Item 1. BUSINESS

Introduction

Cherokee Inc. (the Company, which may be referred to as WE, US, or OUR) is in the business of marketing and licensing the Cherokee and Sideout brands and related trademarks and other brands it owns or represents. We are one of the leading licensors of brand names and trademarks for apparel, footwear and accessories in the United States. Our operating strategy emphasizes domestic and international retail direct and wholesale licensing whereby we grant retailers and wholesalers the license to use the trademarks held by us on certain categories of merchandise, and the licensees are responsible for designing and manufacturing the merchandise.

We and our wholly-owned subsidiary, SPELL C. LLC ("Spell C"), own several trademarks including Cherokee(R), Sideout(R), Sideout Sport(R), King of the Beach(R) and others. The Cherokee brand, which began as a footwear brand in 1973, has been positioned to connote quality, comfort, fit, and a "Casual American" lifestyle with traditional wholesome values. The Sideout brand and related trademarks, which represent an active lifestyle, were acquired by us in November 1997. As of February 3, 2001, we had twenty-three continuing license agreements, covering both domestic and international markets.

Our retail direct licensing strategy is premised on the proposition that in the United States nearly all aspects of the moderately priced apparel, footwear and accessories business can be sourced most effectively by large retailers, who not only command significant economies of scale, but also interact daily with the end consumer. In addition, we believe that these retailers in general may be able to obtain higher gross margins on sales and increase store traffic by directly sourcing, stocking and selling licensed products bearing widely recognized brand names, such as our brands, than through carrying strictly private label goods or branded product from third-party vendors. Our strategy in the United States is to capitalize on these ideas by licensing our portfolio of brands primarily to strong and growing retailers, who, working in conjunction with us, develop merchandise for their stores.

Beginning in 1995, we began to take a number of important steps designed to implement our retail direct licensing strategy. On August 15, 1995, we entered into a strategic alliance with one of the largest retailers in the United States, Target Stores, a division of Target Corp. In November 1997, we reaffirmed our relationship with Target Stores, by entering into an amended licensing agreement (the "Amended Target Agreement") which grants Target Stores the exclusive right in the United States to use the Cherokee trademarks on certain specified categories of merchandise. Under the Amended Target Agreement, Target Stores is obligated to pay royalties based upon a percentage of its net sales of Cherokee branded merchandise, with a minimum guaranteed royalty of $60.0 million over the six-year initial term of the agreement. During the fiscal year ended February 3, 2001 ("Fiscal 2001"), a wide range of Cherokee branded merchandise was sold at over 970 Target stores. Due to the strong presence and sales of Cherokee branded products in Target Stores during Fiscal 2001, royalty revenues from Target Stores totalled approximately $19.3 million, which is 183.5% of the guaranteed minimum royalty for Fiscal 2001 under the Amended Target Agreement.

In August 1997, we entered into a licensing agreement with one of Canada's largest retailers, Zellers Inc., a division of the Hudson's Bay Company, under which Zellers was granted the exclusive right in Canada to use the Cherokee trademarks in connection with a broad range of categories of merchandise. Under the Zellers licensing agreement, Zellers is obligated to pay royalties based upon a percentage of its net sales of Cherokee branded merchandise with a minimum guaranteed royalty of $10.0 million over the five-year initial term of the agreement. Zellers commenced the initial sales of Cherokee branded merchandise in over 350 stores in July 1998 and during Fiscal 2001 royalty revenues from Zellers totalled approximately $3.7 million, which is 180.2% of the guaranteed minimum royalty for Fiscal 2001 under the Zellers license agreement.

To increase our licensing potential, we purchased all of Sideout Sport Inc.'s trademarks, copyrights, trade secrets and associated license agreements on November 7, 1997. The trademarks acquired from Sideout Sport

Inc. included, among others, Sideout, Sideout Sport and King of the Beach. Royalty revenues derived from the Sideout brands have grown from $585,000 during our fiscal year ended January 30, 1999 to approximately $3.0 million during Fiscal 2001.

We are frequently approached by parties seeking to sell their brands and related trademarks. Should an established and marketable brand become available on favorable terms, we would be interested in pursuing such an acquisition. In addition to acquiring brands and licensing our own brands, we assist other companies, wholesalers and retailers, in identifying licensees or licensors for their brands or stores. Generally, as an exclusive consultant, we will perform a range of services including marketing of brands, solicitation of licensees, contract negotiations and administration and maintenance of license or distribution agreements. In return for our services we will normally charge a certain percentage of the net royalties generated by the brands we represent and manage.

Cherokee was incorporated in Delaware in 1988. Our principal executive offices are located at 6835 Valjean Avenue, Van Nuys, California 91406, telephone (818) 908-9868.

Overview of Licensing Business

The Cherokee name, which began as a footwear brand in 1973, has been positioned to connote quality, comfort, fit, and a "Casual American" lifestyle with traditional, wholesome values. The Sideout brand and related trademarks, which represent an active lifestyle, were acquired by us in November 1997. See "Sideout Agreement" below. Our primary emphasis for the past five years has been directed toward domestic and international retail direct and wholesale licensing. As of February 3, 2001, we had twenty-three continuing license agreements, covering both domestic and international markets, fifteen of which pertained to the Cherokee brand.

Our license agreements are with retailers and wholesalers and are either international master agreements or category-specific exclusive or non-exclusive agreements. Of the twenty-three licensing agreements, seven are with retailers, five are with domestic wholesalers and eleven are with international wholesalers or retailers. In retail direct licensing, we grant retailers a license to use the trademarks on certain categories of merchandise. We provide design direction and collaborate with our retailers on pre-approved packaging, graphics and quality control standards. The retailer is responsible for manufacturing the merchandise. We refer to this practice as our "retail direct" licensing strategy. Wholesale licensees manufacture and import various categories of footwear and accessories under our trademarks and sell the licensed products to retailers. Our retail, wholesale and international license agreements provide us with final approval of pre-agreed upon quality standards, packaging and in most cases marketing of licensed products. We have the right to conduct periodic quality control inspections to ensure that the image and quality of licensed products remain consistent. We will continue to solicit new licensees through a small number of executive employees and may retain the services of outside consultants to assist us in this effort.

Our current business strategy is to maximize the value of our existing and future brands by exploiting them in a manner that recognizes the relative market power, in different areas of the world, of the various participants-- manufacturer, wholesaler and retailer--in the chain of supply to the ultimate consumer. In the United States, market power and accompanying economies of scale, are generally and increasingly held by a few dominant retailers of moderately priced merchandise, and, accordingly, in the United States we have pursued our retail direct licensing strategy. In contrast to the retail market in the United States, as well as in Canada, in selected international markets we have sought to develop our brands through wholesale licenses with manufacturers or other companies who have market power and economies of scale in their respective markets. Finally, in some countries, we believe that an owner or licensee of one or more well-known U.S. brands has the opportunity to become a dominant, vertically integrated manufacturer or retailer or both of branded apparel, footwear and accessories. Accordingly, in those countries we have begun to pursue licensing or strategic alignments whereby our brands can become the basis for such a vertically integrated manufacturer/retailer. This strategy permits us to operate with minimal working capital, virtually no capital

expenditures (other than those associated with acquiring new brands and related trademarks), no production costs, significantly reduced design, marketing, distribution and other operating expenses, and a small group of core employees.

United States Retail Direct Licensing

Our retail direct licensing strategy is premised on the proposition that in the United States nearly all aspects of the moderately priced apparel, footwear and accessories business, from product development and design, to merchandising, to sourcing and distribution, can be executed most effectively by large retailers, who not only command significant economies of scale, but also interact daily with the end consumer. In addition, we believe that these retailers in general may be able to obtain higher gross margins on sales and increase store traffic by directly sourcing, stocking and selling licensed products bearing widely recognized brand names (such as our brands) than through carrying strictly private label goods or branded product from third- party vendors. We also expect that the enhanced profitability to retailers of private label products and in-store brands, coupled with the substantial and increasing marketing costs to establish and maintain a widely recognized apparel brand, will result in further erosion of revenues and profitability for mid-sized and small apparel manufacturers and corresponding increased desirability to retailers of well-established brands with broad appeal. Our strategy in the United States is to capitalize on these trends by licensing our portfolio of brand names to retailers, who, working in conjunction with us, develop merchandise for their stores, and to augment that portfolio by acquiring additional brands, which have high consumer awareness, broad appeal and applicability to a range of merchandise categories.

On November 12, 1997, we reaffirmed our relationship with Target Stores by entering into the Amended Target Agreement. This agreement was subsequently assigned to Spell C and pledged as collateral for the Zero Coupon Secured Notes issued by Spell C. See "Recapitalization; Sale of Cherokee Trademarks to Spell C; Issuance of Secured Notes" below. The Amended Target Agreement grants Target Stores the exclusive right in the United States to use the Cherokee trademarks in certain specified categories of merchandise including:

. men's, women's and children's apparel, including intimate apparel, foundations and sleepwear;

. men's, women's and children's fashion accessories;

. bed and bath products and accessories;

. luggage, sports bags and backpacks;

. home textiles;

. domestics and home decor products;

. home furnishings;

. sporting goods; and

. cosmetics, bath and body products.

Some of the above-listed categories are subject to current license agreements between us and third parties. The Amended Target Agreement provides that upon the expiration or termination of such agreements, the categories of merchandise subject to such agreements will become exclusive to Target Stores in the United States. Due to the broad nature of the rights granted to Target Stores in the United States, and the restrictions contained in the Amended Target Agreement, we may not enter into new licensing agreements in the United States with respect to the Cherokee brand, except for retail license agreements for cosmetics, bath and body products with several drug chain stores.

Under the Amended Target Agreement, Target Stores has agreed to pay a royalty each fiscal year, up to and including the fiscal year ending January 31, 2004, based on a percentage of Target Stores' net sales of Cherokee branded merchandise during each fiscal year, which percentage varies according to the volume of sales of merchandise. In any event, Target Stores has agreed to pay a minimum guaranteed royalty of

$9.0 million for each of the two fiscal years ending January 31, 1999 and 2000 and $10.5 million for each of the four fiscal years ending January 31, 2001 through 2004.

The initial term of the Amended Target Agreement commenced on February 1, 1998 and ends January 31, 2004. If Target Stores is current in its payments of the minimum guaranteed royalty, the Amended Target Agreement will automatically renew for the fiscal year ending in 2005, and will continue to automatically renew for successive fiscal year terms provided that Target Stores has paid a minimum guaranteed royalty equal to or greater than $9.0 million for the preceding fiscal year. Target Stores commenced the initial sales of Cherokee branded merchandise in July 1996. Royalty revenues from Target Stores were $5.9 million during our fiscal year ended May 31, 1997, $6.4 million during our eight month fiscal period ended January 31, 1998, $14.6 million during our fiscal year ended January 30, 1999, $16.3 million during our fiscal year ended January 29, 2000 ("Fiscal 2000") and $19.3 million during Fiscal 2001, which accounted for 68%, 75%, 76%, 66% and 68%, respectively, of our consolidated revenues during such periods. See "Risk Factors."

Our retail direct licensees for the Sideout brand continued to achieve positive results from sales of merchandise bearing the Sideout brand. Categories of merchandise under license include men's, women's and children's sportswear; accessories, luggage, sports bags and backpacks, skin care products and hats. During Fiscal 2001, royalty revenues from retail direct licensees for the Sideout brand totaled $2.6 million. Also during Fiscal 2001, Mervyn's exercised its right to renew its licensing agreement for the Sideout brand for an additional term of three years on the same terms and conditions. The renewal term will commence on February 1, 2002 and continue through January 31, 2005. We intend to continue to actively pursue our retail direct licensing strategy to further develop the Sideout brand in the United States.

During Fiscal 2001, the non-exclusive United States retail direct licensees included Brylane, Pamida, Mervyn's, Gart Sport/Sportmart, Bob's Stores and Casual Male. Generally, royalties on non-exclusive domestic retail licenses begin at 3% of the retailer's net sales of licensed products and may decrease depending on the retailer's annual sales of licensed products and the retailer's guaranteed annual sales of licensed products.

During Fiscal 2001, our license agreement with Brylane expired and was not renewed. Additionally, ShopKo Stores Inc., as part of its integration of the Pamida operations, made the decision to discontinue use of the Cherokee brand in its merchandise assortments and requested a termination of the Pamida licensing agreement with us. We agreed to terminate the licensing agreement with Pamida in return for a cash payment of $375,000 as settlement in full of the remaining minimum royalties due under the existing licensing agreement.

As an incentive for our licensees to achieve higher retail sales of Cherokee or Sideout branded products, many of our existing license agreements, including the Amended Target Agreement, are structured to provide royalty rate reductions for the licensees after they achieve certain levels of retail sales of Cherokee or Sideout branded products during each fiscal year. As a result, our royalty revenues as a percentage of our licensees' retail sales of branded products are highest at the beginning of each fiscal year and decrease throughout each fiscal year as licensees reach certain retail sales thresholds contained in their respective license agreements. Therefore, the amount of royalty revenue received by us in any quarter is dependent not only on retail sales of branded products in such quarter, but also the resulting attainment of royalty rate reductions in any preceding quarters in the same fiscal year. The size of the royalty rate reductions and the level of retail sales at which they are achieved vary in each licensing agreement.

During Fiscal 2001, we and Spell C received $22.4 million in aggregate royalties from the United States retail direct license agreements, which accounted for 79.3% of our consolidated revenues during such period.

United States Wholesale Licensing

We currently have five wholesale license agreements that grant unaffiliated manufacturers the license to manufacture and market sunglasses, footwear, handbags, purses and watches under our Cherokee and Sideout trademarks in the United States. Our wholesale license agreements typically require the wholesale licensee to

pay royalties on revenues against a guaranteed minimum royalty that generally increases over the term of the agreement. Two wholesale licensing agreements for the Cherokee brand, which included Outlook for sunglasses and Bueno for luggage, handbags and purses, were terminated during Fiscal 2001. The remaining wholesale licensing agreements for the Cherokee brand will expire during the term of the Amended Target Agreement and the categories of merchandise subject to such terminated license agreements will become exclusive to Target Stores in the United States.

Our wholesale license agreements for the Sideout brand are for product categories including footwear, sunglasses, watches and related time products. The agreements have various expiration dates and contain three- to five-year renewal options. The total number of wholesale licensing agreements for the Sideout brand was three as of February 3, 2001.

During Fiscal 2001, we received $1.2 million in aggregate royalties from our wholesale licensing agreements, which accounted for 4.2% of our consolidated revenues during such period.

International Licensing

We will continue to seek to develop in several international markets both our Cherokee and Sideout brands and other brands we represent through retail direct, master or wholesale licenses with manufacturers or other companies that have market power and economies of scale in their respective markets.

On August 22, 1997, we entered into an international retail direct licensing agreement with Zellers Inc., a Canadian corporation, which is a division of Hudson's Bay Company. Zellers was granted the exclusive right in Canada to use the Cherokee brand and related trademarks in connection with a broad range of categories of merchandise, including women's, men's and children's apparel and footwear, women's intimate apparel, fashion accessories, home textiles, cosmetics and recreational products. The term of the agreement is for five years, with automatic renewal options, provided that specified minimums are met each contract year. Under the agreement, Zellers agreed to pay us a minimum guaranteed royalty of $10.0 million over the five-year initial term of the agreement. Zellers commenced the initial sales of Cherokee branded merchandise in July 1998 and royalty revenues to us from Zellers totaled $3.6 million during Fiscal 2000 and $3.7 million during Fiscal 2001.

During Fiscal 2001, we entered into two exclusive retail direct licensing agreements for the Cherokee brand, one with DongKwang International Co. Ltd., which plans to open retail stores in South Korea and one with Paris, France based Carrefour, the second largest retailer in the world. The Carrefour Group is granted the exclusive right to manufacture, promote, sell and distribute a wide range of products bearing our Cherokee brand in Spain, Mexico and Brazil. The Carrefour Group is obligated to pay us a royalty based upon a percentage of our net sales of Cherokee branded products in those countries. We do not expect to receive royalties until November 2001 under this agreement, and even then there can be no guarantee that any royalties will be significant in amount. If the Carrefour Group exceeds certain retail sales thresholds for Cherokee branded products then the scope of the agreement will be automatically expanded to grant the Carrefour Group the exclusive right to manufacture, promote, sell and distribute products bearing the Cherokee brand in certain other European and South American countries not already covered by the agreement, including, among others, Italy, Greece, Poland, Argentina, Chile, Colombia, Turkey, France, the United Kingdom, Portugal and Germany. Even if the retail sales thresholds are not met, during the term of the agreement, the Carrefour Group also has a right of first refusal to add any of the European or South American countries to the territory covered by the agreement. Further, with respect to Japan, China and several other Asian countries, the Carrefour Group may elect to add any of those countries to the territory covered by the agreement, provided that at the time of such election we do not already have an existing license agreement covering the country to be added. The initial term of the agreement expires December 31, 2003, however, if the Carrefour Group meets certain retail sales thresholds with respect to Cherokee branded products, the agreement may be extended indefinitely by the Carrefour Group for successive three year terms. We expect to continue to solicit additional licensees for the Cherokee brand in Asia, Europe and South America, subject to the Carrefour Group's rights under the agreement.

Including the Carrefour and DongKwang agreements, we have eight international wholesale and/or retail license agreements for the Cherokee brand. Other international licensees include Japan-based Itochu Corporation and its sub- licensees Takaya, Okudo, and Takaishi, China-based Shanghai Eesli Trading Company and Philippine-based Magica Holdings Co. Inc. Under the terms of the Itochu licensing agreement, Itochu will manufacture, promote, sell, distribute and sublicense products bearing the Cherokee brand in Japan. We are currently in discussions to possibly terminate our licensee in China, Shanghai Eesli Trading Company, and we expect to incur no material costs in connection with the termination. During Fiscal 2001, we terminated our master licensing agreement with Magica Holding Co. Inc. for the Philippines and our wholesale licensing agreement with Bravo Enterprises for Mexico and incurred no expense with regard to the terminations.

During Fiscal 2001, we entered into a non-exclusive retail direct licensing agreement for the Sideout brand with Sport-Scheck GmBh, which is based in Munich, Germany. Sport-Scheck is the largest sporting goods retailer in Germany and a division of Otto Versand. Including Sport-Scheck, we have four international licensing agreements with respect to the Sideout brand and related trademarks. Our international licensing agreements for the Sideout and King of the Beach brands are all exclusive and cover countries including Argentina, Japan and Mexico, and product categories including men's, boy's and women's apparel and footwear. Matienzo Mexico, our Mexican licensee, currently distributes to department and specialty stores and has six Sideout stores throughout Mexico. During Fiscal 2001, we terminated our international licensing agreement with AM Moolla and incurred no expense with regard to the termination.

During Fiscal 2001, we received $4.4 million in aggregate royalties from our international license agreements, which accounted for 15.5% of our consolidated revenues during such period.

Other Business Opportunities

We are frequently approached by parties seeking to sell their brands and related trademarks. Should an established and marketable brand become available on favorable terms, we would be interested in pursuing such an acquisition. In addition to acquiring brands and licensing our own brands, we assist other companies in identifying licensees for their brands. Generally, as an exclusive consultant, we will perform a range of services including marketing of brands, solicitation of licensees, contract negotiations and administration and maintenance of license or distribution agreements. In return for our services we will normally receive a certain percentage of the net royalties generated by the brands we represent and manage.

During Fiscal 2001, we assisted Mossimo Inc. in locating Target Stores as a licensee of the Mossimo brand and entered into a finder's agreement with Mossimo, which provides that we will receive 15% of the royalties paid to Mossimo by Target Stores. Under Mossimo's agreement with Target Stores, Target Stores is obligated to pay Mossimo a royalty based on a percentage of net sales of Mossimo branded products, with a minimum guaranteed royalty, beginning in 2001, of approximately $27.8 million over the initial three year term of the agreement. Mossimo's agreement with Target Stores is subject to early termination under certain circumstances. During the fourth quarter of Fiscal 2001, we received initial revenues from Mossimo of $296,600. Mossimo's filings with the Securities and Exchange Commission indicate that there is currently substantial doubt about Mossimo's ability to continue as a growing concern. If Mossimo should enter into bankruptcy proceedings, under bankruptcy law there is a possibility Mossimo could reject the finders agreement and prevent us from receiving any of the royalties paid by Target Stores to Mossimo.

Additionally, we entered into five other exclusive consulting agreements, one to represent Maui and Sons Inc. in the United States and Canada, one to represent Pritikin worldwide, one to represent Bum in Mainland China, Hong Kong and Macao, one to represent Rampage in the Philippines, Mainland China, Hong Kong, Macao, Korea, Taiwan, Singapore, Malaysia, Indonesia, Thailand, Vietnam and Cambodia and one with Aspen Licensing International Inc. to represent its Aspen brand both domestically and internationally. The consulting agreement with Aspen Licensing International Inc. expired during Fiscal 2001.

Recapitalization; Sale of Cherokee Trademarks to Spell C; Issuance of Secured Notes

On December 23, 1997, we completed a recapitalization that resulted in the issuance of a special dividend of $5.50 per share on January 15, 1998. To facilitate the recapitalization, we formed Spell C. LLC, a special purpose, bankruptcy remote, single member Delaware limited liability company, wholly owned by us. We assigned to Spell C all of our right, title and interest in the Amended Target Agreement and sold to Spell C all of our right, title and interest in the Cherokee brand name and related trademarks in the United States. The sale of the rights to the Cherokee trademarks in the United States was subject to certain exceptions which allow us to continue to use the trademarks in the United States in conjunction with our then-existing license agreements and allow us to use the trademarks in the United States in conjunction with retail license agreements in the category of cosmetics, bath and body products. Except for these exceptions, we no longer have the right to license the Cherokee brand and related trademarks in the United States, but retain all rights to do so outside of the United States.

On December 23, 1997, Spell C issued for gross proceeds of $47.9 million, privately placed Zero Coupon Secured Notes (the "Secured Notes"), yielding 7.0% interest per annum and maturing on February 20, 2004. The proceeds from the sale of the Secured Notes were used to pay the special dividend described above. The Secured Notes amortize quarterly from May 20, 1998 through February 20, 2004, in the amount of $9.0 million per year the first two years and $10.5 million per year the third through sixth years. The Secured Notes are secured by the Amended Target Agreement and the United States Cherokee trademarks and brand names. The Secured Notes indenture requires that any proceeds due to Spell C under the Amended Target Agreement and several other license agreements must be deposited directly into a collection account controlled by the trustee under the indenture. The trustee distributes from the collection account the amount of principal due and payable to the holders of the Secured Notes on quarterly note payment dates. Excess amounts on deposit in the collection account may only be distributed to Spell C if the amount on deposit in the collection account exceeds the amount of principal due and payable on the next quarterly note payment date. Such excess amounts, if any, may then be distributed by Spell C to us. During Fiscal 2001, of the $19.3 million in royalty revenues from Target Stores, $10.125 million was paid to the holders of the Secured Notes. At various times during Fiscal 2001, Spell C distributed a total of $7.7 million to us (which amount includes royalty revenues received from Target Stores during both Fiscal 2000 and Fiscal 2001 and interest income earned on royalty revenues). The minimum guaranteed royalty under the Amended Target Agreement is $9.0 million for each of the two fiscal years ending January 31, 1999 and 2000 and $10.5 million for each of the four fiscal years ending January 31, 2001 through 2004. The aggregate scheduled amortization under the Secured Notes is $60.0 million and equals the aggregate minimum guaranteed royalty payable under the Amended Target Agreement, which is also $60.0 million. While we believe that royalties payable under the Amended Target Agreement may continue to exceed the minimum guaranteed royalties payable in upcoming fiscal years, we cannot predict with accuracy whether such royalties will exceed the minimum guaranteed royalties payable during such years, and if they do not, we will not receive further distributions from Spell C during the term of the Amended Target Agreement. See "Risk Factors."

Sideout Agreement

On November 7, 1997, we entered into an Agreement of Purchase and Sale of Trademarks and Licenses (the "Sideout Agreement") with Sideout Sport Inc., pursuant to which we agreed to purchase all of Sideout Sport Inc.'s trademarks, copyrights, trade secrets and associated license agreements. The trademarks acquired from Sideout Sport Inc. include, among others, Sideout(R), Sideout Sport(R) and King of the Beach(R). Pursuant to the Sideout Agreement, we paid $1.5 million at the closing of the acquisition and agreed to pay an additional $500,000 upon release of liens on the assets that were purchased. Most of the liens have since been released and $495,000 of the $500,000 holdback has been paid. Under the terms of the Sideout Agreement, we will also pay Sideout Sport Inc., on a quarterly basis, contingent payments of 40% of the first $10.0 million, 10% of the next $5.0 million and 5% of the next $20.0 million, of royalties and license fees received by us through licensing of the Sideout trademarks. Upon the earlier of such time as we have paid Sideout a total of $7.5 million or October 22, 2004, we will have no further obligation to pay Sideout Sport Inc. During

Fiscal 2001, we made payments exceeding $1.2 million under the Sideout Agreement and since January 1999, we have paid in total over $2.6 million in contingent payments under the Sideout Agreement.

Trademarks

We hold various trademarks including Cherokee(R), Sideout(R), Sideout Sport(R), King of the Beach(R) and others, in connection with numerous categories of apparel and other goods. These trademarks are registered with the United States Patent and Trademark Office and in a number of other countries. We also hold trademark applications for Cherokee, Sideout, Sideout Sport and King of the Beach in numerous countries. We intend to renew these registrations as appropriate prior to expiration. We monitor on an ongoing basis unauthorized uses of our trademarks, and we rely primarily upon a combination of trademark, copyright, know-how, trade secrets, and contractual restrictions to protect our intellectual property rights both domestically and internationally. See "Risk Factors."

Marketing

We have positioned the Cherokee name to connote quality, comfort, fit and a "Casual American" lifestyle with traditional, wholesome values. The Sideout brand and related trademarks represent an active lifestyle. We integrate our advertising, product, labeling and presentation to reinforce these brand images. We intend to continue to promote a positive image in marketing the Cherokee and Sideout brands through licensee-sponsored advertising. Our retail, wholesale and international license agreements provide us with final approval of pre-agreed upon quality standards, packaging and marketing of licensed products. We principally rely on our licensees to advertise the Cherokee and Sideout brands, and as a result our advertising costs have been minimal.

We developed a website (www.cherokeegroup.com), which utilizes a business-to- business E-commerce strategy. The information regarding our website address is provided for convenience and is not a hyperlink. Our goal in developing the website is to enhance communication, information flow and networking with existing and prospective licensees. The website currently includes our profiles and our brands, certain of our financial statements and press releases, as well as a secured area to support our licensees with graphics, packaging and trim items, design concepts, new developments and other administrative needs.

Internationally, we intend to continue to seek to develop both of our principal brands through license agreements and strategic alliances with manufacturers or other companies who have market power and economies of scale in their respective markets. We are also seeking to assist other companies in identifying licensees for their brands. We will continue to market our brands and solicit new licensees through a small number of executive employees and may retain the services of outside consultants to assist us in this effort.

Competition

Royalties paid to us under our licensing agreements are generally based on a percentage of the licensee's net sales of licensed products. Cherokee and Sideout brand footwear, apparel, and accessories, which are manufactured and sold by both domestic and international wholesalers and retail licensees, are subject to extensive competition by numerous domestic and foreign companies. Such competitors with respect to the Cherokee brand include Levi Strauss & Co., The Gap, Old Navy, Liz Claiborne and VF Corp. and private labels developed for retailers. Competitors with respect to the Sideout brand include Quicksilver, Mossimo, Nike and other activewear companies. Factors, which shape the competitive environment, include quality of garment construction and design, brand name, style and color selection, price and the manufacturer's ability to respond quickly to the retailer on a national basis. In recognition of the increasing trend towards consolidation of retailers and greater emphasis by retailers on the manufacture of directly sourced merchandise, in the United States our business plan focuses on creating strategic alliances with major retailers for their sale of products bearing our brands through the licensing of our trademarks directly to retailers. Therefore, our success is dependent on our licensees' ability to design, manufacture and sell products bearing our brands and to respond to ever-changing consumer demands. Companies such as Mossimo have entered into and other companies owning established trademarks could also enter into, similar arrangements with retailers. See "Risk Factors."

Employees

As of February 3, 2001, we employed 14 persons. None of our employees are represented by labor unions and we believe that our employee relations are satisfactory.

Risk Factors

In addition to the other information contained herein or incorporated herein by reference, the risks and uncertainties and other factors described below could have a material adverse effect on our business, financial condition and results of operations and could cause our future business, financial condition and results of operations to differ materially from the results contemplated by any forward-looking statement we may make herein, in any other document we file with the Securities and Exchange Commission, or in press release or other written or oral statement we may make. Please also see "Item 7. Management's Discussion and Analysis of Financial Condition And Results of Operations - Cautionary Note Regarding Forward-Looking Statements" for additional risks and uncertainties applicable to us.

Payments to us from our subsidiary, Spell C, are subject to a number of restrictions under the Amended Target Agreement.

We cannot assure you that our subsidiary, Spell C, will continue to distribute any significant amount of cash or property to us until after the maturity of the Secured Notes, if then. The Secured Notes indenture provides that any royalties payable under the Amended Target Agreement will be deposited directly into a collection account controlled by the trustee under the Secured Notes indenture. The trustee will distribute from the collection account the amount of principal due and payable to the holders on the Secured Notes on quarterly note payment dates. Excess amounts in the collection account may only be distributed to Spell C if the amount in the collection account exceeds the aggregate amount of principal due and payable on the next quarterly note payment date. Such excess amounts, if any, may then be distributed by Spell C to us. The aggregate scheduled amortization under the Secured Notes is $60.0 million and equals the aggregate minimum guaranteed royalty payable under the Amended Target Agreement, which is also $60.0 million. See "Recapitalization; Sale of Cherokee Trademarks to Spell C; Issuance of Secured Notes" and "United States Retail Direct Licensing." There is no assurance, therefore, that in the future there will be any excess amounts available to be distributed to us. We do not expect revenues deposited in the collateral account from sources other than the Amended Target Agreement to be significant during fiscal year 2002. We cannot predict with accuracy whether payments under the Amended Target Agreement will exceed the minimum guaranteed royalty, and if they do not, no distribution will be made to Spell C from the collateral account, and in turn, Spell C will have no funds available to distribute to us. If Spell C does not distribute any funds to us during the balance of the initial term of the Amended Target Agreement it could have a material adverse effect on our business, financial condition and results of operations.

Our business is subject to intense competition.

Royalties paid to us under our licensing agreements are generally based on a percentage of our licensee's net sales of licensed products. Cherokee and Sideout brand footwear, apparel, and accessories, which are manufactured and sold by both domestic and international wholesalers and retail licensees, are subject to extensive competition by numerous domestic and foreign companies. Such competitors with respect to the Cherokee brand include Levi Strauss & Co., The Gap, Old Navy, Liz Claiborne and VF Corp. and private labels developed for retailers. Competitors with respect to the Sideout brand include Quicksilver, Mossimo, Nike and other activewear companies. Factors, which shape the competitive environment, include quality of garment construction and design, brand name, style and color selection, price and the manufacturer's ability to respond quickly to the retailer on a national basis. In recognition of the increasing trend towards consolidation of retailers and greater emphasis by retailers on the manufacture of private label merchandise, in the United States our business plan focuses on creating strategic alliances with major retailers for their sale of products bearing our brands through the licensing of our trademarks directly to retailers. Therefore, our success is dependent on our licensees' ability to design, manufacture and sell products bearing our brands and to

respond to ever-changing consumer demands, and any significant failure by our licensees to do so could have a material adverse effect on our business, financial condition and results of operations. Other companies owning established trademarks could also enter into similar arrangements with retailers. See "Competition."

Our business is dependent on Target Stores, which accounted for 68% of our consolidated licensing revenues in Fiscal 2001.

During Fiscal 2001, 68% of our and Spell C's licensing revenues were generated from a single source, Target Stores, a division of Target Corp. See "United States Retail Direct Licensing." We have assigned all our rights in the Amended Target Agreement to Spell C, which has in turn pledged the Amended Target Agreement as collateral for the Secured Notes. Spell C will be dependent on revenues from the Amended Target Agreement for most, if not all, of its revenues. Although the Amended Target Agreement provides for minimum annual royalty payments, if for any reason Target Stores does not pay the minimum royalties, Spell C will likely be unable to meet, and will default on, its payment obligations under the indenture for the Secured Notes. We are not guarantors of the Secured Notes; however, the United States Cherokee trademarks have been pledged as security for the Secured Notes and the permanent loss of such trademarks as a result of a default would have a material adverse effect on our business, financial condition and results of operations. The Secured Notes mature and the initial term of the Amended Target Agreement expire at approximately the same time. At such time payments from the Amended Target Agreement, if extended or renewed, may be distributed by Spell C to us. If Target Stores elects not to extend or renew the Amended Target License Agreement upon the expiration of its initial term on January 31, 2004, it could have a material adverse effect on our business, financial condition and results of operations. There can be no guarantee that we would be able to replace the Target Stores royalty payments from other sources.The Amended Target Agreement, however, requires one year's advance notice of termination by Target Stores, during which period we believe we would successfully enter into one or more licensing agreements for the Cherokee brand with either retailers and/or wholesalers, in order to replace the lost revenues from Target Stores.

We are dependent on our intellectual property and we cannot assure you that we will be able to successfully protect our rights.

We and Spell C hold various trademarks including Cherokee, Sideout, King of the Beach and others in connection with apparel, footwear and accessories. These trademarks are vital to the success and future growth of our business. These trademarks are registered with the United States Patent and Trademark Office and in several other countries. We and Spell C also hold several trademark applications for Cherokee, Sideout, and King of the Beach in several countries. We monitor on an ongoing basis unauthorized uses of our trademarks, and we rely primarily upon a combination of trademark, copyright, know-how, trade secrets, and contractual restrictions to protect our intellectual property rights. We believe that such measures afford only limited protection and, accordingly, there can be no assurance that the actions taken by us to establish and protect our trademarks and other proprietary rights will prevent imitation of our products or infringement of our intellectual property rights by others, or prevent the loss of licensing revenue or other damages caused thereby. The Patent and Trademark Office is participating in an ongoing study directed to the protectability of Native American Indian signs. We cannot dismiss the possibility that legislation resulting from the study would not have a material impact upon us. In addition, the laws of several countries in which we have licensed our intellectual property may not protect our intellectual property rights to the same extent as the laws of the United States. Despite our efforts to protect our intellectual property rights, unauthorized parties may attempt to copy aspects of our intellectual property, which could have a material adverse effect on our business, financial condition and results of operations. In the future we may be required to assert infringement claims against third parties, and there can be no assurance that one or more parties will not assert infringement claims against us. While we currently have the resources to pursue or defend most infringement claims, any resulting litigation could result in significant expense and divert the efforts of our management personnel whether or not such litigation is determined in our favor.

We are dependent on our key management personnel.

Our success is highly dependent upon the continued services of Robert Margolis, our Chairman and Chief Executive Officer, who is the primary person responsible for conceiving and implementing our overall business and marketing strategy. Mr. Margolis has served as Chairman and Chief Executive Officer since December 1994 when we emerged from bankruptcy. Mr. Margolis is the beneficial owner of approximately 20.7% of our outstanding common stock. We have only fourteen employees and Mr. Margolis' leadership and experience in the apparel licensing industry is critical to the successful implementation of our business and marketing strategy. We do not carry key person life insurance covering Mr. Margolis. While Mr. Margolis' services are provided pursuant to a management agreement with us, this agreement does not ensure Mr. Margolis' continued services. The loss of the services of Mr. Margolis could have a material adverse effect on our business, financial condition and results of operations.

The management agreement with our Chief Executive Officer contains provisions that provide for a substantial cash payment to our Chief Executive Officer upon breach or termination of the management agreement by us.

Mr. Margolis' services as Chairman and Chief Executive Officer are provided to us pursuant to a management agreement. The current term of the management agreement ends February 1, 2004, however, the term may be extended indefinitely for additional one year terms so long as we meet certain pre-tax earnings thresholds. If we terminate the management agreement without cause or Mr. Margolis terminates the management agreement after we materially breach any of the terms and conditions thereof or fail to perform any material obligations thereunder, we must pay Mr. Margolis, within sixty days after the date of termination, a lump sum in cash equal to three times the sum of the annual base compensation under the management agreement at the rate in effect at the time of the termination and the previous year's performance bonus under the management agreement. Mr. Margolis' annual base compensation in Fiscal 2001 was $587,450 and his performance bonus for Fiscal 2001 was approximately $2.175 million and, based on those amounts, the lump sum payment referenced above would exceed $8.0 million.

The occurrence of the following events, among other things, will be deemed to be a material breach of the management agreement by us:

. the assignment to Mr. Margolis of any duties materially inconsistent with, or the diminution of his positions, titles, offices, duties and responsibilities with us or any removal of Mr. Margolis from, or any failure to re-elect Mr. Margolis to, any titles, offices or positions held by him under the management agreement, including the failure of our Board of Directors to elect Mr. Margolis or his designee as Chairman of the Board or the failure to elect, or the removal of, certain other nominees as director from the slate of directors recommended to our stockholders by the Board of Directors;

. a reduction by us in the base compensation or any other compensation provided to Mr. Margolis in the management agreement; or

. a change or relocation of Mr. Margolis' offices that materially and adversely affects Mr. Margolis' working environment or any other substantial, material and adverse changes in Mr. Margolis' working conditions imposed by us.

We do not have sufficient cash to make the lump sum payment to Mr. Margolis, and becoming obligated to make such payment would have a material adverse effect on our business, financial condition and results of operations. Under certain circumstances, the obligation to make such lump sum payment to Mr. Margolis could be triggered if a third party were to acquire us, which could increase the acquisition costs, but, subsequently, each year thereafter reduce our annual operating expenses due to the elimination of annual bonus payments to Mr. Margolis pursuant to the management agreement.