By Joe Cahill, Crain News Service
CHICAGO (Dec. 11, 2013) — Through years of sinking sales and widening losses, Sears Holdings Corp. has voiced nothing but confidence in its long-term future.
But a disclosure document for its recently announced plan to spin off its Lands’ End Inc. unit suggests a gloomier scenario has at least crossed some minds at Sears headquarters in Hoffman Estates, Ill. A paragraph in the “Risk Factors” section discusses what might happen if the struggling 127-year-old department store chain “fails to pay its creditors or enters insolvency proceedings,” a prospect I haven’t seen addressed publicly by Sears before.
If such a fate were to befall Sears, the document warns, a court might deem the spinoff a “fraudulent conveyance,” exposing shareholders of the newly independent catalog retailer to claims by Sears creditors.
Douglas Baird, a professor specializing in bankruptcy law at the University of Chicago Law School, explains how the fraudulent conveyance concept might apply to a corporate spinoff: “A spinoff is a dividend by another name. You’re taking a valuable asset and passing it upstream to shareholders. Companies that are insolvent can’t pass value to shareholders.”
The fraudulent conveyance warning may reflect nothing more than abundant caution by lawyers drafting the Lands’ End spinoff prospectus. Sears still appears solvent and able to pay creditors. Assets exceed liabilities, and a recent $1 billion loan from Bank of America showed Sears still has access to credit.
(Earlier this year the mass merchandiser also floated the idea of selling off its automotive service centers.)
On the other hand, it’s worth noting Sears didn’t include a fraudulent conveyance warning in prospectuses for three previous spinoffs it completed in 2012 and 2011. I also looked at prospectuses from recent spinoffs by other companies and found that some gave a fraudulent conveyance warning and others didn’t.
A Sears spokesman wouldn’t say why Sears decided to flag fraudulent conveyance risk for the Lands’ End spinoff, but not when it gave shareholders the Sears Hometown and Outlet Stores, Orchard Supply Hardware Stores Corp., and a stake in Sears Canada.
While I don’t think the disclosure signals imminent insolvency, I do think it highlights a couple of worrisome issues.
The first is the impact of spinning off Lands’ End, which would deprive Sears of what might be its best-performing individual business unit. Unlike Sears as a whole, Lands’ End has profits and positive operating cash flow. It bolstered the parent company’s dwindling cash supply with a $24 million dividend this year.
While the transaction might benefit shareholders — including Sears CEO Edward Lampert, whose 48-percent stake in Sears entitles him to a corresponding share of the new Lands’ End stock — by giving them a chance to profit if Land’s End does well, there’s no apparent benefit to Sears Holdings Corp.
Parent companies often collect dividends from subsidiaries to be spun off, but Sears has said it will receive no cash in the Land’s End transaction. Of course, Sears could always change its mind and extract one last big dividend from Lands’ End, as it did in the Hometown and Outlets deal.
The lack of value for Sears could buttress a fraudulent conveyance claim by creditors if Sears goes south in the next couple of years. Courts considering such claims generally scrutinize dividends and divestitures that occurred within two or three years of insolvency.
Perhaps more significantly, flagging the fraudulent conveyance risk calls attention to rising debt levels at Sears. Mr. Lampert is borrowing heavily to cover operating losses. Long-term debt climbed 46 percent to $2.86 billion over the past year, and now exceeds total equity by 23 percent. As of the end of the third quarter, assets exceeded liabilities by $2.3 billion, down 40 percent from a year earlier.
“We have ample liquidity,” the Sears spokesman says. “We are on track to generate $2 billion of liquidity this year as compared to our previously stated objective of $500 million. As of quarter end we have $7.7 billion of combined liquidity and net inventory, and have virtually no term debt maturities until 2018 and a revolver in place into 2016.”
All true, but Sears’ operations consumed $1.7 billion in cash during the first nine months of the year — 31 percent more than in the same period last year. While holiday sales will reduce the full year figure, Sears’ need for external cash infusions continues to grow.
Credit rating agencies and other observers have taken comfort from Sears’ vast real estate holdings and other assets that can be sold to raise cash. But as Sears stores continue to deteriorate, their sale value is bound to decline, as is the value of trademarks and other intangible assets tied to the retail operation.
In that context, it’s not surprising Sears might deem it prudent to tell Lands’ End investors what they might face if the unthinkable happens.