Wolf Richter wolfstreet.com, www.amazon.com/author/wolfrichter
Greed and scheming.
The team that is picking through what is left of bankrupt Sears Holding Corp. has filed a lawsuit today against former CEO Eddie Lampert, his hedge fund ESL, Seritage Growth Properties, Bruce Berkowitz of Fairholme Capital Management, and various directors of ESL and Sears, such as US Treasury Secretary Steven Mnuchin, who was an executive at ESL and a director of Sears Holding, serving on its Finance Committee.
The lawsuit (110-page court document) alleges that “Lampert and the other Culpable Insiders” have systematically stripped many billions of dollars’ worth of assets from the retailer for their own benefit, and to the detriment of the creditors. This asset stripping was done in various ingenious ways, involving scores of insiders. But given the magnitude of the court document, I will focus on the biggies, the five “Fraudulent Transfers.”
In 2010, “In the face of Sears’ rapidly deteriorating performance and increasing demands for redemptions by ESL’s investors, Lampert and the other Culpable Insiders began a scheme to strip Sears of assets,” plaintiffs claim, which led to these five “Fraudulent Transactions”:
- The 2011 spinoff of Orchard, a California home improvement retailer with 89 stores (Orchard was liquidated in 2018).
- The SHO rights offering in Oct 2012
- The Sears Canada partial spinoff in Nov 2012 (Sears Canada was liquidated in 2017)
- The Lands’ End spinoff the Apr 2014
- The Seritage transaction in July 2015 (in 2017, Lampert et al. already settled a lawsuit by aggrieved shareholders over the Seritage deal)
“Lampert and the other Culpable Insiders created a false record to conceal the fraudulent nature of these transactions. This included causing reviews of certain of these transactions by committees of independent directors based on solvency opinions by Duff & Phelps that were premised on the unrealistic projections. These processes failed to protect, and indeed ignored, the interests of creditors.”
Below are some select quotes about these five “fraudulent transactions.” This is still long, but it makes for some grisly reading about “culpable insiders” trying to enrich themselves at the expense of others, while gutting a large company alive.
“Fraudulent Transaction” 1: The Orchard spinoff, “first step in Lampert’s plan to strip Sears of assets.”
“Orchard was acquired by Sears Roebuck in 1996. In 2005, Sears Roebuck sold a 19.9% stake in Orchard to Ares Capital Management (“Ares”), a hedge fund, retaining the remaining 80.1%.
“At the time of the spinoff, Orchard was profitable, much more so than the rest of Sears.
“Sears had been planning a spinoff of Orchard since at least April 2010, when it made a formal request for a private letter ruling from the IRS that the spinoff would be tax free. Yet, in that time, Sears never pursued a third-party sale of Orchard.
“Sears Received No Consideration for the Orchard Spinoff.”
In December 2011, Sears spun off its entire 80.1% common stock and 100% preferred stock stake in Orchard as a dividend to its shareholders for no consideration.
After the spinoff:
- Lampert and ESL held 48% of Orchard’s common stock and 61.2% of Orchard preferred stock.
- Ares held 19.9% of the common stock;
- Fairholme held 12.2% of the common and 15.2% of the preferred stock.
- Tisch held 3% of the common and 3.7% of the preferred stock.
- Other public shareholders held 15.9% of the common and 19.9% of the preferred stock.
“The Culpable Insiders Acted with Fraudulent Intent”
“The Orchard spinoff was approved by a Board that included Lampert, Mnuchin, and Tisch. These Culpable Insiders acted with the intent to hinder, delay, and defraud Sears’ creditors through the Orchard spinoff. This intent can be inferred from several traditional ‘badges of fraud’:
“First, the transfer was to insiders. The Culpable Shareholders owned approximately 80.1% of Sears’ stock, and thus received nearly 64.2% of Orchard common stock, and 80.1% of Orchard preferred stock.”
“Second, Lampert and ESL (and William Crowley of ESL) received special rightsunder a shareholders’ agreement between ESL, Lampert, Crowley, Ares, and Orchard” that were “not enjoyed by the other shareholders of Sears who received shares of Orchard in the spinoff”:
- a right of first offer should Ares seek to sell its shares;
- a “tag-along” right should Ares sell its shares to a third party;
- a “drag-along” right should ESL arrange a sale of a large percentage of Orchard’s shares to a third party;
- preemptive rights with respect to Orchard’s future debt offerings;
- registration rights with respect to certain unregistered securities that ESL might acquire; and
- the right, along with Ares, to approve the composition of the boards of Orchard’s subsidiaries and its annual budget.
“Third, Sears received no consideration in the spinoff. The shareholders paid nothing to Sears in exchange for the Orchard stock that they received.
“Fourth, the transfer was unusual and not in the ordinary course of business.”
“Fifth, the Orchard spinoff was not an isolated transaction, but rather the first step in an ongoing scheme to transfer Sears’ most valuable assets to the Culpable Shareholders at the expense of Sears’ creditors. At the time of the Orchard spinoff, the Culpable Insiders already intended to continue with future transactions … that would take Sears past the point of insolvency. In the aggregate, the contemplated transactions that were part of this scheme would result in the divestiture of a substantial percentage of Sears’ assets.
“Fraudulent Transaction” 2: The SHO Rights Offering, Oct 2012, “a further step in the same scheme to divest a declining Sears of its valuable assets.”
“SHO was a wholly owned direct subsidiary of Sears. SHO operated stores that sold appliances and tools under Sears’ brands. SHO stores were generally smaller than Sears’ other stores and did not carry the full line of Sears products. At the time of the spinoff, SHO was profitable, much more so than the rest of Sears.”
Sears Received No Consideration.
“Sears filed a registration statement on Form S-1 for 23.1 million shares, or 100%, of common stock of SHO on April 30, 2012. Sears also created 105,919,089 rights to purchase shares of SHO (the “SHO Rights”). The SHO Rights gave their holders the option to purchase 0.22 shares of common stock of SHO at an exercise price payable to Sears of $15 per share. Sears distributed all 105,919,089 of the SHO Rights to its shareholders on September 7, 2012, of which approximately 80.8% were given to the Culpable Shareholders.
“The SHO Rights were valuable securities…. After its first day of trading, SHO had a market capitalization of $709 million. The shareholders paid aggregate consideration of $346.5 million to exercise the SHO Rights, implying a transfer of $362 million from Sears to its shareholders.”
“The Culpable Insiders Acted with Fraudulent Intent.”
“The SHO rights offering was approved by a Board that included Lampert, Mnuchin, and Tisch. These Culpable Insiders acted with the intent to hinder, delay, and defraud Sears’ creditors through the SHO rights offering. This intent can be inferred from several traditional “badges of fraud”:
“First, the transfer was to insiders. The Culpable Shareholders owned nearly 80.8% of Sears’ stock, and thus received nearly 80.8% of the SHO Rights.”
“Second, Sears received no consideration for the distribution of the SHO Rights and inadequate consideration for the exercise of the SHO Rights.
“Third, the transfer was unusual and not in the ordinary course of business.”
“Fourth, the SHO rights offering was not an isolated transaction, but rather a continued step in an ongoing scheme to transfer Sears’ most valuable assets to the Culpable Shareholders at the expense of Sears’ creditors.”
“Fifth, the SHO rights offering was premised on unrealistic, bad-faith projections of Sears’ future performance. Sears retained Duff & Phelps to provide a solvency opinion to support the transaction. Duff & Phelps was provided with projections from management regarding Sears’ performance (the ‘2012 Solvency Projections’)” that “predicted, incredibly, that revenue, EBITDAP, and EBITDAP margin, which had been declining, would instead begin to grow through 2017. Sears’ actual results fell dramatically short of the projections. Rather than turning around, revenue steadily fell; and EBITDAP and EBITDAP margin fell and remained negative.”
“Fraudulent Transaction” 3: Sears Canada partial spinoff, “yet another step in a continued scheme to divest a declining Sears of its valuable assets.”
“Prior to the spinoff, Sears indirectly owned 95.5% of Sears Canada (through Sears Roebuck and certain of its subsidiaries). The remaining 4.5% was publicly traded on the Toronto Stock Exchange.”
“Sears Received No Consideration.”
In November 2012, Sears spun off 44.5% of Sears Canada to its shareholders. “Sears’ shareholders paid no consideration to Sears for the Sears Canada shares. This reduced Sears’ remaining stake in Sears Canada to just 51%.”
The day before the spinoff was announced, the 44.5% stake was worth at least $621 million. The day before the final approval of the spinoff, the 44.5% stake was still worth at least $501 million.
“[J]ust two months after the spinoff, on December 31, 2012, Sears Canada paid a $102 million dividend. If this dividend had been paid before the spinoff, 95.5% of it would have been paid to Sears (and 4.5% to Sears Canada’s public shareholders). Instead, because the dividend was paid after the spinoff, only 51% of the dividend was paid to Sears. The value representing the difference between 51% and 95.5% was instead paid to Sears’ shareholders (who became Sears Canada’s shareholders as a result of the partial spinoff). The primary beneficiaries were Lampert and ESL, followed by Fairholme and Tisch.”
“The Culpable Insiders Acted with Fraudulent Intent.”
“The Sears Canada partial spinoff was approved by a Board that included Lampert, Mnuchin, and Tisch. These Culpable Insiders acted with the intent to hinder, delay, and defraud Sears’ creditors through the Sears Canada partial spinoff. This intent can be inferred from several traditional ‘badges of fraud’:
First, the transfer was to insiders. The Culpable Shareholders owned 81.2% of Sears’ stock, and thus personally received 81.2% of the distribution, or nearly 36.3% of the equity in Sears Canada.
Second, Sears received no consideration for the Sears Canada shares.
Third, the transfer was unusual and not in the ordinary course of business.
Fourth, the Sears Canada partial spinoff was not an isolated transaction, but rather a continued step in an ongoing scheme to transfer Sears’ most valuable assets to the Culpable Shareholders at the expense of Sears’ creditors.
Fifth, the Sears Canada partial spinoff was premised on unrealistic, bad-faith projections of Sears’ future performance. For the Sears Canada partial spinoff, Duff & Phelps undertook only minor updates to its solvency analysis for the SHO rights offering,” and “continued to predict, unrealistically, that revenue, EBITDAP, and EBITDAP margin, which had been declining, would instead begin to grow through 2017.”
“Fraudulent Transaction” 4: Lands’ End Spinoff in 2014 “a fraudulent transfer and an illegal dividend.”
“The Lands’ End spinoff transferred the common stock of the Lands’ End business (worth more than $1 billion at the time) from Sears to its shareholders, the largest of whom were the Culpable Shareholders.
“The shareholders paid Sears no consideration for Lands’ End.
“Sears acquired Lands’ End in June 2002 for $1.86 billion. Sears owned Lands’ End indirectly through Sears Roebuck, its wholly owned subsidiary. Because of its strong cash flow and profitability (particularly in comparison to Sears’ other business units), Lands’ End was one of Sears’ ‘crown jewels.’”
“Lampert insists on a spinoff to benefit ahareholders, rather than alternatives that would have generated more proceeds for sears…. Despite planning the Lands’ End spinoff for at least two years, Sears never seriously pursued any alternatives, including a third-party sale of Lands’ End, which would have maximized the proceeds to Sears and left such proceeds available to creditors. Nor did Sears engage an investment banker to conduct a sale process or obtain an independent valuation.”
“As Lampert and other insiders knew, prospective buyers existed. On January 9, 2014, Sears received an unsolicited indication of interest from Leonard Green & Partners and the Tommy Hilfiger investment group (“LGP/TH”). LGP/TH stated that they were “highly interested” in investing in Lands’ End, which they valued at $1.6 billion (including net debt). LGP/TH proposed a “sponsored spin” transaction that would give LGP/TH a 25% stake in Lands’ End (alongside Sears’ shareholders) and deliver proceeds of either $850 million or $1 billion (depending on the transaction structure) to Sears.”
“Lampert summarily rejected this opportunity. Just six days later, Lampert personally told LGP/TH that the proposed transaction was a “non-starter”—not because it failed to maximize proceeds to Sears, but because it would have diluted his and ESL’s stake in Lands’ End relative to a non-sponsored spin.”
“Ultimately, Lands’ End was distributed to Lampert, ESL, and Sears’ other shareholders for no consideration, following a pre-spin dividend from Lands’ End of $500 million. Lands’ End’s stock price on its first day of trading confirms that the standalone company (after paying the pre-spin dividend) was worth more than $1 billion. Lampert and ESL, as the largest Sears shareholders, were by far the largest beneficiaries of the transaction, receiving Lands’ End stock then worth at least $490 million.”
“The Land’s End Spinoff left Sears and Sears Roebuck insolvent.”
“At the time of the Lands’ End spinoff, Sears had existing debt obligations with an aggregate principal amount of more than $3.8 billion. Together with interest, Sears required more than $4.7 billion (and more than $4.3 billion by 3Q 2018 alone) to pay off its debt.
“Sears’ total cash and cash equivalents immediately after the Lands’ End spinoff (including the pre-spin dividend) were approximately $842 million. Even assuming that Sears used all of these funds for principal and interest payments (rather than to fund continued operating losses, as actually occurred), Sears still would have required more than $3.4 billion of additional free cash flow by 3Q 2018.”
“Sears had no basis to expect to earn anything close to what it needed. After the Lands’ End spinoff, it could not reasonably have expected to earn $841 million in free cash flow by 1Q 2016 (when the asset-based loan (“ABL”) came due). In reality, Sears ultimately saw free cash flow of approximately negative $1.7 billion in FY 2014, negative $2.4 billion in FY 2015, and negative $1.5 billion in FY 2016.”
“After Lands’ End, the only way Sears could have made the ABL principal payment due in 1Q 2016 was by selling core assets. And that, of course, is what Sears ultimately did, paying down the ABL with part of the proceeds of the Seritage transaction (discussed in more detail below).”
“But even with non-ordinary-course sales of core assets, after the Lands’ End spinoff, Sears could not reasonably have funded $4.3 billion in debt principal and interest payments by 3Q 2018 (when the Second Lien Notes would come due). Not coincidentally, 3Q2018 is when Sears ultimately filed for bankruptcy….
“In light of Sears’ declining financial performance over the preceding years and the numerous adverse qualitative trends, as detailed above, it was not reasonable to assume that Sears could achieve the level of cash flow necessary for timely debt principal and interest payment.”
Despite a cumulative net loss of $5.3 billion in the four fiscal years prior to the Land’s End spinoff, FYs 2010–2013, “Duff & Phelps, the valuation advisor hired to opine on Sears’ solvency at the time of the spinoff, opined that Sears was solvent only by adopting management’s speculative top-down projections about future performance.”
“The 2014 Solvency Projections were unrealistic and unreasonable. In the base case, Duff & Phelps assumed that revenue, gross margin, Earnings Before Interest, Taxes, Depreciation, Amortization, Rent Expense, and Pension Expense (“EBITDARP”), and EBITDAP would increase rather than continuing to decrease (and, in the case of EBITDAP, would turn positive instead of negative), and would continue to increase dramatically over the entire three-year projection period.”
“Even in the sensitivity case, Duff & Phelps assumed that Sears’ revenue decline would slow and then turn to growth and that EBITDAP and EBITDAP margin would become positive and increase (rather than remaining negative and continuing to decrease). In other words, even the “sensitivity” case assumed a substantial turnaround in Sears’ profitability.”
“Duff & Phelps did not consider the far more realistic likelihood that Sears’ results would stay on the same downward track, or that they would, at best, stabilize at 2013 levels. Without these unwarrantedly optimistic assumptions, Sears would have had negative free cash flow, and thus would be unable to make scheduled debt principal and interest payments starting between 2014 and 2016.”
“The Lands’ End spinoff left Sears and Sears Roebuck with unreasonably small capital.”
“After the Lands’ End spinoff, Sears had insufficient capital or reserves to account for its normal business operations and to repay its existing debt load, much less sustain operations through any difficulties likely to arise in its line of business, including general or industry-wide economic downturn. Sears was also left with insufficient capital or reserves even to survive a continuation of established trends in its free cash flow, net sales, margins, and net profits (losses).”
“The Culpable Insiders Acted with Fraudulent Intent.”
“The Lands’ End spinoff was approved by a Board that included Lampert, Mnuchin, Tisch, and Alvarez. The Culpable Insiders acted with the intent to hinder, delay, and defraud Sears and Sears Roebuck’s creditors through the Lands’ End spinoff. This intent can be inferred from several traditional ‘badges of fraud’”:
First, the transfer was to insiders. In Lampert’s words, he wanted to give Lands’ End to “ourselves.” The Culpable Shareholders owned approximately 74.7% of Sears’ stock, and thus personally received approximately 74.7% of the equity of Lands’ End…. In total, the Culpable Shareholders received at least $756 million in value from the Lands’ End spinoff.
Second, Lands’ End comprised a significant percentage of Sears’ EBITDA-producing assets. In FY 2012 (the last year in which Sears had positive EBITDA), Lands’ End comprised 17.3% of Sears’ EBITDA. The year before, FY 2011, Lands’ End had comprised a majority, 52.3%, of Sears’ EBITDA.
Third, Sears and Sears Roebuck received no consideration in the spinoff. The shareholders paid nothing to Sears or Sears Roebuck in exchange for the Lands’ End stock that they received.
Fourth, the transfer was unusual and not in the ordinary course of business.
Fifth, as noted above, Sears and Sears Roebuck were insolvent prior to the transaction, or became insolvent as a result of the transaction.
Finally, the Culpable Insiders (and Duff & Phelps) knew or should have known that the 2014 Solvency Projections could not realistically be achieved. By this time, Sears had fallen short of the performance projections in its four immediately preceding Annual Plans, for fiscal years 2010 through 2013. Sears also had fallen short of the multi-year projections that had been submitted to Duff & Phelps in 2012 for its analysis of the SHO rights offering and Sears Canada partial spinoff. These shortcomings were material.
“In the words of former Sears CEO Alan Lacy: “In 2014, with the Lands’ End spinoff, and then the Seritage spinoff…, that’s when it seemed to shift into, [Lampert’s] managing for cash flow, or liquidation. Everybody knew how the movie was going to end. It was just a question of how many minutes are left.”
“Fraudulent Transaction” 5: Seritage Transaction in July 2015, “a fraudulent transfer and an illegal dividend.”
“Ever since the Kmart/Sears merger, analysts and financial journalists have speculated that Lampert’s intentions for Sears involved some type of “real estate play.” The Seritage transaction, which closed in July 2015, proved them right.”
“The Seritage transaction constituted a fraudulent transfer and an illegal dividend. The sale-and-lease-back agreement, and related agreements, between Sears and Seritage (the “Sale-and-Lease-Back”) undervalued the real estate by hundreds of millions of dollars and saddled Sears with grossly one-sided and costly lease terms, and the Seritage rights offering transferred highly valuable subscription rights to Sears’ shareholders (again, principally to the benefit of the Culpable Shareholders) for no consideration.”
First…
“First, Sears sold to the Seritage Defendants the title (or joint venture interests) for the land under 266 of its most profitable stores for a purchase price of approximately $2.58 billion, while simultaneously agreeing to lease those spaces back from the Seritage Defendants. The purchase price was ostensibly based upon appraisals of the properties by C&W. But the appraisals were fundamentally flawed, and, as a result, the transferred real estate was undervalued by approximately $649 to $749 million.”
Second…
“Second, Sears transferred subscription rights to purchase shares in Seritage common stock to the Culpable Shareholders and other Sears shareholders for no consideration. The trading price of the subscription rights reflects that they were worth approximately $400 million. And for Lampert, ESL, the ESL Shareholders, and Fairholme, the value of the subscription rights was even greater. Those insiders benefited from a side agreement pursuant to which they exchanged some of their subscription rights plus cash for other classes of Seritage stock and interests in the Seritage Operating Partnership, which were particularly valuable.”
“Sears’ financial condition was even worse in July 2015, when the Seritage transaction closed, than it had been fourteen months earlier when Lands’ End was spun off. That was due in part to Sears’ continuing losses (it recorded a net loss of $1.68 billion in FY 2014) and in part to the Lands’ End spinoff itself, which divested Sears of one of its few profitable subsidiaries.
“Yet Sears transferred the Seritage subscription rights for no consideration and the real estate for grossly inadequate consideration. The inadequate consideration is confirmed by Seritage’s stock price increase on its first day of trading, closing at $37.73 (up 27.6% from $29.58)—a one-day increase in Seritage’s market capitalization of $453 million. By April 15, 2016, less than one year later, Seritage’s stock price had increased more than 50%, to $56.47, giving it a market capitalization of $3.2 billion.
“Seritage also paid quarterly dividends since December 2015 totaling approximately $209 million. On information and belief, the Culpable Shareholders have received approximately $131 million of dividends from Seritage.”
“The terms of the Seritage transaction—including the price Seritage paid Sears for the properties, the rent and other terms of the leases between Sears and Seritage, and the terms of the rights offering—were established unilaterally by Lampert and others who reported to him, and without negotiation.
“Lampert, however, was grossly conflicted because, once the transaction went through, he and ESL would be by far the largest shareholders of Seritage. No consideration was given to the interests of creditors….”
“Lampert was the driving force behind the Sale-and-Lease-Back transaction. As a result, the Sale-and-Lease-Back proposal was developed, while other alternatives were not seriously considered.
“By September 21, 2014, the Company was moving forward with the creation of a REIT. Because legal restrictions on ownership concentration in REITs would have prevented Sears’ largest shareholders—Lampert, the ESL Shareholders, and Fairholme—from owning the same percentage of the REIT as they owned of Sears, substantial attention was devoted to developing transaction features that would benefit these large shareholders….
“By November 2014, the principal elements of the transaction—including the creation of a new REIT, an estimate of the number of properties to be sold to the REIT, and the terms of the master lease whereby the REIT would lease back the properties to Sears—were in place.
“Pursuant to a “Subscription, Distribution and Purchase and Sale Agreement” between Sears and Seritage dated June 8, 2015, the newly created REIT (Seritage) issued and delivered to Sears 106,597,798 unitized subscription rights (“Seritage Rights”). The Seritage Rights gave their holders the option to purchase new shares of common stock of Seritage at an exercise price payable to Seritage of $29.58 per share. The balance of Seritage’s capital structure consisted of third-party financing secured by the real estate to be acquired from Sears.
“Sears distributed all 106,597,798 of the Seritage Rights to its shareholders that same day, of which 81,359,794, or 76.3%, were given to the Culpable Shareholders. The shareholders did not pay Sears any consideration in exchange for the Seritage Rights.”
“The Seritage Rights were valuable securities. Between June 9 and 26, 2015, the Seritage Rights traded on the NYSE. The volume-weighted average trading price of the Seritage Rights over this period was $3.75 per right. Based on this price, the 106,597,798 Seritage Rights were worth at least $399 million. As Sears’ CFO wrote in an email before the closing, “the market thinks [Sears] is selling something for about $600M less than it is worth.”
“In fact, the Seritage Rights were worth materially more than this amount, because the trading price did not account for the more valuable interests that Lampert, the ESL Shareholders, and Fairholme were able to obtain by “exchanging” their excess rights (which they did not trade on the NYSE) plus cash with Seritage for Class B and Class C shares of Seritage and operating partnership interests. These other interests were worth more than Seritage common stock because they gave Lampert, the ESL Defendants, and Fairholme the special ability to block a change of control.”
Third though fifth…
“Third, Sears Roebuck contributed its joint venture interests in GS Portfolio Holdings LLC and MS Portfolio LLC, for no consideration, to Seritage GS Holdings LLC and Seritage MS Holdings LLC, respectively.
“Fourth, Kmart Corporation contributed Seritage KMT Finance LLC to KMT Mezz for no consideration.
“Fifth, Sears Roebuck contributed Seritage SRC Finance LLC, Seritage GS Holdings LLC, and Seritage MS Holdings LLC to SRC Mezz for no consideration.
“The Sale-and-Lease-Back Undervalued the Transferred Real Estate Assets and Joint Venture Interests.”
“On or about July 7, 2015, Sears and Seritage closed on the Sale-and-Lease-Back of 266 Sears stores. These 266 properties were selected to include only stores that generated sufficient EBITDA to be able to pay the assigned rent to Seritage, and thus represented Sears’ most valuable available properties.
“Seritage paid Sears a total of $2.58 billion for the real estate assets and joint venture interests, a purchase price that was purportedly based in primary part on appraisals performed by C&W…. C&W’s appraisals were fundamentally flawed and undervalued the properties by between $649 and $749 million, which in turn meant Seritage underpaid at least that much for the properties….
“Confirmation can be found in Sears’ subsequent sales, through the Petition Date, of 36 properties at prices that were, on average, 40% higher than C&W’s valuation…. [A fair valuation would have resulted in a purchase price at least $649 to $749 million more than Seritage paid Sears.”
“Onerous Master Lease Terms Further Benefited Seritage at Sears’ Expense.”
“The Sale-and-Lease-Back contained one-sided terms that benefited Seritage and harmed Sears. Two terms in particular were unfair to Sears:
- Seritage’s right to “recapture” up to 50% of the space at most of the stores it purchased, and 100% of the space at the remaining stores; and
- Sears’ obligation to pay a punitive termination fee calculated as one year’s rent if Sears elected to terminate the lease with respect to individual stores.
“Seritage’s recapture right harmed Sears because it left Sears’ most profitable stores vulnerable to eviction or having their footprint materially reduced. Specifically, this clause allowed Seritage to recapture up to 50% of the space at 224 properties, and 100% at 21 other properties (plus auto care centers). Notably, the agreement imposed no limitation on Seritage’s right to lease the space to anyone, including competitors of Sears.
“Sears’ liability to pay a punitive termination fee harmed Sears because it increased the cost of Sears’ stated strategy of closing unprofitable stores….
“Taken together, the Sale-and-Lease-Back terms ensured that Sears would continue to pay Seritage rent, even for unprofitable stores, and that Seritage could invest those funds in redevelopments that ousted Sears from its most profitable stores.
“As noted, Duff & Phelps, Sears’ advisor on the transaction, estimated the value to Seritage of these unusual lease terms at between $204 and $409 million. To date, Sears has paid Seritage more than $570 million in rent, termination fees, or tenant reimbursements.”
“The Sale-and-Lease-Back was not the product of an arm’s-length negotiation process. Since Seritage did not exist prior to the transaction, all decisions about Seritage were made by Sears personnel and—as Robert Schriesheim, former CFO of Sears, explained to counsel for the Subcommittee—mainly by Lampert himself.
“Jeffrey Stollenwerck, Sears’ head of real estate, similarly stated that he was not aware of any “negotiation” of the Sale-and-Lease-Back or of any person tasked with protecting Sears’ interests.
“Nor did Sears allow a disinterested committee of the Board (such as the RPT Committee) to negotiate the terms. The RPT Committee, in evaluating the transaction, did not have an independent real estate appraisal firm and never considered hiring one. Indeed, the RPT Committee’s sole focus in reviewing the transaction was whether Lampert and ESL were getting a better deal than other Sears shareholders.
“The RPT Committee did not consider, and was not authorized to consider, any of the other key aspects of the transaction, including the price of the rights offering, the value of the property itself, the one-sided lease terms, and the Company’s solvency. The RPT Committee did not consider Sears’ creditors and whether the transaction would harm them.
“The Seritage Transaction Left Sears and the Real Estate Transferors Insolvent under the Balance-Sheet Test.”
“After the Seritage transaction, Sears had a negative net asset value and was thus insolvent under the balance-sheet test. Due to Sears’ prolonged negative earnings and the lack of any reasonable indication that the problems were temporary, Sears could not be valued under the income approach (discounted cash flow) or the market-multiples approach.
“Using the asset approach—i.e., fair value of its net assets under the premise of an orderly (or disorderly) liquidation—the fair value of Sears’ total assets at the time was no more than $13.3 billion in an orderly liquidation, which would have yielded net equity of negative approximately $1.5 billion (and a net asset value of negative approximately $2.3 billion after considering the estimated wind-down of corporate overhead).
“While Duff & Phelps opined that Sears was solvent and had adequate capital following the Seritage transaction, it managed to reach that conclusion only by committing fundamental errors, including relying on bad faith, unachievable projections provided to it by the Company’s management…. Duff & Phelps also overvalued Sears’ inventory, real estate, property, plant, equipment, and trade names by billions of dollars.”
“The Culpable Insiders Acted with Actual Fraudulent Intent.”
“The Seritage transaction was approved by a Board that included Lampert, Mnuchin, Tisch, Alvarez, and Kamlani. The Culpable Insiders had the actual intent to hinder, delay, and defraud Sears and the Real Estate Transferors’ creditors with the Seritage transaction. This intent can be inferred from the traditional ‘badges of fraud’”:
“First, the transfer was to insiders. The Culpable Shareholders owned approximately 76.3% of Sears’ stock, and thus personally received approximately 76.3% of the Seritage Rights.
“The Sale-and-Lease-Back was made with a new entity controlled by these same insiders. Moreover, Lampert, ESL, the ESL Shareholders, and Fairholme also enjoyed a side agreement that exchanged their excess subscription rights plus cash for special controlling interests in Seritage. As the sole limited partners of the Seritage Operating Partnership, Lampert and ESL have the ability to veto any “change in control” (such as a merger, consolidation, conversion, or other combination). Lampert became the chairman of Seritage’s board of trustees, and Thomas Steinberg, a long-time investor in ESL, became another trustee.
“Second, Sears received no consideration for the rights offering, and inadequate consideration for the Sale-and-Lease-Back.
“Third, the transfer was unusual and not in the ordinary course of business. The transaction sold Sears’ crown jewels, putting its most profitable stores at risk of being “recaptured” and leased to its competitors.
Fourth, as noted above, Sears was insolvent, or became insolvent, under both the balance-sheet and cash-flow tests.
Fifth, Lampert, ESL, the ESL Defendants, and Fairholme also intended to use the proceeds of the transaction to repurchase debt held by themselves
Sixth, Sears and the Culpable Shareholders (through their ownership and control of Seritage) maintained possession and control of the transferred real estate assets.
“Notably, prior to the transaction, the Culpable Insiders also were aware of analyst reports and financial journalism that opined that the transaction was unfair to Sears. In the words of Evercore’s analyst, Sears’ strategy was to “[p]ut 250 of the best stores in the REIT, get $2B in cash and hope that this is sufficient to fund the business for 2 years to get past fraudulent conveyance statutes.”