Collateral Leakage: The J.Crew and Chewy Trapdoors
Some credit agreements contain loopholes that let a borrower move valuable collateral or subsidiaries out of reach of existing lenders and use them to raise new, structurally senior debt — a maneuver nicknamed after the companies that first exploited it publicly.
Prerequisites: Restricted Payment Baskets and Covenant Capacity
Lenders assume the collateral securing their loan will stay put. Two well-known transactions showed that assumption can be wrong, because loose covenant drafting sometimes leaves a door open for a borrower to move assets out of the collateral pool entirely.
The "J.Crew trapdoor" let a borrower transfer valuable intellectual property to an unrestricted subsidiary the existing lenders had no claim on, then use it to raise fresh debt — legally exploiting definitions in its own credit agreement rather than breaching them.
What happened
In 2016, J.Crew transferred its trademarks — its most valuable asset — into an unrestricted subsidiary, a legal category the credit agreement itself excluded from the lenders' collateral package, using investment-basket capacity the agreement permitted. That subsidiary then licensed the trademarks back and used them as security to raise new debt, effectively subordinating the original lenders behind new creditors secured by an asset they had originally lent against. Chewy did something similar a few years later, moving intellectual property assets to fund a dividend to its private-equity owner, leaving existing lenders exposed to a diminished collateral pool.
Both transactions were legal under the letter of their credit agreements — the trapdoor existed because the documents defined "unrestricted subsidiaries" and investment capacity broadly enough to allow it, not because any covenant was violated.
Worked example
A borrower's credit agreement allows up to $100 million of "investments in unrestricted subsidiaries." Management transfers a $150 million trademark portfolio into a newly created unrestricted subsidiary, using an appraisal that values the transferred asset within the $100 million basket, then has that subsidiary borrow $120 million secured by the trademarks. Existing lenders, who once had a claim on those trademarks, now rank behind the new $120 million of debt on that specific asset — prompting later credit agreements to close the loophole with tighter, named restrictions on which assets can ever leave the collateral pool.
Further reading
- Debtwire and covenant-review commentary on the J.Crew and Chewy transactions