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Capital Markets

Canny Collateral Move Comes Under Fire

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April 28, 2017

Collateral transfer move enabling borrowers to take on more debt under fire.

football x's and o'sA tactic some companies have used to maximize the use of collateral to increase leverage has recently come under legal scrutiny. This comes after lenders filed suit to block the maneuver by one firm and restore confidence in loan terms intended to protect secured lenders.

In March, J. Crew sent a proposal for a distressed debt exchange to its payment-in-kind (PIK) lenders and later transferred intellectual property (IP) to a subsidiary that is not a part of its loan agreement. It intended to use the secured debt at that entity as part of the exchange.

When the IP is transferred to a corporate entity outside the credit agreement, it reduces the collateral available to the lender should the borrower file for bankruptcy, and it also permits the borrower entity to take on more debt, thus increasing the company’s overall leverage.

Fitch Ratings issued a note April 18 about the incident, noting that IP such as trademarks and brand names ranks among the most valuable collateral for lenders to specialty in-mall retailers, after liquid assets that are typically reserved for asset-based lending. Fitch said this is especially true for retailers with minimal real estate ownership.

Companies in other industries can potentially pursue similar tactics. A key condition is that the company’s trademark and brand and especially operations, such as J. Crew’s, are very strong when the loan is originated, so that covenants are relatively flexible and permit the borrower to transfer a portion of the collateral.

“Lenders want to hedge themselves [with loan covenants] and they look to the key subsidiaries. But for businesses to grow and prosper, banks need to give companies some freedom to run their businesses,” said Lyuba Petrova, a director at Fitch and co-author of the note.

Fitch says other companies that have “drained” IP rights out of loan agreements include Toys R Us and discount jeweler Claire’s Stores, with Neiman Marcus potentially exploring the tactic as it reviews options to optimize its capital structure. In a similar transaction, iHeartMedia, which operates 850 radio stations, moved 100 shares of Clear Channel Outdoor to an unrestricted subsidiary last year. Those shares could secure new debt issuance, providing a liquidity lever in the future.

“For companies with valuable IP assets and whose credit agreement terms provide channels they could use to stream assets away from secured lenders, it’s certainly a possibility they can explore if they are revisiting their capital structures,” Petrova said.

The covenants permitting J. Crew to transfer IP rights out of subsidiaries covered by the loan agreement were struck when J. Crew was in a much stronger position financially and operationally, and it had better growth prospects. It began the process of transferring IP rights to unrestricted subsidiaries last October, aggregating amounts under baskets for permitted investments of up to $250 million, or 72% of total IP assets, according to Fitch. Debt comprised a $1.5 billion secured term loan, $543 million of senior PIK toggle notes, and a $350 million asset-based revolver.

The term loan creditors would lose most of their collateral if the transfer takes place, Fitch says.

Those lenders, represented by Wilmington Savings Fund Society (WSFS) have taken the issue to the New York State Supreme Court, arguing that the transfer is not in compliance with the terms of its documentation and constitutes fraudulent conveyance. Fitch states that WSFS’s goal is to reverse the transfer and restore the term loan lenders’ collateral, adding that an outcome favoring the banks is “key to restoring confidence in terms intended to protect secured lenders.”


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