July.01.2020
More than three years have passed since J.Crew’s infamous “trap door” maneuver. Faced with a mounting debt burden, J.Crew utilized multiple baskets in its credit facility to reallocate its core property – its J.Crew trademark – to several unrestricted subsidiaries. As a result, J.Crew was able to remove such property from the credit support provided to its senior lenders and use the transferred intellectual property to secure debt at an unrestricted subsidiary. These maneuvers generated vast publicity and triggered a scramble to find a solution to prevent future debtors from engaging in similar collateral stripping. In response, lenders have included various blockers in their credit facilities. However, most blockers have focused on the specific maneuvers used by J.Crew instead of solving the larger issue of how to stop the transfer of material assets of the credit group to unrestricted subsidiaries. The authors of this article propose additional solutions that lenders should consider to protect their credit facilities from collateral stripping, especially as the current distressed environment may lead some debtors to become more creative and sophisticated in their tactics.
J.Crew used three primary baskets to transfer material intellectual property to unrestricted subsidiaries: (a) a general investments basket, used to make direct investments by loan parties in unrestricted subsidiaries, (b) a basket that allowed investments by loan parties in restricted subsidiaries that were not loan parties and (c) a basket that allowed investments (including investments in unrestricted subsidiaries) by non‑loan party restricted subsidiaries, financed with the proceeds received from investments in such non-loan party restricted subsidiaries (i.e., amounts received by non-loan party restricted subsidiaries under the basket described in clause (b) above). The combination of the baskets in clauses (b) and (c) above is commonly referred to as the “trap door.”
In response, lenders began to include several blockers in their credit facilities. Two types of restrictions have become prevalent in credit facilities: (a) a restriction on the transfer of material intellectual property and (b) a restriction on investments by non-loan party restricted subsidiaries in unrestricted subsidiaries. The first restriction focuses exclusively on intellectual property and comes in three main varieties that restrict (i) designation of subsidiaries that hold material intellectual property as unrestricted subsidiaries (which does not prevent future transfers of material intellectual property to such unrestricted subsidiaries), (ii) transfers by loan parties of material intellectual property to unrestricted subsidiaries (which does not prevent such transfers by non-loan party restricted subsidiaries) and (iii) transfers by loan parties and non-loan party restricted subsidiaries of material intellectual property to unrestricted subsidiaries (which does not prevent transfers of other material assets). The second restriction focuses primarily on the “trap door” and prevents non-loan party restricted subsidiaries from making investments in unrestricted subsidiaries using proceeds received from loan party investments. As mentioned above, while these restrictions resolve some of the specific weaknesses that J.Crew was able to exploit, they fail to safeguard against leakage of other material assets.
The current distressed environment has inspired other debtors to employ J.Crew’s tactics. After its revenues shrank following the spring of 2020 shutdown in Las Vegas, Cirque du Soleil reportedly transferred non-U.S. intellectual property to subsidiaries beyond its first lien creditors’ reach and used such intellectual property to secure emergency financing.[1] Similarly, Travelport reportedly designated two subsidiaries with material intellectual property into unrestricted subsidiaries, thus stripping such intellectual property as collateral from an existing credit facility.[2] More recently, Party City designated its balloon business as unrestricted in one of several steps to remove credit support from its existing creditors.[3] Going forward, debtors will continue to use unrestricted subsidiaries (together with other carve-outs and baskets) to strip collateral from existing credit facilities in their search for additional capital.
In order to address these vulnerabilities, in addition to the protections discussed above, lenders should consider implementing one or more of the following limitations with respect to unrestricted subsidiaries:
A separate restriction on transfers by any loan party or any restricted subsidiary (whether or not it is a loan party) to any unrestricted subsidiary of any assets that are either (a) specifically identified and scheduled as material or (b) material to the business of the underlying debtor and its restricted subsidiaries. This article primarily focuses on transfers of assets to unrestricted subsidiaries. However, lenders should also consider broadening the above restriction to prevent the transfer of material assets to subsidiaries that are not loan parties (and not just unrestricted subsidiaries).
A requirement of the delivery of a third‑party valuation and a fairness opinion for transfers of assets (over a threshold amount) to unrestricted subsidiaries. This restriction would hamstring debtors’ ability to undervalue assets (for purposes of meeting investment baskets) and to claim that the underlying assets are not material.
A cap on the percentage of assets held or revenue generated (as compared to the assets held and revenue generated by the underlying debtor and all subsidiaries) by each unrestricted subsidiary and by all of the unrestricted subsidiaries in the aggregate.
If the lenders have the appropriate leverage to pursue such a measure, a complete elimination of “unrestricted subsidiaries” (particularly for those borrowers that are struggling to comply with their existing credit facilities and are looking for relief amidst the current market).
In distressed environments, lenders are likely to exert greater leverage in negotiations and should use such opportunities to tighten weaknesses such as those utilized by J.Crew, Cirque du Soleil, Travelport and Party City.
* Robert Harrington, a law clerk in Orrick’s Banking & Finance group, is also an author of this article.
[1] See Andrew Willis, “Cirque du Soleil Asset Transfer Angers Creditors”, The Global and Mail (May 15, 2020).
[2] See Charles W. Tricomi, “Travelport Shops at J.Crew for an Answer to its Liquidity Issue”, Xtract Research (May 19, 2020).
[3] See Valerie A. Potenza, “Party City’s Balloon Bonds: J. Crewed Again”, Xtract Research (June 2, 2020).