An imminent bankruptcy filing by Sears Holdings Corp. (NASDAQ:SHLD) is not likely. A bankruptcy filing on or just after July 10, however, is extremely likely. There are a number of legal issues that impact the filing date. Filing for Ch.11 may actually be beneficial for Eddie Lampert and his cronies.
July 7 - $500 Million Loans Due
There is a $500 million secured loan due July 7. These loans were made by entities associated with Lampert, and payment by Sears could be subject to a "clawback" under section 547 of the Bankruptcy Code if Sears files for bankruptcy within one year because Lampert is an insider. (For non-insiders, the look-back period is only 90 days.) Lampert would be forced to return the money to Sears' bankruptcy estate.
In order to avoid this clawback issue, Sears and Lampert would have to be very careful in drafting a new loan agreement that pays the maturing one and creates a new loan. For example, the maturing one had an upfront fee of 1% plus a 1% funding fee for an amount drawn. Even if the $500 million eventually is not subject to a clawback, any new fees could be. They need to make sure "that such transfer was... intended by the debtor and the creditor to or for whose benefit such transfer was made to be a contemporaneous exchange for new value given to the debtor" - section 547(c)(1)((a)).
If they pay the loan using funds from another lender, which is highly unlikely, there would be a very strong case for a clawback. An easy solution to this problem is not paying the loan and file for bankruptcy. (Of course, this is not the sole reason to file.)
July 7 - Second Year Anniversary of Asset Sale
The effective date for the $2.7 billion sale-lease back deal with Seritage Growth Properties (NYSE:SRG) was July 7, 2015. The possibility of fraudulent conveyance has been talked about frequently by investors and vendors. This is not a new issue.
Section 548 of the Bankruptcy Code covers this issue: "(a)(1)avoid any transfer … that was made or incurred on or within 2 years before the date of the filing of the petition, if the debtor voluntarily or involuntarily- (i) received less than a reasonably equivalent value in exchange for such transfer or obligation; and... (ii) was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation; (ii)(iv) made such transfer to or for the benefit of an insider, or incurred such obligation to or for the benefit of an insider..."
July 8 is the first calendar date to avoid the fraudulent conveyance issue. Since July 8 is a Saturday, July 10 would be the first business day to file.
Approaching Fall and Christmas Shopping Season
Many vendors have been worried that SHLD would go bankrupt and that they would not receive full payment for the money due to them under bankruptcy. Some may have been willing to still deal with SHLD because they thought the bankruptcy risk was impacted by the two-year fraudulent conveyance issue, which would reduce the risk of a filing. As it gets closer to the 2-year anniversary, vendors may become much more reluctant to deal with Sears and, therefore, have fewer and fewer product brands on their shelves.
After a bankruptcy filing, purchases from vendors are post-petition trade claims. These have a higher priority standing than pre-petition trade claims. If SHLD files for Ch.11 and is able to keep from going into Ch.7, some vendors may be more willing to deal with Sears knowing that the new post-petition transactions have better chance of being paid in full.
The current modest short squeeze in SHLD reflects the ability to borrow stock and does not reflect an improvement in financial conditions. (Read this article for more on the short squeeze.) This stock price increase is not a proxy for actual positive changes in operations. One wonders if vendors are being deceived by the stock price improvement and are now more willing to deal with SHLD. I think that the recent insider buying was an attempt to pop the stock price and encourage vendors to continue to ship summer merchandise.
Other Timely Events
There is a modest interest payment due July 15, and $43 million in notes mature October 15.
I think the earliest date SHLD will file for bankruptcy will be July 10. The sooner they file, the better in order to get vendors to ship fall and Christmas merchandise to their stores. Otherwise, they could have fewer and fewer brands on their shelves. Depending on the DIP financing, vendors may be more likely to ship to Sears post-petition.
I do also not think that the two anniversary and the due date for a $500 million loan that was signed in April 2016 is just a coincidence. The loan maturity was timed for a potential bankruptcy filing if operations continued to weaken.
As SHLD burns cash, they are moving closer to Ch.7 liquidation as I covered in a recent SHLD article. The faster they file for Ch.11 improves their chances of not being forced into liquidation.
Chapter 11 - A Possible Positive For Lampert
First Gain - Dilution Of New Equity For Other Stakeholders
Many companies file for bankruptcy to reduce their debt and deleverage. While it is fairly easy to completely cancel unsecured debt, it is not as easy to eliminate secured debt. Secured debt holders cannot be forced to accept equity under a reorganization plan - they have the right to demand an auction/sale of their collateral. Therefore, Lampert will have to be very creative to offer secured claim holders just enough recovery, but not too much, to get their approval for a plan.
At this point, it is pretty much up to Eddie Lampert if and when SHLD files for bankruptcy. Many investors assume that since he owns so much SHLD stock and debt that he would never want to file unless it is absolutely necessary. That line of thinking may be incorrect. There are actually many reasons why he would actually be better off after a new SHLD emerges from a Ch.11 bankruptcy. (Not a Ch.7)
Lampert and certain preferred fund managers, such as Bruce Berkowitz, may end up with a greater financial interest in a new SHLD after it exits Ch.11 bankruptcy because other current stakeholders are either wiped out or receive highly diluted new stock. It is important to consider Lampert's total amount of recovery and not just the recovery for each of his specific holding.
This is what I am expecting to happen under a Ch.11 reorganization plan: Equity and unsecured debt holders, in my opinion, will get no recovery. They will be cancelled and get nothing. Some of bank loans get cash and full recovery. The $100 million pension secured claim will get cash. This cash and future working capital will come from a rights offering and a possible other new security offering, such as a privately-placed convertible preferred. Secured debt will get the equity in a new SHLD and some combination of rights, cash, new debt. The positive kicker here for Lampert is the new equity will be highly diluted. The positives of the dilution will flow to Lampert and his cronies, while the negatives of the dilution will flow from the rest of the secured debt holders.
As I mentioned in a prior SHLD article, there was a precedent set recently in the bankruptcy case of Peabody Energy Corp. (NYSE:BTU). A group of institutions, mostly hedge funds, participated in a $750 million privately-placed convertible preferred offer. Unlike most convertible preferred stock where the conversion price is set at a premium, this preferred conversion price was set at a 35% discount. Those that were allowed to participate made millions and those that were not allowed, which included all retail debt holders, saw their new stock get massive dilution.
Bankruptcy Judge Schermer considered the capital raising procedure to be distinct from the distribution in a specific claim class. The judge ruled that Peabody's plan met requirements of section 1123((a))(4) "provide the same treatment for each claim or interest of a particular class." Retail noteholders strongly disagreed.
The convertible preferred is only part of the possible dilution. I would also expect a rights offer to buy new stock distributed to secured debt holders. The rights offer would be backstopped and the payment for the backstop would cause even more dilution. Since many retail investors do not participate in rights offers, those who backstopped the offer will use those unused rights to buy new stock at a discount.
There is a very real possibility that Lampert will use this same type of capital raising methods to pay secured creditors diluted stock. This would not only eliminate debt, but could actually increase Lampert's total financial interest in SHLD because of the dilution for other stakeholder's new equity.
Second Gain - Pension Liability Reduction
The pension liability could be greatly reduced in bankruptcy, but the actual pension assets would not be included in the bankruptcy estate that are distributed to various stakeholders. They have a $1.75 billion pension and post-retirement benefits liability on their balance sheet, and they have been forced to make large cash contributions to the plan (plan is legacy old employees) because projected benefit obligations are $5.165 billion and the plan's assets are only $3.567 billion. They made a $317 million cash payments towards benefits in 2016, and they are forecasting that they will need to make $312 million contribution in 2017 and $297 million in 2018.
Terminating a pension plan liability in Ch.11 is not the same as terminating a standard contract, which often is fairly easy to do in bankruptcy. The termination follows ERISA requirements. The most likely method that Lampert would try is to use the "distressed termination." SHLD would have to satisfy one of the following financial distress tests:
- The bankruptcy court has determined that the company will not be able to reorganize with the plan intact and approves the plan termination or;
- It has been demonstrated that the sponsor cannot continue in business unless the plan is terminated or;
- It has been demonstrated that the costs of providing pension coverage have become unreasonably burdensome solely as a result of a decline in the number of employees covered by the plan.
(Note: the fourth possible distress test is seeking liquidation in bankruptcy.)
The termination gets more complex because of an agreement in 2016 with Pension Benefit Guaranty Corporation - PBGC. PBGC has a secured $100 million lien on assets, which would be part of a higher priority claim class.
The attempt to terminate the pension plan gets even more complicated because the current U.S. Treasury Secretary Steven Mnuchin is on the three-member PBGC board that would make the decision. Mnuchin was on SHLD board and was Lampert's college roommate. He also still holds SHLD investments. While he has agreed to recluse himself, it does complicate the issue.
Even if the plan is not terminated, the pension liability, except the $100 million secured claim, would be treated as an unsecured claim and have lower priority than secured claims. This is potentially a huge savings for Lampert.
Third Gain - Terminate Leases
Under Ch.11, they will be able to terminate leases. With only profitable stores and greatly reduced leverage, a smaller business model may be successful.
July 10 is most likely the earliest date that SHLD would file for bankruptcy. They would no longer have to worry about fraudulent conveyance for the SRG deal. There are actually advantages for Lampert to have a filing, but that does not mean there are advantages for retail holders of SHLD stock and bonds.
I rate SHLD common stock a strong sale. I rate SHLD debt a strong sale for retail holders because I envision a potential Ch.11 reorganization plan that would be greatly disadvantageous for retail holders because of their inability to participate in certain capital raising schemes contained in a plan. A change from Ch.11 to Ch.7 may, however, make for a fairer distribution to retail debt holders.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in SHLD over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am also naked SHLD call options