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J. Screwed - A Paper

posted by Mitu Gulati

A number of months ago now, I listened to a fun podcast episode on Planet Money titled "J. Screwed" about contract shenanigans by J.Crew, as it was making its way into deep financial distress.  I'm fascinated by the exploitation of contract loopholes in debt contracts. So, of course, I wanted to know more. I went digging into the world of Google.  But I couldn't find anything good in the literature that explained to me the details of what was going on (the contract term in question, how widespread this problem was, how the market had reacted, etc., etc.). The best I found was a blog post that fellow slipster, Adam Levitin, kindly pointed to me.

But now there is a wonderful article up on ssrn by the author of that post (a former student of Adam at Georgetown Law, I believe).  The appropriately titled article, "The Development of Collateral Stripping By Distressed Borrowers" by Mitchell Mengden, is here.

The abstract reads as follows:

In the past decade, private equity sponsors have taken a more aggressive stance against creditors of their portfolio companies, the most recent iteration of which has come in the form of collateral stripping. Sponsors have been using creative lawyering to transfer valuable collateral out of the reach of creditors. This Article delves deeper into the issue by examining the contract terms and litigation claims raised by these transactions.

The lack of protective covenants and ease of manipulating EBITDA and asset valuations are key conditions that permit collateral stripping. Each of these conditions were present in the past decade, primarily due to the protracted expansionary stage of the credit cycle. Lenders, however, can protect themselves from collateral stripping by negotiating stricter covenants and tighter EBITDA definitions, as well as pursuing ex post litigation for fraudulent transfers, illegal distributions, and claims for breach of fiduciary duty.

Contractual opportunism and creative lawyering will almost certainly continue to pervade credit markets. This Article provides a roadmap of ways that lenders can protect themselves from opportunism during contracting and throughout the course of the loan. As this Article concludes, ex post litigation claims are often an inadequate remedy, so lenders should seek to tighten EBITDA definitions and broaden protective covenants—even if to do so requires other concessions—to avoid litigation.

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