greater significance to the operation of a business than just their value, may need to be specifically excluded from a basket that allows transfers of assets. For example, in an asset-based facility, does the lender really want to allow the borrower to be able to transfer its accounts receivable that would otherwise be in the borrowing base as a “permitted investment”? What about being allowed to transfer equity interests of the borrower? Too often, baskets are broadly drafted without consideration of the ramification as to the types of assets that may be transferred and the consequences to the business or the borrowing base.
  • Third, the investment baskets are only one way for a company to transfer its assets. The investment baskets need to be considered in conjunction with the baskets under the negative covenant limiting asset dispositions, to understand exactly how the borrower can change its business (and increase the risk to the lenders) through asset transfers in the form of permitted investments.

If the lenders want the benefit of their assumptions about the business they have agreed to finance, the loan documents need to be drafted to reflect those assumptions. The more specific the drafting, the more likely the expectations of the lenders as to what the borrower can or cannot do will be met. Unfortunately, as lenders have acquiesced to allowing borrower’s counsel to have greater control over the drafting of the documents, the risk to lenders of transactions that were not contemplated increases, with the resulting consequences for the lenders.

David W. Morse is a member of the law firm of Otterbourg P.C. in New York City and is presently head of the firm’s finance practice. He has been recognized in Super Lawyers, Best Lawyers and selected by Global Law Experts for the banking and finance law expert position in New York.  Morse is a representative from the Commercial Finance Association in one of the current projects of the United Nations Commission on International Trade Law (UNCITRAL) concerning secured transactions law.











David W. Morse

David W. Morse is a member of the law firm of Otterbourg P.C. in New York City and is presently head of the firm’s finance practice