A Tongue-in-Cheek Revisiting of Value Leakage Protection
Ever since U.S. apparel and accessories retailer J. Crew Group, Inc. (“J. Crew”) controversially utilized provisions in its senior secured credit agreement to move valuable intellectual property (including the J. Crew trademark itself) outside its secured lenders’ collateral pool, the words “J. Crew” are synonymous with value leakage. In what was a novel move to service debt under its affiliate’s existing unsecured payment-in-kind (PIK) notes, J. Crew proverbially robbed Peter to pay Paul. In 2016 and 2017, J. Crew structured a multistep transaction to contribute assets to an unrestricted subsidiary via a foreign restricted subsidiary and consummate an eventual debt exchange and paydown, thereby avoiding bankruptcy for the time being. When faced with distress, whether due to impending maturities in the capital structure, overleveraging, macroeconomic factors like the COVID-19 pandemic, or basic liquidity issues, borrowers, no doubt inspired by J. Crew’s maneuvers, have turned to liability management to achieve value-creating asset-transferring transactions where few unencumbered assets existed, often intended to secure the incurrence of new debt.
Post–J. Crew, lenders were, justifiably, quick to react. Credit agreements incorporated what we in the space colloquially call “J. Crew protections”—that is, language attempting to prevent J. Crew–like arrangements by expressly prohibiting the transfer or exclusive licensing of material intellectual property from loan parties or restricted subsidiaries to unrestricted subsidiaries (and, sometimes, prohibiting the ownership of material intellectual property by, or the exclusive licensing of material intellectual property to, unrestricted subsidiaries). Today, J. Crew protections are so ubiquitous that little effort is spent negotiating whether or not to incorporate them, at least in some form, into credit agreements. Lenders expect such provisions to be de rigueur, as their internal investment committees focus on risk management to ensure what constitutes “collateral” at closing actually remains “collateral” over the life of the loan.
Different iterations of J. Crew protections have evolved, with some credit agreements strictly defining what constitutes material intellectual property, and others prohibiting the ownership of material intellectual property by, and the transfer or exclusive licensing thereof to, non-loan parties. Perhaps because J. Crew protections became a “check-the-box” item for lenders, drafting often covers only material intellectual property. Rarely do such provisions address other material assets, though some (although a minority of) credit agreements tailor their J. Crew protections to deal-specific, material “crown jewel” assets. For instance, taking a page from managed care deals, loan parties with valuable customer contracts particularly important to their businesses may agree to restrictions on transfer and ownership of such customer contracts (those important contracts must always be an asset of a loan party, for example). The “default” J. Crew protection formulation, however, still focuses solely—or primarily—on intellectual property, regardless of whether the relevant loan parties actually own or license any intellectual property at all, let alone material intellectual property.
There is, of course, merit to the attention devoted to material intellectual property—after all, intellectual property is a relatively portable asset. It is easier to transfer a trademark, for instance, than convey real property (which may be subject to third-party financing or liens) or assign a valuable contract with a non-affiliated counterparty (which counterparty may have notice and/or consent rights). Once transferred out of the ring-fenced credit group and collateral pool, such intellectual property—in addition to becoming out of reach of the original secured creditors—may secure new debt incurred at the non-loan party level, or be sold to an unaffiliated buyer. None of the foregoing, though, changes the fact that different assets are material to different companies.
From a creditor perspective, the focus (or refocus, as it were) on collateral stripping and other forms of leakage in the wake of J. Crew and its inspired “offspring” (think Revlon, Neiman Marcus, Travelport, etc.) is undoubtedly a good thing. Lenders should understand the nuances of loan documentation, how deal terms have developed with added market competition, and what actions are often—to the surprise of some—permitted by the “four corners” of the credit agreement. In light of the above and the legacy of J. Crew, lenders and their counsel should consider a “bespoke” take on J. Crew protections.
Take Proper Measurements
At the diligence stage, lenders should drill down on the credit group’s assets, focusing, in particular, on which assets may be material and essential to the business of the corporate enterprise. This exercise might require specific inquiries and extra review, including by specialists and experts.
Tailor to Fit
J. Crew protections included in commitment letters and, ultimately, loan documents should be “tailored” to properly (i) capture the nature of such assets and, (ii) anticipating potential pitfalls, “button up” potential leakage and contribution.
When defining material assets, a good rule of thumb is to capture, at a minimum, material intellectual property, as most borrowers cannot reasonably push back against that limitation at this juncture in the debt capital markets. Then, “fashion” additional defined terms or descriptions for any other material assets, as needed. Pay special attention to ensure the “fit” of such defined terms. Descriptions should be not only sufficiently “slim cut” to ensure that all applicable material assets are captured but also comfortable enough to not unreasonably interfere with the loan parties’ business. A common formulation is to look at the materiality of certain assets in relation to the business of the borrower and its subsidiaries (or the borrower and its restricted subsidiaries, depending on the deal) as a whole.
The suggested sartorial approach to J. Crew protections should not stop at defining material assets. While the typical restrictions on the transfer, exclusive licensing, and ownership of material intellectual property probably work for other material assets, lenders should consider different ways in which other types of material assets may be distributed from collateral pools. This often dictates a holistic review and analysis of covenants and permissions, including, but not limited to, basket capacity and terms around unrestricted subsidiaries (and the designation/redesignation thereof) and non-loan parties, if and as applicable.
Consider Your Retail “Consumers”
An additional reason to adopt a made-to-measure approach to J. Crew protections is that the investment theses of institutional investors, agent banks, and direct lenders differ. In syndicated credits, the makeup of the lender group can dictate terms and outcomes—if there is a significant appetite for a credit in the primary market, J. Crew protections may be nonexistent or watered down, at best, as sponsors and borrowers are able to push for looser and more flexible terms. Deals led by private credit, on the other hand, may take a more conservative and fulsome approach to material intellectual property and assets, sometimes requiring the same to be owned by or exclusively licensed to loan parties. As is the case with any important provision, the final form of a credit agreement’s J. Crew protections should be the product of “threading the needle” through the often-diverse objectives of all applicable lenders and their borrowers.
An additional consideration: While J. Crew and other liability management transactions often carry a negative connotation in the world of leveraged finance, their use is not always nefarious and may even be beneficial. For instance, transferring value away from a credit group might create positive value in other areas—such value, in turn, can be contributed to the original credit group (and, by extension, its creditors) in the form of cash, a debt exchange, or terms tightening, helping to avoid insolvency, bankruptcy, or other negative consequences or to spur a refinancing or consensual reorganization.
The proliferation of J. Crew protections might, at times, relegate them to little more than boilerplate, instead of the useful shield against value leakage they were intended to be. A thoughtful, made-to-measure approach in dealmaking and loan documentation can help ensure that J. Crew protections do not go out of style. In sum, in J. Crew, as in clothing, bespoke is almost always preferable to prêt-à-porter.
