Lenders can still get J Screwed

Higher US interest rates should be creating a “lender’s market”. At least in theory.

Financing is less abundant when the safest bonds and money-market funds pay a decent yield. So lenders and bond investors should have an easier time negotiating companies’ borrowing costs (higher) and contract terms (tougher). That ostensibly gives investors a break from all the aggressive lawyering that characterised corporate borrowing in the decade after the global financial crisis.

And yet! Debt markets are very open, with record bond issuance in January. So the long-awaited strengthening of contractual protections for lenders may be somewhat . . . cosmetic.

Take for example the “J Crew blocker” that has been increasingly popular in loan covenants. The provision is meant to stop companies from transferring valuable assets away from existing lenders’ legal claims and into a subsidiary that can issue new debt (usually one that is “unrestricted”), the way J Crew did in 2016.

There’s bad news for lenders with these “blockers”, however: you, too, can still get J Screwed. In a recent note, Covenant Review’s Ian Feng highlights problems with the way the blockers work today, and proposes an alternative.

First, a couple of the problems:

1) Sometimes these covenants only cover transfers of intellectual property. But IP doesn’t have the same importance to an oil & gas exploration company as it would to a brand like J Crew, so other assets might be available for transfer.

2) Contracts often prevent transfers of IP that is “material” to the company’s business. But if IP is less valuable to the overall business than it was to J Crew’s, does that mean it isn’t material? “There are no clear answers to these questions, which is why most blocker provisions will simply defer to the borrower’s ‘good faith’ determination of what is or is not material to its business,” writes Feng. “To market participants, this should smack of putting the fox in the henhouse.”

And more broadly, corporate-finance lawyer types are creative! They certainly were in this loosely drafted J Crew blocker that popped up recently:

One loan contract* stated that a company couldn’t transfer material intellectual property . . . unless it agreed to relicense the IP back to the parent company, according to Cov Review.

The problem is, the relicensing is exactly what J Crew did when it transferred its IP to an unrestricted subsidiary. The company’s goal was never to limit its ability to use its IP; it was to move the IP away from its contractual shackles to use as a bargaining chip with lenders.

As Cov Review puts it: “. . . the blocker was essentially a command to ‘not do as J Crew did, except if you do as J Crew did.’”

Feng’s proposed solution is to put a hard-dollar limit on asset transfers to unrestricted subsidiaries, which would dodge the problems of materiality and asset type altogether. These caps would limit management’s ability to isolate key corporate assets and give new lenders better security than existing lenders, while still permitting some flexibility.

*Sadly, CR didn’t specify which loan this was. And borrowers (annoyingly) can be stingy about loan doc access. But we remain curious, and this one seems to have gotten some attention, so do let us know off-record if you’ve run across it . . .