Restricted Payments and Collateral-Stripping Trapdoors
Loan agreements limit how much cash and collateral a borrower can send out of the lending group — but the exceptions written into those limits are exactly the loopholes companies have used to move assets beyond lenders' reach.
Prerequisites: Bond Covenants, Intercreditor Agreements and Lien Priority
Lenders to a company don't just lend to the parent — they lend against a whole group of subsidiaries, and the collateral and cash flow of that group is what actually backs the loan. A restricted payments (RP) covenant limits how much cash the company can pay out of that group as dividends, buybacks, or intercompany transfers, so lenders aren't left holding claims against an empty shell. The trouble is that every RP covenant comes with baskets — specific dollar or percentage carve-outs that allow payments anyway — and those baskets are what companies use to move value, and sometimes collateral itself, beyond lenders' reach.
A restricted payments covenant is supposed to keep value inside the fence that secures a loan. The baskets and carve-outs written into it are trapdoors: legal, pre-negotiated ways to move cash or collateral out of that fence, and distressed borrowers have learned to use them aggressively when a restructuring looms.
How the trapdoor works
The classic move, sometimes called "J.Crew-ing" after the 2016 case that popularized it: a covenant permits the company to designate certain subsidiaries as unrestricted, meaning they sit outside the loan's collateral package and covenant limits. A company under stress transfers a valuable subsidiary — a brand, a piece of IP, a profitable unit — to an unrestricted subsidiary, using an "investments" basket that was originally meant for ordinary-course activity like joint ventures. Once outside the fence, that subsidiary can borrow fresh money from new lenders, secured by the very asset the original lenders thought was backing their loan.
Worked example
A retailer's term loan permits "investments in unrestricted subsidiaries" up to the greater of $200 million or 25% of trailing EBITDA. Trailing EBITDA is $1 billion, so the basket allows up to $250 million.
- Facing a maturity wall, the company transfers its intellectual property — valued at $220 million and previously pledged to the term loan lenders — into a newly formed unrestricted subsidiary, using $220 million of the $250 million basket capacity.
- The unrestricted subsidiary then pledges that same IP to a new group of investors in exchange for $200 million of fresh financing, ranking ahead of the original term loan on that specific asset.
- Original term loan lenders, who priced their loan assuming the IP was part of their collateral, now find it structurally subordinated to a new, unaffiliated lender — without any default having occurred and without their consent, because the transaction stayed inside the letter of the RP and investments baskets.
What this means in practice
These maneuvers, often bundled under the umbrella term liability management exercises, exploit the gap between what a covenant was drafted to permit (ordinary intercompany reshuffling) and what its literal text allows (moving core assets outside creditor reach). In response, newer credit agreements add explicit "J.Crew blockers" that carve IP and other key assets out of the investments basket, and lenders increasingly negotiate for majority-lender consent before any unrestricted-subsidiary designation involving material assets.
Reading a covenant's headline limit — "restricted payments capped at 25% of EBITDA" — tells you almost nothing on its own. The exceptions, definitions of "unrestricted subsidiary," and the size of the general baskets are where the actual risk lives, and distressed-debt investors read those definitions line by line before they read anything else.
Related concepts
Practice in interviews
Further reading
- Xtract Research, J.Crew and Serta Trapdoor Case Studies
- Moody's, Covenant Quality and Restricted Payments Baskets