What happened in the actual J.Crew transaction?

The actual “J.Crew” transaction itself fell into the first category mentioned above. J.Crew used a combination of a few baskets under its loan documentation to first move material IP (the J.Crew trademark no less!) into a non-loan party (or in bond land, a non-guarantor Restricted Subsidiary), meaning it did not directly guarantee the loan, and then as a second step relied on a separate clause (sometimes deemed the “J.Crew trap door”) to move the IP from the non-loan party into an Unrestricted Subsidiary, meaning it was then no longer subject to the loan covenants. The Unrestricted Subsidiary then raised new debt, secured it on the newly transferred IP assets, and repaid PIK debt that had been incurred at a holding company above the loan Restricted Group.

The second step set out above is arguably the most controversial aspect of the J.Crew transaction because it relied on a liberal reading of the loan documents. Specifically, the “trap door” clause allowed the non-loan party to use “proceeds” received from investments in it to make investments in Unrestricted Subsidiaries. Whether “proceeds” refers to the original investment in the non-loan party, or rather in amounts received as a result of the investment (like revenue, etc.), is subject to debate. But, most would struggle to read the clause the way J.Crew did and we don’t have a definitive answer here either as the lawsuit on this was never decided (in fact, the lawsuit itself was preemptively filed by J.Crew in order to have further leverage over creditors - good stuff!).

There is also a question about whether it should be considered an “investment” where you divest yourself of an asset, that you then immediately license back (in this case, creating increased costs for the restricted group with no clear / obvious benefit).

This is certainly not an issue that is isolated to J.Crew, other similar transactions have occurred, such as, among others, Travelport, Claire’s Stores and iHeart Communications. They weren’t identical to J.Crew, but the overarching theme is they used surprising methods to transfer value out of the restricted group.

How did this J.screw creditors?

Unrestricted Subsidiaries are not subject to the restrictive covenants, and designating an entity as an Unrestricted Subsidiary, assuming the covenants permit that transaction, typically would also permit the release of any guarantee / security that was granted by that subsidiary (similarly, moving assets to an Unrestricted Subsidiary will generally permit the release of security over those assets). The main requirement to designate an Unrestricted Subsidiary is that the company must have investments capacity equal to the fair market value of its interest in that subsidiary.

Putting this all together - it allowed them to take value out of the group (the actual asset), which diminished the business, and also diminished the security package. When the investors added up capacity when making their initial investment decision, they were not combining the baskets in the way J.Crew used them to come to a total amount of value that could simply leave the group.

J.Crew “like” transactions

While the specific “trap door” investments clause J.Crew used in its transaction is rare in Europe, the same type of manoeuvre can be accomplished using any available capacity for investments (including both Restricted Payments (RP) and Permitted Investments (PI) capacity). It’s important, when reviewing modern documentation, to treat PI capacity similar to RP capacity when considering the total ability of the company to distribute value.

The Drop Down Financing

Intralot is a recent European HY bond example where a company incurred debt (perfectly fine), then combined RP and PI capacity to transfer assets (and the debt) to an unrestricted subsidiary and finally secured that debt, so it was both structurally senior and effectively senior. Intralot did this via a four step process in relation to its existing unsecured debt (though whether it did so in compliance with its bond documents or not is currently subject to legal proceedings, clients can see our coverage here. If you are not a client, you can request a copy here).

First, Intralot incurred new unsecured debt at a guarantor restricted subsidiary level (Intralot Inc) which required compliance with its debt covenant. This guarantor restricted subsidiary was considered the US crown jewel - noteholders claim it generated 70% of Intralot’s EBITDA and earnings. Then, this US crown jewel and its new debt was moved into an unrestricted subsidiary - the FMV of the investment in the unrestricted subsidiary required capacity under the RP covenant. The new debt, among other things, reduced the FMV of the investment - noteholders allege this was part of a series of “manufactured factors to depress the value” of Intralot Inc. The result of this manoeuvre is that the new unsecured debt became structurally senior as Intralot Inc (now an unrestricted subsidiary) was released from its guarantee in favour of the existing unsecured debt and it became effectively senior as Intralot Inc, no longer bound by the covenants in the existing bonds, was able to grant security in favour of the new debt.

The Two-Step Dividend

While not strictly a “J.Crew” transaction, use of the unrestricted subsidiary designation could be used to achieve a “two-step” dividend. For example, Neiman Marcus designated its MyTheresa entities as unrestricted subsidiaries using RP/PI capacity. They then spun off their MyTheresa business to parent entities, i.e., they converted investment capacity in the Unrestricted Subsidiary into dividend capacity (see diagram below).

One might see this and immediately think, how is this possible given the Unrestricted Subsidiary is still a subsidiary, so any dividends would need to ultimately flow through the group ... right?

They were able to complete step two using a carve-out to the RP covenant which is almost universally included in some form or another. The carve-out essentially allows for any proceeds received from an Unrestricted Subsidiary to pass through the group and be used to make dividends. The argument for including this carve-out is that if you could have distributed assets anyway, why should you be prevented from further distributing the proceeds from it? One could argue either way on this, but it has clearly been widely accepted. Also note that this step is not subject to any default/Event of Default blocker nor a ratio test.

Another Two-Step Dividend - URS Value Transfer language

Another variation of this is to utilise a different carve-out (here is a second formulation) to the RP covenant which is specifically included to permit any value transferred using a PI or other investment permitted under the documentation to a parent or shareholder of the parent. It specifically says such a transfer will not be deemed to be a “direct or indirect” action by the Issuer or any Restricted Subsidiary. The point is, this explicitly permits transactions that might be questionable because they are an “indirect” transaction achieving what would not have been permissible directly. We usually point these out in our Legals QuickTakes, however, given Unrestricted Subsidiaries aren’t limited by the covenants anyway, this language is arguably unnecessary, but it’s inserted to eliminate any doubt - and solidifies the point that there is increasingly little to no difference between RPs and PIs. We track this on 9fin’s Covenant Capacity tool.

The Blackhole

A “black hole” is a particularly egregious expansion of J.Crew style trapdoor provisions. In a J.Crew scenario, while there may be an unexpected transfer of value out of the Restricted Group, the baskets relied on are still subject to limits on quantum. In the case of a black hole, the provisions can be manipulated to effectively permit unlimited value leakage. For example, in a customary HY bond or leveraged loan with a HY style covenant package, there is no limit on transfers of assets and value from guarantor Restricted Subsidiaries to non-guarantor Restricted Subsidiaries. If there is also a ‘trapdoor’ provision, those non-guarantors may make investments outside of the Restricted Group with amounts that were permitted to be invested in them (which, of course, is not limited).

Black holes are understandably very rare, but they have been found in a few US loans, and in at least one US HY bond (Superior Industries) - although it didn’t clear the market and was removed in the final (see this on 9fin’s Covenant Explorer here).

J.Crew Blockers and other Defensive Tactics

There are a number of approaches that have been taken to defend against unexpected value transfers following J.Crew and other similar transactions. These approaches are typically called “J.Crew blockers”, and those seen in European HY often, unfortunately, simply address specific manoeuvres investors were surprised by in the past. This misses the broader point that there will always be new and exciting ways for value leakage to occur. With this in mind, we first set out the typical “blockers” below, but then we also walk through a few of the broader defensive measures that could be taken to button-up potential leakage.

“J.Crew blockers”

Typically J.Crew blockers appear in one of two places, in the PIs definition, or at the end of the RP covenant.

They are most often focused on prohibiting the transfer of material intellectual property (or some variant), or the designation as Unrestricted Subsidiaries entities that have material intellectual property.

The first blocker often sits at the end of the PI definition (Ahlstrom / Pizza Express), and simply says that any transfer of material IP to an Unrestricted Subsidiary does not constitute a “Permitted Investment”.

1. Pros: It prevents material IP from being leaked out of the group via a PI, and generally would have prevented the J.Crew transaction from occurring.
   
2. Cons: It doesn’t prevent material IP from being distributed via RPs, and it is not completely clear that the designation of a Restricted Subsidiary as an Unrestricted Subsidiary (which happened to have material IP) would be captured, but we think the expectation is that it would be. Overall, the blocker discussed above is better. Furthermore, fundamentally it only blocks material IP, and no other assets, from being distributed.
   

The second blocker (which comes in various forms: Asda / Iceland / Lutech, Organo, Cerdia, Advanz Pharma) sits at the end of the RP covenant and limits the transfer of certain assets to any affiliates of the Issuer (including Unrestricted Subsidiaries) by way of an RP or PI. Typically these are again only focused on material intellectual property, or perhaps even only specifically listed IP / patents (such as in Covis Pharma, whose “J.Crew style blocker” was limited to specified patents, and of those only ones that generate more than 10% of total revenue).

Other Defensive Tactics

The following tactics are ones which we either have not seen in European HY, or have seen extremely rarely. They seek to achieve the broader goal, which is to eliminate unexpected value transfer, rather than myopically focusing on IP.

1. Block transfers of assets between Guarantors and Non-Guarantors. This concept doesn’t really apply in bonds as typically the covenants (beside debt incurrence) ignore the difference between guarantors / non-guarantors (i.e., you could transfer assets between them unchecked), but in loans, there is a significant difference between the two, and they often do block these kinds of transfers. This is the actual J.Crew trapdoor (i.e., it allowed a transfer of assets from Guarantors to non-Guarantors, which then could make uncapped investments in Unrestricted Subs.). Note however that the “Blackhole” discussed above is a provision which, although it hasn’t cleared the European HY bond market to our knowledge, would achieve a similar result in bonds (because there is structurally no limit on transferring to non-Guarantors).
   
2. Require a 3rd-party valuation and fairness opinion for transfers to Unrestricted Subsidiaries. Typically in bonds this only applies to Asset Sales, but the same concept could apply here, and would ensure at the very least any assets (including IP) being transferred to an affiliate of the issuer are done so at arm’s length.
   
3. Limit the total percentage of assets or EBITDA or revenue generated by unrestricted subsidiaries on an individual and aggregate basis. This is a blunt way of ensuring that nothing valuable escapes the group, however, this is likely less effective as, for example in J.Crew, an issuer could only transfer a portion of an asset (i.e., sell just 60% of the rights to IP) and manipulate these figures.
   
4. Prohibit aggregating the use of RPs / PIs when make distributions to Unrestricted Subsidiaries - although it’s easy to see how this drafting could end up with a lot of loose ends, for example, it would need to cover distinct but related transactions, and would therefore need to focus on substance over form.
   
5. Eliminate the automatic lien and/or guarantee release mechanism when an asset/entity is transferred to an affiliate (inclusive of unrestricted subsidiaries). This would mean that assets which have liens, or entities that provide guarantees, might need to maintain those protective measures. This is especially notable in bonds which don’t have guarantor coverage tests.
   
6. Ensure that it is clear what is meant by “financing [an investment] with proceeds” language. In other words, make it more clear, in the context of a loan, what the term “proceeds” means - i.e. value received from third parties (the asset should be cash generative) rather than like in J.Crew where the entire investment made in the entity was considered “proceeds from the investment”.
   

Conclusion

What happened in the J.Crew transaction that captured the attention of every investor at the time is not really what is at issue in most cases where an issuer does something unexpected. However, it was instructive to remind investors that it’s important to understand all of the unexpected areas where value can leak from the restricted group. In addition, investors were successfully able to have a blocker included post-launch in Advanz Pharma (2021), Lutech (2021) and Cerdia (2022), to name a few. Hopefully this article has helped you to understand what really happened in J.Crew, but also to understand what else could happen, and how to defend against it.

If you want to review whether an issuer has the ability to perform an unexpected transfer of value on a particular transaction, what should you look out for? The following is intended to be a short list to help you focus your review on the key points.

1. Does the transaction include a “J.Crew blocker”?
   
2. Who can the issuer make investments in: joint ventures, 3rd parties, unrestricted subsidiaries? How large are the RP/PI baskets which could allow value leakage to such entities?
   
3. Ensure that any purported J.Crew blockers aren’t too narrow, i.e., they cover the relevant assets, cover future assets, and would capture the distribution of a subsidiary that contains the asset as well as the transfer of the asset itself.
   
4. Consider removing any Unrestricted Value Transfer language if present, particularly where there are large RP/PI baskets included which could enable indirect value leakage to shareholders.

This article is part of a series aiming to be a reference or guide on technical issues within the leveraged finance market. Other articles in this series include

Portability Trends in European HY

Down and Dirty with the “Available Amount”

Asset Sale - or is it?

Who’s in Control? A quick look at the Change of Control provision (9fin Educational)