The J. Crew Blocker: Panacea or Red Herring?

When the history of the leveraged loan market is written, there will certainly be at least one chapter (if not several chapters) devoted to the J. Crew saga.1 Indeed, J. Crew’s infamous 2016 “drop down” of its trademarks to unrestricted subsidiaries was a watershed moment for most investors in the broadly syndicated loan market. While it wasn’t the first instance of a liability management transaction (LMT), it was one of several such LMTs to gain substantial attention from the debt markets generally.

In the intervening years, lenders have pushed for greater protections to prevent a repeat of a “J. Crew” transaction.2 One key market response has been the adoption of “J. Crew blocker” provisions. These provisions, which appear in most new issue loans (and are added to older deals at the first viable opportunity), are intended to block transfer of specific assets to unrestricted subsidiaries. Though rightly held up as one of the few instances where the market came together to fight borrower overreach in a consistent manner, in hindsight, the J. Crew blocker is hardly a panacea to the problem of value leakage. Although it is often the subject of underwritten flex, simply getting a borrower to add a J. Crew blocker to its credit agreement is not a guarantee that it will not engage in a future LMT. Anecdotally, it even appears that some borrowers and arrangers have taken advantage of the market’s focus (some would argue blinkered focus) on blockers as a quick means of appeasing prospective lenders without giving up too much in the way of actual flexibility. There is an argument therefore, that J. Crew blockers today are merely a red herring, a sponsor’s magic trick to lull lenders into a false sense of security.

In this report we highlight key weaknesses in blocker technology and also propose an alternative solution that may be more beneficial to lenders hoping to navigate this brave new world of liability management. In the interest of brevity, the focus of this report is on value transfers to unrestricted subsidiaries. Leakage, however, can arise from other transactions too, including transfers to non-loan party restricted subsidiaries or distributions to equity holders via the Restricted Payments covenant. In such instances, different forms of protection may be desired.

Ultimately, it is important for prospective lenders not to assume that the presence of a J. Crew blocker will provide true leakage protection. That said, we understand that blockers are a critical part of the syndication process. As such, we are now happy to offer “Deal-at-a-Glance” (DAAG) capabilities on our new issue reports. These DAAGs provide high level answers on common questions (including whether there is a J. Crew blocker included) though we caveat that subscribers should always refer to our full loan reports for a deeper dive on the various limitations that might be built into the blocker language.

J. Crew blocker weaknesses

First, a hard truth: J. Crew blockers are not ironclad. No matter how many lawyers’ billable hours are poured into these provisions, weaknesses will remain. As a general matter, we see three main problems with J. Crew blockers as they exist in the current market:

(1) They are limited in scope: J. Crew blockers are often limited to transfers of intellectual property (patents, trademarks, copyrights, and the like). This is due to both (1) the fact that in the case of the original J. Crew transaction, IP happened to be the category of asset that held substantial value and was therefore transferred out of the restricted group and (2) the relative ease of transferring ownership in IP from one entity to another (usually necessitating only minimal paperwork). Unfortunately, this IP-only focus sometimes turns the blocker into a solution in search of a problem. Consider a scenario where the core of the borrower’s business is some other category of asset (e.g., real property, physical assets, or even contracts), which is freely transferable to unrestricted subsidiaries as far as the credit agreement is concerned.3 An IP-only J. Crew blocker in such instances would be extra verbiage with no meaningful impact.

(2) They are subjective: Blockers are almost always drafted with subjective standards in mind. For example, a typical blocker will only prohibit the transfer of IP (or, if you are lucky, other assets) that are “material” to the business of the borrower and its subsidiaries. Materiality, however, is a highly subjective and ultimately ambiguous construct which can make enforcing a blocker difficult. How does one ascertain whether the asset transferred “material” to the business? Should materiality be tied to how the business is run in the ordinary course? Should it be tied to the future value to the business (e.g., revenue-earning potential)? Should it be tied to a specific dollar amount? 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. To market participants, this should smack of putting the fox in the hen house.

(3) There are still ample opportunities for loopholes: J. Crew blockers are conceptually simple but surprisingly difficult to implement in practice. Which entities are subject to the prohibition? How is the concept of “Material IP” defined? Is the prohibition a negative covenant or an affirmative one? Do they apply at all times or only upon the designation of the subsidiary as unrestricted? Are there exceptions to the block (there are always exceptions)? How these questions (and those like them) are answered can result in vastly different levels of protection.4 This degree of complexity can be problematic to assess during the increasingly fevered rush to allocation. Arrangers may promise to implement a “J. Crew blocker,” but what actually ends up in the final credit agreement is often so heavily qualified that there may as well have been no such protection at all.5

With all of the J. Crew blocker’s weaknesses, investors should ask themselves whether there is a better solution to preventing future drop–down LMTs. One approach that we have encountered—more in the private credit loan market than in the broadly syndicated–side—has some promise: a hard cap on unrestricted subsidiary investments. Specifically, this refers to an aggregate global cap on the amount of value that can be transferred to unrestricted subsidiaries during the life of the credit facilities.

The hard cap can be drafted as an override (“notwithstanding the foregoing, investments in Unrestricted Subsidiaries cannot exceed…”) or by limiting such investments to a specific carveout of the Investments covenant (for example, the basket for investing in unrestricted subsidiaries, with all other baskets essentially closed off for such purposes). Ideally, such caps should also prohibit, if relevant, (1) reclassification (i.e., the ability to reallocate basket usage to other carveouts to then free capacity going forward) and (2) rebuilding (where basket capacity increases due to returns on investments).

For true protection, lenders could even request that changes to the hard cap require affected lender (rather than majority lender) consent, though this may prove to be a bridge too far even for the most amenable of borrowers’ counsel. Hard caps have the benefit of being an objective restriction rather than a subjective one since the limitation will be governed by a specific dollar amount.6 Further, hard caps can bypass any scope concerns—since the cap simply limits the amount that can be transferred to an unrestricted subsidiary, it is less important as to the kinds of assets subject to investments (so long as the cap is set at a mutually agreeable amount). Short of removing unrestricted subsidiary flexibility entirely, the hard cap could provide far more robust protection against leakage than a blocker. A hard cap would also bring the unrestricted subsidiary concept back to its historical roots, i.e., allowing for a limited amount of flexibility to make investments in entities that are outside of the credit group.

That is not to say that the hard cap is perfect replacement for blockers. As with any provision, hard caps are just as ripe for manipulation by sponsor’s counsel as blockers (or indeed any provision in a credit agreement). However, there is a colorable argument that the hard cap is conceptually simpler than a J. Crew blocker, and therefore simpler to document (and harder to hide loopholes within).

Of course, there is no law against having both a hard cap and a J. Crew blocker, and having both features would increase the overall protection against drop–down LMTs. Each provision would help plug the gaps left by the other: a blocker to prevent the transfer of a specific material asset and a hard cap to ensure that total value lost to unrestricted subsidiaries is reasonable and determinable. And, in fact, some private credit deals do take this approach, so there is meaningful precedent out there if you know where to look.