LBB: LEVERAGED BRAND BUYOUTS AND THE VALUE BEHIND THE BRAND.

• Author: Ffrench, Kyle

1. Introduction

   In 2013, shareholders of J. Crew approved a $3.1 billion sale of the popular preppy retailer to two private equity firms. (1) Today, J. Crew is struggling under the weight of this leveraged buyout ("LBO") with almost $2 billion in debt and declining retail sales. (2) To avoid bankruptcy, J. Crew exploited a "back-door provision" in its term loan agreement ("TLA") that allowed the company to transfer certain of its intellectual property ("IP") assets to unrestricted subsidiaries that were not subject to the restrictions of the TLA. (3) In a two-step process, J. Crew transferred $250 million worth of its trademarks and other IP assets including its most value-driving asset, the J. Crew brand, into newly created non-guarantor restricted subsidiaries (the "J. Crew Swap"). (4) Since these newly created restricted subsidiaries were not guarantors of J. Crew's existing debt, a provision in the TLA allowed for the transfer of $250 million worth of IP assets from the non-guarantor restricted subsidiaries (i.e., J. Crew International) into unrestricted subsidiaries that were not bound by the terms or debt obligations of the TLA. (5) J. Crew then offered to exchange the $500 million outstanding debt of unsecured noteholders of its indirect parent company, Chinos Holdings, Inc., that were set to mature in 2019 with new notes issued by the unrestricted subsidiaries secured by the $250 million in IP assets. (6) The J. Crew Swap had been voted against by a minority group of the senior secured lenders under the TLA ("Dissenting Lenders"). In a dispute between J. Crew and the Dissenting Lenders, the Supreme Court of New York agreed with J. Crew that the transfer was permissible under the TLA, and denied the Dissenting Lenders' request for a temporary restraining order barring the transaction. (7) In order for the Dissenting Lenders to establish a legal basis on which to seek redress, they must prove the threshold issue: that their consent was required for the J. Crew Swap to be effectuated. (8) Whether the consent of the Dissenting Lenders was required depends whether the IP assets that were transferred constituted "all or substantially all" of the company's assets. (9)

   J. Crew is not the first company to attempt such a deal. (10) One well-known instance of IP-secured financing is Thomas Edison's use of his patent for the incandescent electric light bulb as collateral to start his company, General Electric. (11) The ability of a company to transfer assets into subsidiaries is more or less ubiquitous in leveraged finance, and the J. Crew Swap may serve as a blueprint for other struggling retailers. (12) In today's retail environment where consumer preference has moved away from brick-and-mortar to online commerce, a number of debt-burdened retailers are seeking alternative methods to traditional financing in order to improve liquidity, reduce overall debt, and stay afloat. (13) Traditional financing agreements generally involve the use of a company's tangible assets (i.e., machinery, equipment, inventory, etc.) as collateral to secure loans. (14) Moving away from this traditional form of security, companies are looking to their IP assets as a source of untapped value for purposes of refinancing. (15) Likewise, retailers that are going out of business often sell off their iP assets, such as brand names and logos, in auctions to the highest bidders. (16) A struggling retailer is thus able to generate cash to repay its creditors, while competitors are able to buy these valuable brand names and potentially profit from their goodwill without physical store fronts. (17) The valuation of IP assets--trademarks in particular--is critical, but may it not fit within the current legal structure. (18) This Author believes that the dispute over the J. Crew Swap presents an overarching question that complicates the issue of valuation even further: do brands themselves generate value independent from the company's IP assets?

   This Note analyzes the value of IP assets in overleveraged companies, focusing on the value of trademarks and brands. Part II provides an overview of trademark law from their historical purpose of trademarks as a single-source identifier to their modern brand function as a source of product differentiation. (19) Part II also explores the current legal framework in determining whether an asset disposition involves "all or substantially all" of a company's assets and the corresponding IP valuation methods. (20) Part III outlines the events that led to the J. Crew Swap and the resulting concerns for creditors. (21) Part IV postulates that the value of a brand name resulting from its IP assets is the driving force behind a company's value. (22) Lastly, Part V concludes that trademarks are likely the main source of value for many companies today. (23)

2. History

   A. Intellectual Property Defined

   The term intellectual property refers to the intangible creations of the mind to which the law affords protection. (24) Pursuant to the U.S. Constitution, authors and inventors are provided the exclusive right to their own creations and discoveries in order to "promote the progress of science and useful arts." (25) Granting individuals the exclusive right to use their own intellectual creations aims to secure a fair return for the inventor's creativity and labor, and serves as an incentive for further creation. (26) This policy of incentivizing creation is at the heart of IP law's purpose. (27)

   B. Trademarks

   Trademarks are used to distinguish a company's goods or services from competitors' by associating the company's products or services with a unique identifier. (28) Trademarks are defined by the United States Patent and Trademark Office ("USPTO") as those unique identifiers, including words, names, symbols, or devices that are used in connection with goods or services to indicate their source. (29) Under U.S. trademark law, a mark is legally forfeited after it ceases to be used to identify the origin of products or services. (30) A mark that becomes too generic and thus fails to function as a single-source identifier is legally forfeited. (31) Yet, while a trademark may "die" once it is no longer in commercial use or fails to function as a single-source identifier, the associated trademark may continue to be recognized in conjunction with the underlying asset for years to come. (32) This continued recognition suggests that trademark law's protection of marks as a single-source identifier fails to capture its value in its entirety. (33)

   The goal of trademark law is not to prevent others from making or selling the same goods or offering the same services as the trademark owner, but to prevent others from using a mark that is confusingly similar to the trademark owner's to sell their own goods or services. (34) When consumers associate a word or symbol with a certain company, they are able to distinguish goods sold under that word or symbol from goods sold by other companies. (35) To protect this association, the law provides the trademark owner with an enforceable right to exclude others from the use of the same or similar identifying mark. (36) By providing trademark owners with the exclusive right to their source-identifying mark, consumers are ensured that an item sold under a particular mark is produced by the same source as other items bearing that same mark that the consumer has liked or disliked in the past. (37) Moreover, by preventing sellers from misappropriating marks that they do not own, trademark law protects consumers from mistakenly believing that a product or service is coming from a source that they are familiar with, when it in fact is not. (38)

   Trademark law protects the valuable information communicated to consumers through a mark that enables them to easily recognize and purchase the exact goods that they are seeking. (39) It guards the mental associations that consumers form between a particular product or service and the trademark used to identify it in the marketplace. (40) In turn, this protection assures that the trademark owner will benefit from the reputation-related rewards associated with a desirable product or service, often referred to as a company's goodwill. (41) The function of a trademark or a brand name is in the trademark owner's exclusive right to use it because for a trademark to have value it must solely identify the source from which the goodwill arose. (42)

   C. Goodwill

   Inextricably tied to trademarks is a company's goodwill. (43) Goodwill is defined as a "business's reputation, patronage, and other intangible assets that are considered when appraising the business, especially for purchase; the ability to earn income in excess of the income that would be expected from the business viewed as a mere collection of assets." (44) Trademark law prohibits the sale or assignment of a trademark without the goodwill it symbolizes by holding such an assignment null and void. (45) Allowing the assignment or licensing of a trademark without the associated goodwill would permit a company to profit from the accompanying reputation-related rewards of built-up goodwill without incurring the cost associated with building goodwill. (46) It is a trademark, therefore, that functions as the communicative identifying symbol of a company's goodwill. (47) The association between trademarks and goodwill led to the expansion of trademark law from protecting trademarks as a single-source identifier to protecting the use of trademarks by others that may dilute a mark's goodwill even when there is no likelihood of confusion between products. (48) The expansion of trademark law from a mechanism for protecting consumers and incentivizing producers to create high-quality products to a vehicle for protecting the value of a company's accumulated goodwill has led to trademarks as a corporate vehicle to monetize through branding. (49)

   D. Trademarks as Brands

   While trademark law treats trademarks and...