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JC Penney's (NYSE:JCP) bondholders might have the upper hand.

In the 8-k filed with the SEC, section 8.1 was of interest. It mentions a letter concerning a Notice of Default under a 1994 indenture.

Below is what I view as a key paragraph:

The attorney alleges that the Company, by entering into the Credit Agreement and granting a lien on its inventory, violated Section 5.08 of the Indenture, which restricts the Company's ability to issue, assume or guarantee any notes, bonds, debentures or other similar evidences of indebtedness for money borrowed that are secured by certain property identified in the Indenture without simultaneously granting an equal and ratable security interest to the holders of the Debentures. Under the Credit Agreement, the lenders have a security interest in certain inventory and related current assets of the Company; however, there are not now, nor have there ever been, any loans outstanding under the Credit Agreement, and therefore the Company has not issued indebtedness for money borrowed secured by inventory. Further, Section 5.08 of the Indenture is not a negative covenant as to liens on inventory. The negative covenant extends only to "Principal Property," a term which is defined in the Indenture as consisting of "real property and tangible personal property owned by the Company . . . constituting a part of any store, warehouse or distribution center." Inventory does not constitute a part of a store, warehouse, or distribution center.

If, as the company mentions, there have never been any loans outstanding, then why pay financial institutions for the Credit Agreement and why expand the agreement?

The section for Cash Flow Outlook in the 10-Q filed with the SEC mentions the following:

We may borrow under our credit facility for general corporate purposes including, but not limited to, seasonal working capital needs and to support ongoing letters of credit.

It further mentions that the credit facility may be used for the issuance of letters of credit. The credit facility contains covenants that may restrict the company's ability to incur indebtedness, prepay or modify certain indebtedness under certain conditions.

In the discussion of the Credit Facility is this passage:

No borrowing, other than the issuance of standby and import letters of credit totaling $214 million as of October 27, 2012 have been made under the 2012 Credit Facility.

I could be wrong but that appears to suggest that there are borrowings under the Credit Facility. This might be a key section for bondholders.

Now let's look at what the State of Texas considers "tangible personal property." According to the Texas Sales Tax FAQ:

2. What is tangible personal property?

The statutory definition for "tangible personal property" is "personal property that can be seen, weighed, measured, felt, or touched or that is perceptible to the senses." See Sec. 151.009.

The Harris County Appraisal District in Houston Texas website contains this information:

Tangible personal property includes such things as furniture, fixtures, inventories, equipment, motor vehicles, vessels, and aircraft. These items are typically referred to as business personal property.

According to the recent 8-k filing, JC Penney does not feel that inventories qualify as tangible personal property. However, the State of Texas might disagree with that understanding.

If the company has breached the indenture and it's not cured within 90 days, then approximately $2.9 billion worth of bonds may be declared immediately due and payable. Given JC Penney's low credit rating on its outstanding bonds, the cost of issuing new bonds to repay the outstanding bonds might be costly. Shareholders, management and or the board might wish they had the $900 million used during the nine months ending October 2011 to repurchase 24.4 million shares at $36.98. The stock closed Wednesday under $20.

It is unclear how the court will rule on the Notice of Default. However, the common stock may face pressure should the bondholders prevail. There might be a remote possibility that the bondholders becoming the new equity owners should stockholders not raise the cash to repay the bonds. Might cash be raised by selling equity or might the credit facility permit debt to be issued?

Given the risk-reward tradeoff between the common stock and the outstanding bonds, the bonds appear to offer the more attractive risk-reward payoff with investors being paid to wait for a turnaround.

Source: J.C. Penney's Bondholders May Have The Upper Hand