From what I've gathered since my first article Sears: A Vulture's-Eye View was published, there's a general misunderstanding or lack of knowledge about the mechanics of bankruptcy, so this series of articles attempts to rectify that. From scratch. They are not intended as an exhaustive treatment of the myriad issues bankruptcy presents; rather, as an inquiry into relevant Sears (OTCPK:SHLDQ) case facts and their pertinence to Chapter 11. For a seasoned viewpoint on bankruptcy, I recommend WYCO Researcher. If you're more interested in the financial particulars, try Elephant Analytics.
Quotes are heavily employed and are often condensed and/or paraphrased for brevity and clarity; thus, I've skipped interpretation where I felt meaning was conveyed clearly. Footnotes appear at the end of each section.
Sears' Unsecured Bond and Warrant Prospectus
There's often a lot of questions and uncertainty concerning unsecured bondholder and warrant rights in the context of bankruptcy. While I'm not explicitly valuing Sears' securities, it is paramount to consider the rights they expressly reserve. This is precisely why it's imperative never to rely solely on prospectuses. Though helpful, they usually state, in some form, that they're summaries of more ironclad documents.
From Sears' prospectus (regarding unsecured bonds):
The following description is a summary of the material provisions of the Notes and the Indenture. It does not restate the Indenture in its entirety. We urge you to read carefully the Indenture because it, and not this description, defines your rights as a holder of the Notes.”
And regarding warrants:
The following description is a summary of the material provisions of the Warrant Agreement. It does not restate the agreement in its entirety.
The Warrant Agreement is not an indenture qualified under the Trust Indenture Act of 1939. Accordingly, it may be difficult for warrant holders to take actions to enforce their rights under the Warrants or the Warrant Agreement.
Holders of the Warrants will have no rights as common stockholders.”1
Footnotes: Sears' Unsecured Bond and Warrant Prospectus
1And you thought common stockholders were last in line. Read that last sentence again, and again, and again, and again. Make it a chant, if you need.
Unsecured Bond2 Indentures
Verifying the more authoritative Unsecured Indenture (POSASR3 to form S-3, Exhibit 4.2, dated Oct 30, 2014; substantially similar to the one dated November 21, 2014; Supplements notwithstanding), Under Article XVI4 (Subordination of Securities), Section 16.02, Distribution on Dissolution, Liquidation and Reorganization:
Holders of Senior Indebtedness shall be entitled to receive payment in full before the Holders of the Securities are entitled to receive any payment on Indebtedness evidenced by the Securities."
And Article XVI, Section 16.09, Reliance on Judicial Order5:
Holders of the Securities shall rely upon any order entered by any court in which insolvency, bankruptcy, receivership, liquidation, reorganization or similar case or proceeding is pending."
Subordination is a concept wherein bond indentures must unambiguously subordinate themselves to other, more senior securities. You cannot rely on senior indentures, as a legal remedy, to enforce seniority in right of payment without consent (see above language). And while the term "unsecured" should be self-explanatory, it generally means there's no collateral (or lien on assets) offered prior to or in any event of default.6
Footnotes: Unsecured Bond Indentures
2Excluding the SRAC and Medium Term Notes, discussed in Part 4 of this series.
3Post-effective Amendment to an Automatic Shelf Registration statement
4In a nutshell, the unsecured indentures mince no words: unsecured bond holders are paid after more senior (including secured, if any) indebtedness is paid in full under virtually all circumstances (barring a well-negotiated Plan of Reorganization confirmed by the court).
5"Reliance on Judicial Order." This bears repeating.
6In the context of a secured creditor (or lien holder), "unsecured" generally means the shortfall in value against the full amount for which all or a portion of the liens are unperfected. A related concept is "undersecurity," where the actual collateral value is less than the lien; but foregoing a harangue on semantics, calling the shortfall "unsecured" is moot if there's no money to pay it (unless there's other collateral pledged as adequate protection; see Part 1 of this series). Subrogation is an equitable remedy involving breach of trust and is not covered here.
The Warrant Agreement also outlines its limitations in bankruptcy (POSASR to form S-3, Exhibit 4.4, dated October 30, 2014; substantially similar to the one dated November 21, 2014; Supplements notwithstanding):
This Agreement has been authorized except as may be limited by bankruptcy, insolvency, moratorium, reorganization and other similar laws affecting the enforcement of creditors’ rights."7
Though unsecured bondholder recoveries (not evaluated in this series per se) are based on a surfeit of factors — only one of which is their relationship to other securities in the capital structure — warrant recoveries, in my ephemeral experience, are a hazy prospect. There is, however, at least one prior case (two if you read the following citation) of warrants surviving bankruptcy, and it can be found in SEC et al. v. Leventritt, 179 F.2d 615 (2d Cir. 1950)).
Unfortunately, the current Bankruptcy Code was enacted in 1978, so it's unclear if this case would still apply today. Nonetheless, it is instructive because the original Plan of Reorganization cancelled the warrants; the Bankruptcy Court confirmed the POR, deeming them "worthless"; on appeal8, the Second Circuit reversed the decision because the merits of the case hinged on whether it was permissible to appraise the warrants as "worthless," indicating "there was positive evidence from several lines of approach that they had a very real value."
Despite its reversal, the Court affected a cautionary tone:
If the possibility of these warrants ever having any exercise value is so remote as to be unreal, then payment to the warrant holders is not only not necessary, but positively unlawful. To pay warrant holders any more than the real value of their warrants is to take assets unjustly from the owners of the common stock. Care must be taken lest the emphasis on rights be all one way.”
Besides the fact that the common stock these warrants reference will likely be cancelled as a result of the upside-down capital structure, is there "positive evidence" they have any real value? To put it mildly, we'd have a better shot at ramping up Mt. Everest through the atmosphere in a race car and using the moon's gravity assist to propel us to Mars.9
Footnotes: Warrant Agreements
7A bankruptcy court order turns on its head the idea warrants will adjust in a Chapter 11 (not a stockholder-approved) reorganization, regardless of what the prospectus says (see the first section on prospectuses and the first sentence of this section's last paragraph directly above this footnote).
8The warrants survived on appeal. That's a long walk to get to a far cry.
9The shorter, less colorful answer is "no."
The Pension Benefit Guaranty Corporation
Note: A follow-up section has been added for clarification.
There's lately been speculation as to why the PBGC, Sears' largest unsecured creditor, is notably silent on the docket. If they're pari passu with other unsecured bondholders, doesn't that suggest, at least indirectly, the unsecured bonds aren't in jeopardy?
Hardly. As I aim to demonstrate, their status as an "unsecured" creditor is contingent upon a unique set of conditions, none of which strengthen the unsecured bondholder thesis and, in any event, are only loosely connected to said bondholders.
First of all, what is the PBGC and how does it work? Here's an amalgamated summary primer from pbgc.gov:
The PBGC insures the retirement incomes of more than 37 million American workers in private-sector defined benefit pension plans.
When does the PBGC step in?
- If a sponsoring company seeking to reorganize in bankruptcy proves that it cannot remain in business and continue funding the pension plan
- If a plan runs out of money to pay benefits due
- If a sponsoring company files for liquidation
How is it funded?
PBGC receives no taxpayer dollars. Operations are financed by insurance premiums, investment income, assets from pension plans trusteed by PBGC, and recoveries from failed single-employer plans."
In the event Sears fails, how would the PBGC inherit its pension? To begin answering that, let's quickly audit the Riecker Declaration (Docket 3, pg. 35):
In March 2016, the Company entered into a pension plan protection and forbearance agreement with the PBGC and agreed to continue to “ring fence” the real estate assets and IP held by certain of the Company’s subsidiaries. The subsidiaries granted the PBGC a “springing lien” on the Ring-Fenced Assets — which included the IP related to the Kenmore, Craftsman, and DieHard brands — which lien would be triggered upon the occurrence of a limited set of conditions. Because the conditions have not occurred, the springing lien in favor of the PBGC has not been triggered."
From the PBGC ("What is the financial status of the Sears Holdings defined benefit pension plans?"):
The two Sears Holdings pension plans together are underfunded by about $1.5 billion. That is, the money in the pension plans is about $1.5 billion less than the value of future benefits payable by the plans to current and future retirees."
Without belaboring the minutiae, per the latest 10-Q: in addition to the "springing lien" on Kenmore and DieHard assets, the PBGC retained the proceeds from last year's Craftsman sale, has a 15-year income stream on its sales, and was given a lien on $100 million of real estate assets to secure the Company's minimum pension funding obligations through 2019.
At November 3, 2018, the net book value of the securitized trademark rights relating to Kenmore and DieHard was approximately $0.5 billion. The net book value of the securitized real estate assets was approximately $0.5 billion at February 3, 2018."
Let's recap: The PBGC has springing liens on the Kenmore and DieHard brands as well as an income stream from Craftsman; the liens haven't been triggered yet (i.e., not sprung/foreclosed upon), and although the pension is underfunded by $1.5B, it's currently funded through 2019. If Sears fails, the PBGC will foreclose and be paid by asset "recoveries from [the] failed single-employer [plan]" to uphold pensioner payments. This is how insurance works.
Still with me?
Under the Consolidated List of the 20 Largest Unsecured Claims (Excluding Insiders), the PBGC is listed as the largest creditor, whose claim is classified as "unknown" and "unliquidated." Disregarding Craftsman income, if we know the amount by which the pension is underfunded (~$1.5B) and the net book value of the KD IP and pledged real estate (~$1B), why is it classified as "unknown"? Couldn't we say the unsecured claim is roughly ~$500M?
Luckily, it's a little simpler than that.
Where Does It Go From Here?
We don't need to spin our wheels in order to suppose that the PBGC, as an insurance company, probably isn't a huge fan of taking the wheel of an outdated, expensive, underfunded legacy pension, especially if they have to foreclose on assets in a messy bankruptcy process. There's no reason to believe they're not in communication with Sears, and as long as the premium payments and assets continue to fulfill current pension obligations10, the PBGC's claim is "unsecured, unknown, and unliquidated" insofar as Sears hasn't liquidated and the revenue from the sale of KD IP and real estate assets is unknown; in which case, the proceeds from the sale of those assets would most definitely flow to the PBGC, and the shortfall, if any, would become pari passu unsecured claims with other unsecured bondholders. If Sears doesn't liquidate, the PBGC will happily hold its shadow over the assets while it collects premiums. The belief that these assets benefit any entities other than the current reinsurance program or the PBGC, is fever-dream logic.
Pension Benefit Guaranty Corporation (Clarification)
Note: Final post-hoc update included at the end of this section.
Another Seeking Alpha contributor kindly pointed out to me that the "springing lien" in favor of the PBGC amounts to a "2nd lien" on the Kenmore, DieHard, and pledged real estate assets. After reviewing the more robust Pension Plan Protection and Forbearance Agreement, I believe that to be correct.
With a caveat.
In order to understand the KD IP and real estate assets, you must first understand how they were collateralized to satisfy tax and regulatory requirements for self-insurance purposes (like insurance reserve requirements). That's where Sears Reinsurance11 steps in. Here's a brief but informative introduction. All set? Let's take a closer look at Docket 3's "springing lien" language. According to Riecker (lines separated for emphasis):
Because the conditions for the springing lien to be triggered on the remaining intellectual-property-related Ring-Fenced Assets include
payment in full of the KCD Asset-Backed Notes
the grant of such lien ceasing to constitute a default thereunder,
neither of which has occurred, the springing lien in favor of the PBGC has not been triggered."
"Or the grant of such lien ceasing to constitute a default thereunder."
This peculiar language also appears in the PPPFA and references the IP Notes Indenture which governs the notes issued by KCD IP, LLC, a bankrupt-remote non-public entity. Which means there's no access to that indenture. What unique conditions would allow a lien to be sprung on the assets backing the notes and not constitute an event of default under those notes' indenture is anybody's guess. But we do know, however (recall the "payment in full" clause), from the Craftsman sale in 2017 that $900M of KCD IP notes were repaid in full and the PBGC retained residual rights to the trademarks and sales thereof — when Sears Holdings wasn't bankrupt.
Sears Reinsurance, anyhow, is a special purpose insurance/reinsurance vehicle used to cover, among other things, product, property, casualty, and workers compensation insurance. That's the entity holding the notes. If you read the "Springing Lien" language, Security Agreement, and the Subordination Agreement between the "Sears Parties" (e.g., KCD IP, LLC) and the PBGC, they allow for these "excluded" obligations, as well as the note principal, to be paid ahead of the PBGC, except for that "when-a-springing-lien-doesn't-constitute-a-default" thing (which can't be understood with the information presently available).
So, with the lack of transparency I think it would be safest (and easiest) to assume for now that when those assets are sold, the proceeds will pay down the notes and the "residual liens" will attach to future sales, giving the PBGC an income stream, just like in the Craftsman transaction.
FINAL UPDATE: The KCD IP Indenture was filed by the notes' Trustee with the Court on 12/27/18 (Docket 1426) as an exhibit to a motion requesting adequate protection and Removal of the Servicer and Manager for failure to perform their contractual obligations.
Since the commencement of these chapter 11 cases, the Debtor Licensees have failed to make payments due with respect to their continued use of the Trademarks under the License Agreements and any Sublicenses. Likewise, KCD IP, as Issuer, has failed to make required payments on the Notes. KCD IP’s failure to make the required payments constitutes an Event of Default under the Indenture.
The Servicer and Manager have failed to communicate with the KCD Indenture Trustee and, upon information and belief, perform their respective duties under the Servicing Agreement and Management Agreement. Importantly, it appears that the Servicer and Manager have failed, and continue to fail, to enforce the License Agreements or otherwise perform their duties under the Servicing Agreement with respect to the License Agreements and any Sublicenses against their affiliates who are licensees or sub-licensees, despite repeated demands."
The only interesting amendment I see to the original Indenture is from the Second Supplemental Indenture that changes the "payment in full" language to include non-cash payment, which appears to be replacement liens on other assets or replacement assets themselves. This may be what the "springing lien not constituting a default" refers to (by deduction: if the liens are sprung but the noteholders are given equivalent/replacement payment with new liens or assets).
In any case, nothing concerning Sears Reinsurance or the PBGC appears to materially affect the retail stock or bond investor, and I don't think it's necessary to investigate the matter further. The only remaining question is that if Sears Reinsurance (the purchaser of the notes) is the vehicle used to "self-insure" against product, workers comp, property, and casualty liability, and the proceeds flow to them first, what happens to Sears Reinsurance if the program terminates as a result of a Sears Holdings liquidation? Does it stop and/or where does the money go? To Be Continued...not be me, though.
What about ESL's Indicative Bid? Doesn't it include the KD IP?
All else being equal, if Sears remains a going concern, there's nothing to immediately suggest the pension will be terminated; otherwise, see above.
Footnotes: The Pension Benefit Guaranty Corporation
10The debtors were authorized to pay, among other things as more fully set forth in the DIP budget, Employee Benefit Programs (Docket 798), which the Debtors "estimate that the PBGC Premium due in September 2019 will be approximately $35 million" (Docket 31, ¶ 50).
11There's no compelling evidence Sears Reinsurance would or could offer any "float" for common shareholders, notwithstanding a total Sears' liquidation. See Dylan Street Capital's excellent assessment, here.
The UCC and Fraudulent Conveyance
You may already be aware there's an impending battle between the Unsecured Creditors' Committee and ESL, so I'll just hit the headlines and try to add a little flavor.
- The Who (not the band): A Subcommittee was formed prior to the Petition Date and is investigating transactions involving affiliates (meaning ESL) that occurred prior to the Petition date.
- The Why: The Subcommittee’s investigation is focused on whether or not Sears was solvent at the time of certain transactions, the fairness of the transaction terms, and the intent of the relevant parties (meaning ESL)
- The What: The SHO separation, the Sears Canada Transactions, The Land's End Spin-off, the Seritage Transactions, and ESL's Debt Transactions with Sears ("Between 2016 and the Petition Date"). See Docket 609, Item B.
- The When: The Orders Granting Motion For Leave to Conduct Expedited Discovery were signed on 11/16/2018.12
At issue is fraudulent conveyance under 11 U.S. Code § 548:
The trustee may avoid any transfer of an interest of the debtor in property, or any obligation incurred by the debtor, that was made or incurred on or within 2 years13 before the date of the filing of the petition, if the debtor voluntarily or involuntarily —
- Made such transfer with actual intent to hinder, delay, or defraud
- Received less than a reasonably equivalent value in the exchange
- Was insolvent on the date that such transfer was made or became insolvent as a result of such transfer
- Intended to or believed that the debtor would incur debts that would be beyond the debtor’s ability to pay as such debts matured; or
- Made such transfer to or for the benefit of an insider
So, wait, there's only a 2-year look-back period for applying fraudulent conveyance laws? The short answer is "yes." The less clear answer is..."maybe?" As you'll see below, the Courts have broad powers, and in the Subcommittee's motion to conduct expedited discovery, they reserved the right to verify any potential recourses14:
The Subcommittee and its legal advisors are also analyzing the strength of potential defenses, including defenses that claims are barred by the applicable statutes of limitation."
The court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title. No provision of this title shall preclude the court from taking any action necessary to enforce or implement court orders or rules, or to prevent an abuse of process."15
Which is exactly what the Court did: it granted expedited discovery orders allowing the UCC and the Subcommittee to investigate the stated transactions. Recently, according to the WSJ: the UCC "has identified claims against ESL related to its past transactions with Sears." What is the nature of those claims? Who knows, but back in November, ESL disagreed (Docket 575, ¶ 2):
ESL will not leave unanswered baseless allegations levied against it by other creditors — or any — that are completely divorced from the facts, and deliberately ignore that ESL’s actions have always been taken in good faith, on fair terms, alongside third parties, regularly reviewed by independent and experienced advisors, and beneficial to all Sears stakeholders."
Unsurprising posturing on both sides if you ask me. The truth? Without being party to the investigation, your guess is as good as mine.
Footnotes: The UCC and Fraudulent Conveyance
13NY state law is 6 years, though I'm unsure if that's applicable in federal court. Also, the federal statute under § 548 is 10 years for self-settled trusts, which I don't believe is at issue in this case.
14What's the difference between a good lawyer and a great lawyer? A good lawyer knows the law. A great lawyer knows the judge.
15I'm admittedly too inexperienced to ascertain if § 105(a) can supersede the statute of limitations in § 548. It would appear § 105(a) applies to title 11 generally, which § 548 falls under, but it probably has the power, however, to recharacterize any ESL debt to which § 548 applies as contemplated by the UCC's investigation. See Docket 609, ¶ 17. I don't know how much of ESL's debt would apply, but it would be difficult to argue it wouldn't be a boon for unsecured creditors. That said, a purchase of unsecured bonds based on little more than hoping for this outcome is simply gambling.
Please remember the concepts, law, and procedures explored in this series cannot possibly be handled with anything resembling sufficiency but are merely intended as mini crash courses on core ideas and their applications to Sears' bankruptcy. For more robust treatments of bankruptcy subjects in general, see authors Peter Nesvold (accompanied by Jeffrey Anapolsky and Alexandra Lajoux) and Stephen Moyer.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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