Collateral Controversy: The J. Crew Manoeuvre and the Fight Over Loan Agreement Loopholes

Introduction

In the 2010s, U.S.-based retailer J. Crew Group, Inc. (the “Borrower”) negotiated certain of its credit agreements to include specific provisions which ultimately enabled it (through what has been called a loophole or the “trap door”) to delever certain of its assets and move certain collateral out of the security ringfence, much to the dismay of its secured term lenders (the “Secured Lenders”).

The ensuing litigation and controversy made waves in the United States, both in the financial and legal sectors. Lessons learned through such litigation have caused pause for some Canadian lenders and have placed a spotlight on negotiating certain protective provisions into loan agreements, with a particular focus on ways to protect lenders from falling victim to the trap door.

Factual Background

In 2014, the Borrower entered into an amended and restated credit agreement (the “Credit Agreement”) with the Secured Lenders for $1.57 billion (the “Term Credit Facilities”). In 2016, the Borrower faced a precarious situation whereby it became clear that more than $500 million of its unsecured payment-in-kind notes (“PIK Notes”) would mature in the next few years and the added interest costs of these PIK Notes would threaten the financial viability of the Borrower. The Borrower needed to raise significant funds quickly in order to pay off the PIK Notes and, in order to do so, it required collateral to secure such new funding.

With substantially all of its assets already pledged as collateral in connection with the Term Credit Facilities, the Borrower relied on certain provisions of the Credit Agreement to move roughly 72% of its trademark collateral (which it valued at $250 million) (the “IP”) outside of the ringfence securing the Term Credit Facilities. Such IP collateral would then assist the Borrower in accessing new funding.

Legal Provisions

The transfer of IP was enabled by the following provisions of the Credit Agreement:

First, Section 7.02(c) of the Credit Agreement permitted, among other things, investments by loan parties in non-loan party restricted subsidiaries not exceeding the sum of (x) the greater of $150 million and 4.00% of total assets and (y) the Available Amount (an amount tied to earnings and defined in the Credit Agreement).

Next, Section 7.02(n) permitted, among other things, the use of a general investment basket, allowing investments not exceeding the sum of (x) the greater of $100 million and 3.25% of total assets and (y) the Available Amount.

Lastly, Section 7.02(t) acted as the proverbial trap door baked into the Credit Agreement, and included the following language:

So long as any Lender shall have any Commitment hereunder or any Loan or other Obligation hereunder (other than (i) contingent indemnification obligations as to which no claim has been asserted and (ii) Obligations under Secured Hedge Agreements and Cash Management Obligations) shall remain unpaid or unsatisfied, each of Holdings and the Borrower shall not (and, with respect to Section 7.13, only Holdings shall not), nor shall Holdings or the Borrower permit any Restricted Subsidiary to make or hold any Investments, except:

(t) Investments made by any 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 made pursuant to Sections 7.02(c)(iv), (i)(B) or (n);…

It should also be noted that despite being used more than 100 times throughout the Credit Agreement, the word “proceeds” was never defined. This becomes important when examining the mechanics of (and justification for) the IP transfer, as detailed below.

Application and Outcome

The Borrower took the position that it could make use of the above provisions to do the following:

Step 1 – Transfer the Borrower’s IP into a Cayman Islands restricted subsidiary (“J. Crew Cayman”): While still being subject to the terms under the Credit Agreement per J. Crew Cayman’s status as a restricted subsidiary, as a non-U.S. entity, J. Crew Cayman was not obligated to guarantee the parent company’s secured debt.

Step 2 – Transfer the IP from J. Crew Cayman into an unrestricted subsidiary (“Unrestricted J. Crew”): By virtue of being unrestricted (meaning not subject to the Credit Agreement’s covenant package and therefore outside the Secured Lenders’ grasp), Unrestricted J. Crew was then able to recollateralize the IP for the purpose of incurring new indebtedness, which was ultimately used to prepay the PIK Notes.

The Borrower also relied on provisions in the Credit Agreement that govern transactions with affiliates and took the view that these provisions allowed the transfer of IP.

In response to the above transfer of IP, the Secured Lenders issued a notice of default alleging that the transfer violated the Credit Agreement, which prompted the Borrower to pre-emptively file a lawsuit to seek a declaratory judgment from the court stating that the IP transfer was in full compliance with the Credit Agreement (and, therefore, that no default or event of default had occurred).^[1] After agreeing to (i) repay Secured Lenders part of the loan at par and (ii) make certain amendments to the Credit Agreement (including tightening certain covenants and deleting the Section 7.02 trap door),^[2] the Borrower entered into mutual releases with a majority of Secured Lenders and the successor administrative agent.

Around the same time, a minority (12%) of Secured Lenders and some affiliated funds filed a complaint against the Borrower, certain guarantors and the administrative agent, claiming that the amendments to the Credit Agreement were ineffective due to the lack of unanimous consent among the Secured Lenders. While nearly 100% of PIK Notes holders agreed to participate in an initial exchange of PIK Notes for new senior secured notes issued by Unrestricted J. Crew, only 88% of Secured Lenders supported the Credit Agreement amendments. The complaint alleged that this lack of unanimous consent meant the transfer of IP violated the terms of the Credit Agreement and that such transfer constituted a fraudulent conveyance.^[3]

This lack of unanimity also initially disturbed some legal commentators, who categorized the Borrower’s settlement negotiations as “coercive,” especially since the Borrower was allowed to capitalize on the trap door-enabled recollateralization of its IP assets without facing the scrutiny of the courts.^[4] The non-consenting minority plaintiffs faced various setbacks in court and eventually lost their appeal in 2019.^[5] It should also be noted that this recollateralization only bought the Borrower a few more years of “runway” before it filed for Chapter 11 bankruptcy in 2020, re-emerging from restructuring four months later under new ownership while holding reduced debt obligations.^[6]

Discussion

Part of what made Section 7.02(t) of the Credit Agreement so useful and flexible for the Borrower is that its use of the term “proceeds” remained undefined in the Credit Agreement. Generally speaking, “proceeds” are defined as something derived from an earlier transaction, such as cash, dividends, interest, resale value or some other form of profit.^[7] In the context of intellectual property, proceeds most often come in the form of fees paid as part of licensing agreements.

Since no such definition existed in the Credit Agreement, the Borrower was able to stretch its definition of proceeds to include not only the above traditional definition, but also the investment itself (in this case, the “investment” of the IP into the restricted subsidiary). By being able to classify the IP as both the original investment and then reclassify it as proceeds of that very same investment, the Borrower employed a form of circular logic, thereby allowing it to use Section 7.02(t) to transfer the IP outside of the secured collateral structure. Some scholars suggest that the Borrower’s power to transfer the IP in such a way could have been thwarted by merely requiring the addition of the word “cash” before “proceeds” in Section 7.02(t), even if “proceeds” remained undefined in the Credit Agreement.^[8] Such ambiguity was central to the fate of the Secured Lenders and to the subsequent legal debate about how to shut the J. Crew trap door.

It is also arguable that restricting investments to those made by arm’s-length third parties (as opposed to loan parties or their affiliates) would have prevented the transfer of the IP.

Aside from the Borrower’s appeasement of some of its Secured Lenders via its 2017 amendments to the Credit Agreement as part of its settlement terms (as noted above), lawyers were quick to employ new drafting strategies to help their lending clients ward off the risks of similar trap doors being used to circumvent the priority interests of secured creditors. Today, similar risk aversion in drafting loan agreements has spread to Canada and Europe.^[9] Such drafting strategies (often called “J. Crew blockers”) have included:^[10]

1. creating restrictions on the amount of EBITDA and/or consolidated assets that may be allocated to unrestricted subsidiaries;
2. creating restrictions on transfer of intellectual property (or other “crown jewel” assets) to unrestricted subsidiaries;
3. imposing caps on a borrower’s ability to invest in non-loan parties;
4. removing automatic lien release mechanisms in cases where collateral has been transferred to affiliates;
5. specifying that general baskets may not be used to incur debt that is secured by collateral held by an unrestricted subsidiary; and
6. ensuring that all relevant terms are defined, including, but not limited to, all material assets (in short, better to over-define than under-define).

Conclusion

While J. Crew may have been one of the first borrowers to implement the trap door, it certainly wasn’t the last drafting manoeuvre to allow collateral leakage. In subsequent years, many other high-profile companies made use of their own trap doors, including Cirque du Soleil, PetSmart, Neiman Marcus and Revlon.^[11]

As the lessons learned from J. Crew (and others) guide a new generation of lender’s counsel in mitigating risk by trying to shut trap doors before they are used to the detriment of their clients, borrower’s counsel are working hard in trying to circumvent these “J. Crew blockers.”^[12] Only time will tell whether this legal arms race leads to more effective drafting and predictable outcomes or if, instead, it ushers a race to the bottom where counsel become overly distrustful of their counterparties, with clients footing the bill for these increased risk mitigation efforts.

The Financial Services Group at Aird & Berlis LLP will continue to monitor developments in loan agreement structuring and collateral protections in Canada and abroad. Please contact the authors or a member of the group if you have any questions or require assistance.

[1] Peter Wells, “J. Crew sues over right to move IP assets,” Financial Times (1 February 2017), online: <ft.com/content/73412d84-ab16-3b76-8d8d-3c01934ac69a>; J. Crew Group, Inc., et al. v. Wilmington Savings Fund Society, FSB, Index No. 650574/2017 (Sup. Ct. N.Y. Cnty.).