What Really Happened At The Sears Hearing, And Now What?

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About: Sears Holdings Corporation (SHLDQ), Includes: SWK
by: WYCO Researcher
Summary

Judge Drain approved the sale of almost all assets to Lampert/ESL.

The sale will make Sears "administratively insolvent" and unable to confirm a reorganization plan to exit Ch.11 bankruptcy.

A $80 million secured note claim given to PBGC could have a negative impact on paying shareholders for releases.

Lampert/ESL are planning to sell $700 million in real estate over the next 3 years.

Judge Drain was greatly influenced by the potential loss of 45,000 jobs.

Sears Holdings Corp. (OTCPK:SHLDQ) has been almost completely liquidated following the section 363 sale of most of the company's assets to Lampert/ESL, which was approved on February 7 by Judge Drain after 3 days of hearings in White Plains. Some Sears and Kmart stores will, at least in the near term, remain open, but additional stores are expected to close. Recoveries for SHLDQ shareholders and unsecured noteholders most likely will only be very modest payment for releases. Expected recoveries for holders of second lien notes still remains unclear.

The Sale Hearing

I attended the sale hearings on Monday and Thursday, but I did not attend the hearing on Wednesday because I had a partner's meeting. There were extremely long lines to get into hearings which were packed with lawyers representing various interested parties.

The reality is that the sale hearings were a total waste and the "auction" process was just a sham. The only real variable was how much was Lampert/ESL going to pay for the "Going Forward Stores", and any other possible outcome was not even seriously considered. As evidenced by his admonishment of those who were critical of Eddie Lampert at the end of the hearing and his extreme pressure in a private conference of negotiators to find a way for the sale to Lampert be finalized, Judge Drain had already decided weeks ago that Lampert would get his approval to buy the assets.

When comparing the sale versus liquidation currently, the results favored the sale. If Sears, however, would have filed for Ch.7 instead of Ch.11 last October and completely liquidated during the Christmas shopping season, liquidation may have been the better result. They would not have incurred massive legal/ consulting fees and proceeds from selling inventory during the holidays would have generated higher revenue.

An auction of assets, under section 363 of the Bankruptcy Code, was to take place to raise the most money for paying various claims. One of the members of the subcommittee of the board stated in court that the committee had already decided prior to receiving actual bids that it would be unlikely that selling individual assets would collectively be higher than just selling all the assets to ESL. Why did they even bother establishing an auction process since section 363(b) does not require a formal auction process (at least in the Southern District of New York according to Judge Drain's ruling from the bench)?

The difference between selling all the stores in one package versus selling individual stores was time - the subcommittee wanted the sale completely quickly - within 4 months from filing Ch.11, while the Official Committee of Unsecured Creditors - UCC and others were willing to allow for a longer term period to get the maximum amount. I find it ironic that Lampert/ESL are planning to sell $100 million of already closed stores this year plus an additional $200 million worth of real estate this year and for the next 2 years for at least a total of $700 million over the next 3 years. So, Lampert is buying the stores now to sell a major portion over three years to get the maximum amount.

If there was not actually going to be a real "auction", why bother requesting bids? Many bidders and even potential bidders incurred large legal/consultant fees submitting these bids, only to find out that it was a waste of time/money. At an earlier hearing, a lawyer representing a landlord bidder asked in court about the status of his bid and if it was considered "qualified" that allow him to bid at the auction. There were just apathetic responses from both Judge Drain and lawyers from Weil Gotshal. That was the moment I realized the auction was going to be just a sham. If this was going to be a real auction, the judge should have given strict instructions in court on how to handle this issue.

The lawyers from Akin Gump who represent the UCC have filed impress written objections with the court (docket 2042), but their performance in the actual hearing was very disappointing. They had terrible presentation skills and focused too much on unimportant issues instead of stressing only critical points. Multiple times, Judge Drain seemed frustrated by their line of questioning and faulted their assertions. These lawyers missed key opportunities to challenge the sale and the selling process. Unsecured noteholders and even SHLDQ shareholders were poorly served here.

The sale almost fell apart twice on Thursday. First, there was still the dispute that was announced at the hearing on Monday over $166 million accounts payable. ESL had informed Sears it was not assuming/paying the $166 million. On Thursday, the issue was not settled and Sears said the deal was off if it was not assumed/paid by ESL. Lampert's lawyers said it was a contract issue to be decided in the future. Judge Drain agreed it was a contract issue and because of a district court's decision on contract issues, he could not make an actual ruling on the issue. He did later, however, opined in his bench decision that he thought Sears was right and that ESL needed to assume/pay the $166 million. (At the time of writing this article, I do not know what ESL actually did on the $166 million issue.)

The second problem was an objection by Stanley Black & Decker Inc. (SWK) over the assumption by ESL to use the Craftsman name. Their lawyer asserted that the contract allowed the contract to be assumed only if all or almost all of Sears assets were sold. He further asserted that because many stores had already closed prior to the sale, the sale itself was not for all/almost all assets, which, therefore, would mean the use of the Craftsman name could not be transferred by the sale. Lawyers for Sears stated that they thought if the contract could not be transferred, the entire sale would be terminated. The judge ruled against SWK. I expect future litigation on this issue outside of the bankruptcy court.

There are a number of other issues regarding the sale. The section 503(b)(9) claims assumption by ESL is capped at $139 million, but the current estimate is over $173 million. It seems that the difference of $34 million will be a priority claim to be paid out of the special $240 million "wind-down" account. This issue is also another example how the lawyers for Sears are walking all over Judge Drain. He instructed Weil, Gotshal lawyers to set a bar date for 503(b)(9) claims at hearing in December that I attended. They still have not followed his instructions, so there is no way of knowing for certain the amount of these claims. Another issue is the $200 million "cure" cap for costs from assuming/transferring leases/property. It seems Sears Holdings will get stuck if the cure amounts total more than $200 million.

The Sale of Sears Holdings - Tax Issue

The order to approve the sale was signed on February (docket (2507). It includes this statement that was added to the original order:

Debtors are required to take actions as instructed by Buyer in order to secure and preserve the qualifications of certain of the transactions ...for U.S. federal income tax purposes ... the Debtors may be directed to convert any of the corporate subsidiaries of Sears Holding Corporation into limited liability companies whether on or before the Closing Date of the Asset Purchase Agreement or anytime afterwards.…"

This seems to be the method that the huge net operating losses - NOLs - are being transferred to NewCo (ESL/(Lampert). I was wondering how they would do this. ESL is buying operating limited liability companies and not just specific assets. You need, in my opinion, to buy/transfer operations and not just assets to get operating losses.

The timing of the amended statement this week may indicate that tax lawyers/accountants decided that they would use a different process to transfer the NOLs than they included in the APA. (For Eddie's sake, they better be right.)

Second Lien Noteholders

There were no objections filed by 2lien noteholders, so they consented to the terms of the sale transaction. Consents were not solicited, it was the reverse - you had to file an objection if you were against the terms of the sale. "All holders of Claims or other persons and entities... that failed to timely object, or withdrew their objections to the Sale Motion, the Sale Transaction, or this Sale Order are deemed to consent to the relief granted herein for all purposes…"

What are 2liens getting? They gave their consent to what? Even Judge Drain said it was not clear what they are specifically getting. Any 507(b) claim or any other claim will now be only against Sears Holdings. They can't file any claim against NewCo/ESL/Lampert. As per the sale order:

The sale and transfer of the Acquired Assets of the Debtors to the Buyer, including the assumption by the Debtors and assignment, transfer and/or sale to the Buyer of the Assigned Agreements, will not subject the Buyer or ESL to any liability (including any successor liability) under any laws... except that, upon the Closing or such other date as specified in the Asset Purchase Agreement, the Buyer shall become liable for the applicable Assumed Liabilities.

I never read or heard in court about any assumption of 2lien note liabilities by ESL. In court, they went item by item of liabilities that were being assumed, and there was no mention of 2lien notes.

PBGC Settlement and Releases

Pension Benefit Guaranty Corp. - PBGC and Sears have agreed to a settlement. The term sheet (docket 2529) indicates that the pension plans have been terminated, and PBGC will get an $800 million unsecured claim and an $80 million secured note claim that "will have a first priority lien against (and sole recourse to) any net proceeds of estate avoidance actions successfully pursued on behalf of the Debtors' estates on or after October 15, 2018". PBGC will still retain its claims against the Sears entities that were not part of the bankruptcy filing. So, proceeds from any future sale of these non-debtor entities could end up following to PBGC and not Sears Holdings.

The $80 million secured claim could be a major issue for SHLDQ shareholders expecting to get paid for releases. It is unclear if PBGC will get all of the $35 million paid by ESL for releases (PBGC will still have a $45 million priority claim for any future payments from litigation). This could mean SHLDQ shareholders will not get paid for their releases, or mean payments from future litigation against ESL/Lampert and other parties would go to PBGC for the first $80 million.

This is a huge issue for shareholders and option traders. Are they getting paid for releases or are stockholders getting zero recovery?

Reorganization Plan

Despite the mention of a reorganization plan in the PBGC term sheet, there still may not be a reorganization plan. Sears could not in good faith enter into an agreement that required a confirmation of a plan because they are "administratively insolvent" after the sale. By the way, there is no specific statement in the term sheet that requires a confirmation of a plan. In order to confirm a plan under section 1129, administrative claims must be paid. Currently, they are about $42 million short. It is unclear if this shortfall includes estimated expenses for creating the plan and disclosure statement. Plus, there are costs to solicit ballots and other costs.

Multiple times during the hearing, Judge Drain mentioned that companies which became administratively insolvent after 363 sale of assets do not have confirmations of plans but just have a dismissal of their bankruptcy petition. Was he implying that he expected this course of action for Sears? In addition, Weil, Gotshal lawyers never mentioned that "we are working on a plan and expect it to be done etc., etc.".

There will be a hearing on February 14 to extend the exclusive period to file a plan until June 12 and to extend the period to solicit ballots until August 13. Assuming they use the entire time period, the earliest that there would be a confirmation hearing is the very end of August, which would most likely mean that the earliest they could exit bankruptcy is mid-September. All this assumes they continue with the normal Ch.11 process and don't convert to Ch.7 or final a motion to have the Ch.11 petition dismissed. (If it is dismissed or a conversion to Ch.7, SHLDQ shares would be cancelled.)

EDIT UPDATE

Hearing held February 14. Exclusive period extended only to April 15 and not June 12. Period to solicit ballots extended until June 12 and not August 13. Expecting to have a liquidating trust.

Jobs

Listening in court to Judge Drain, it seemed the issue of 45,000 jobs was the issue here. It is beyond me why those opposing the sale never mentioned that some jobs would actually be created by selling individual stores for other uses. For example, I talked to a lawyer of a landlord who was expecting to have a medical urgent care center replace a Sears store that was expected to have total payroll greater than a typical Sears store. Plus, if the new occupants of these stores create more foot traffic for a mall, other retailers in the mall might hire additional employees.

As mentioned above, Lampert/ESL stated that they are expecting to sell $700 million in real estate over the next 3 years, that could mean many more stores will close and employees being let go. Under the terms of the sale, there is no requirement to keep any stores open nor a guarantee that they keep the current number of employees.

Conclusion

Sears Holdings bankruptcy case has captured the attention of many investors who never trade bankruptcy securities because the company is an American icon. I made a very nice profit on my short of SHLDQ that I opened back in September 2007 and closed when the stock was trading between $2 and $3 because the cost to carry was too high versus potential profits. I continued to write on this bankruptcy case despite no longer having a financial interest because the case will be considered a classic bankruptcy case for decades to come. While, over the years, I was directly involved in some of the largest bankruptcies/M&A deals/proxy fights, I would rather watch this case from the box seats.

There seems to be a lack of clarity regarding certain items in the sale order and in the PBGC agreement, as evidenced by the parties who negotiated them and their $166 million accounts payable disagreement. So, it is not unexpected that investors are uncertain about key terms for recovery by 2lien holders and the potential $80 million priority for payment of releases. Therefore, I am not to able make any recommendations regarding the notes and SHLDQ stock.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.