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The "Back-Door" Provision: What It Means For Fixed-Income Investors

Summary

In 1Q2017, J.Crew caused its term loan facility to trade down roughly 30.00% when it announced a $250 million IP asset transfer.

A lack of understanding of how investment baskets could be used in conjunction caused creditors to be blindsided by the transfer.

It is very important for fixed-income investors to thoroughly analyze all covenants and baskets in a credit agreement before investing in a company's debt.

One of the most integral steps of analyzing any sort of fixed-income investment, albeit monotonous at times, is understanding the restrictions imposed by the facility’s credit agreement. Often times prohibiting the borrower, and any restricted subsidiaries, from engaging in risky activities that could result in value leakage for creditors (i.e. granting liens, incurring additional indebtedness, M&A activity, etc.), the credit agreement serves as a fixed-income investor’s protection against moral hazard. However, perhaps equally as important for a fixed-income investor to understand are the certain exceptions to these negative covenants called baskets – which when ignored can produce truly devastating results for lenders.

In early 1Q2017, J.Crew sent shock waves through the distressed debt market when it announced its two-step plan to transfer $250 million of its IP assets to a non-guarantor unrestricted subsidiary, which is not bound by the terms of the credit agreement. The transfer effectively freed capacity for the Company to incur additional indebtedness secured by a lien on the IP – the proceeds of which would be used to negotiate a restructuring of $500 million 7.75%/8.50% senior PIK Notes issued by its holding company. [1]

While extremely beneficial for the Company, a notable corollary was that the Company’s $1.567 billion term loan facility had become structurally subordinated to the newly issued Notes and shortly thereafter the loan traded down roughly 30.00%. Many loan holders, including Highland Capital, filed a lawsuit to block the asset transfer; however, it was eventually ruled that the credit agreement did in fact allow the company to transfer the assets, and the resulting provision was coined the “Back-Door.”

The “Back-Door” provision is a two-step process that utilizes three frequently found baskets in the credit agreement. The first basket that J.Crew took advantage of permitted investments in restricted subsidiaries up to the greater of $150 million and 4.00% of total assets plus an additional amount based on earnings, while the second allowed investments by restricted subsidiaries in unrestricted subsidiaries up to the greater of $100 million or 3.25% of total assets plus an additional amount based on earnings. [2] Essentially, this allowed J.Crew to transfer 72.04% interest in its trademarks (worth $250 million) to a foreign restricted subsidiary in the Cayman Islands. Due to the potential adverse tax consequences of a foreign subsidiary guaranteeing domestic debt, this Cayman Islands subsidiary was still restricted by the terms of the credit agreement, however, was not a guarantor of the facility.

The second part of the “Back-Door” provision entails the use of a third investment basket, which, as stated in the credit agreement, allows investments by a restricted subsidiary (the Cayman Island subsidiary) into an unrestricted subsidiary “financed with the proceeds received from an investment in such restricted subsidiary.” Ultimately, the Company could now grant a lien on the $250 million of IP originally pledged to lenders of the term loan facility to incur additional indebtedness, contrary to the stipulation of the credit agreement and wishes of the senior creditors.

J.Crew should serve as a precautionary tale to all fixed-income investors of what could happen in the absence of a thorough analysis of the covenants and baskets in a credit agreement. Although many secured lenders are now including language in credit agreements, known as the ‘J.Crew blocker,’ geared at prohibiting the transfer of IP, a lack of comprehending the terms of the credit agreement and how baskets can be used in conjunction can easily be exploited at the peril of the very creditors whom loan documents are intended to protect.

References:

[1] Explanation of J. Crew "back-door" provision and proposal for how lenders might address this in their documentation. Retrieved from https://www.jdsupra.com/legalnews/explanation-of-j-crew-back-door-10684/

[2] The J.Crew "trap door" and its implications for the future of leveraged finance. Retrieved from The J.Crew "trap door" and its implications for the future of leveraged finance 

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.