J.C. Penney Company, Inc. (NYSE:JCP) filed a complaint asking the Court of Chancery in Delaware to declare that it is not in default of its bond agreements and that it did not  prevent its creditors from declaring an event of default or take further action related to the notice of default sent by the counsel for certain bond holders.


The retailer filed the lawsuit against U.S. Bank National Association, which serves as Indenture Trustee after receiving a notice of default from Brown Rudnick LLP, a law firm representing a group of hedge fund creditors alleging that J.C. Penney Company violated the terms of its bonds by granting a lien on its inventory

JSO Capital Partners, Blue Crest Capital, and other bondholders demanded that J.C. Penney Company Inc (NYSE:JCP) fix its debt-term violations within 90 days or else the company must repay approximately $326 million of outstanding bonds the creditors owed. The notice also warned that the retailer could be in default on all its $2.9 billion bond debt.

The bondholders argued that J.C. Penney violated the terms of the Indenture after using its merchandise in its inventory as collateral for the $1.5 billion credit line in January last year.

Based on complaint filed by the retailer, the law firm representing the bondholders incorrectly referred to the $1.5 billion credit limit as “indebtedness” and failed to assert that J.C. Penney borrowed money under the 2012 Credit Facility.

J.C. Penney argued that the Indenture does not create a negative covenant to liens on inventory, instead the negative covenant extends to principal property (consist of real property and tangible assets) owned by the company as part of a store, warehouse or distribution center as defined by the agreement. According to the company, an inventory is not part of a store, warehouse or distribution center.

Adam Cohen, founder of Covenant Review, a credit-research firm engaged in analyzing legal risks of debt said a retailer’s inventory is not generally included in the restricted collateral under the principal property umbrella. He explained that it’s not part of the real property such as buildings, stores or warehouses.

In a statement, Ken Hannah, CFO of J.C. Penney said, “We believe this notice of default is invalid, completely without merit and is intended to create self-interested trading opportunities in the market, and we will therefore vigorously defend the interests of J.C. Penney and all of our constituencies.”

J.C. Penney received the default notice amid its efforts to revive the company by transforming its stores across the country.

Analysts at Piper Jaffray Companies (NYSE:PJC) commented that J.C. Penney’s ability to pledge inventory as collateral is significant for its turnaround strategy, as the company needs funds its 2013 store remodel plan. The analysts expects J.C. Penney’s stock to come under pressures as investors consider the possibility that it might be forced to pull inventory from the borrowing base of its credit facility, which could cast doubts on its financial ability to implement its turnaround strategy. They expect the stock to decline to their price target of $17 per share.

On the other hand, analysts at BMO Capital Markets predict three possible negative outcomes if J.C. Penney Company Inc (NYSE:JCP) loses the legal battle against its creditors. According to them, the retailer is forced to renegotiate it credit agreement, a judge rules in favor of providing for equal and ‘ratable’ security interest in the inventory to the holders of the debentures causing the company to collateralize more of its assets, and the bondholders declare the debt immediately due and payable, which could force the company into bankruptcy. They expect the stock to be weak as a result of this situation.