Saving Sears: Eddie Lampert's complicated dance

By Reuters

Dec 10, 2014 01:58 AM EST

Tax rules and concerns about Sears Holdings Corp's (SHLD.O) tenuous financial condition may force CEO Eddie Lampert to do a complicated dance as he plans to spin off the retailer's best real estate into a separate trust. 

Last month, the troubled retailer and its chief executive disclosed plans to form a real estate investment trust (REIT) that would acquire as many as 300 Sears stores and lease them back to the retailer. This, CreditSights estimated, could help Sears raise $2.6 billion, providing a critical cash injection.

But based on a Reuters analysis of the proposed REIT and interviews with commercial real estate experts, potentially large ownership stakes held by Lampert and others could conflict with U.S. tax rules designed to prevent small groups from having voting control of a REIT.

Sears' financial woes might also create complications, legal experts said. Sears has lost more than $6 billion over the past four years, and some credit analysts have warned of a possible bankruptcy in the long run. Fitch Ratings, for example, warns the retailer could run out of money in 2017. Given that risk, the spinoff must be structured so it could stand up to scrutiny under federal provisions discouraging certain transfers of major assets prior to any bankruptcy.

Sears declined comment. But it has said it's confident it has ample assets to fund its recovery, including a property portfolio with a book value of $5 billion. It has raised $2.2 billion in liquidity in 2014 and recently pointed to a narrower quarterly loss as a sign of better days to come.

THE "5/50"

Sears plans to fund the REIT by offering shareholders the right to buy stock in proportion to their Sears ownership. But an Internal Revenue Service guideline prevents five or fewer shareholders from owning 50 percent of a REIT's equity, a provision known as the 5/50 rule. Lampert, his hedge fund, ESL Investments, and Fairholme Capital Management alone own more than 72 percent

Because the rule is aimed at individuals, Fairholme and ESL, which own 24 percent and 24.8 percent respectively, could argue they are not in violation. That's because their investors individually hold only small stakes.

According to a securities filing, Fairholme provided advisory services to about 200 clients in the past fiscal year, suggesting a fairly wide investor base.

Lampert's ESL, though, provided services to less than 10 clients.

It is possible that ESL's ownership group is small enough that the 5/50 limitation would be reached simply by combining Lampert's personal shares, his interests in ESL, and one additional large Sears investor - for example, board member Thomas Tisch, who owns 3.96 percent of the company.

If faced with running afoul of the rule, the simplest way for Lampert to comply would be to sell some of his rights. "He'd be taking a big chunk of good assets that people like, and getting people to pay him cold hard cash," said Chris Dickerson, a restructuring lawyer at DLA Piper.

Lampert could also solve his IRS problem in other ways.

For example: buy non-voting preferred shares in addition to common equity. This would allow him to retain an economic interest in the REIT, while ceding voting control.

Another approach: structuring the deal so that the REIT is not the direct owner of the stores. Lampert could then allocate his ownership between a separate property-owning entity that sits under the REIT's umbrella and common equity in the REIT itself, said Gerald Thomas, a partner at law firm McGuireWoods


Another key to making this deal work: determining a fair price for the properties - and the lease terms, said DJ Busch, an analyst at real estate firm Green Street Advisors. The terms can't favor one group over the other, especially given the potential conflicts of interest in the REIT, which would place Lampert and other Sears shareholders on both sides of the deal.

This is important, legal experts said, because Lampert could be vulnerable to lawsuits should Sears wind up insolvent. That's because it is illegal in certain cases to move assets out of creditors' reach prior to bankruptcy, under a concept called "fraudulent conveyance."

The federal statute of limitations on fraudulent conveyance provisions is two years; in some states it is as high as six years. To avoid liability, Lampert must make sure the REIT pays fair market value for the properties and that the deal does not leave Sears insolvent. 

Fraudulent conveyance lawsuits have precedent in the retail sector, although in circumstances that differ from the proposed Sears REIT. In 2012, equity owners of retailer Mervyn's paid creditors $166 million to settle a lawsuit alleging they improperly separated Mervyn's real estate from its retail operations when they bought the company four years prior to its 2008 bankruptcy.

For its part, Sears is well-aware of this potential pothole. Earlier this year, it noted a "fraudulent conveyance" risk in a disclosure related to the spin-off of retailer Lands' End.

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