Description

Disclaimer: The Author of this post and related persons or entities (“Author”) may hold a position in this issuer’s or related securities. The Author makes no representation that it will continue to hold such positions. The Author is likely to buy or sell long or short securities of this issuer and makes no representation or undertaking that the Author will inform the reader or anyone else prior to or after engaging in such transactions. While the Author has tried to present facts that it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note or subsequent comments. The views expressed in this note and in subsequent comments are only the opinion of the Author. The reader agrees not to make investments based on this note and to perform his or her own due diligence and research prior to taking a position in this issuer’s or related securities. Reader agrees to hold Author harmless and hereby waives any causes of action against Author related to the below note and associated comments.

When we started writing this, we had planned to post it on grizzlybear’s SRG short message board. However, given its length (in addition to the fact that we hope the VIC gods will count it towards our quota), we decided it should stand on its own.

This writeup focuses on why we believe that grizzlybear’s short thesis is flawed and that the anticipated fraudulent transfer litigation is unlikely to meaningfully impair SRG’s intrinsic value and thus our long case for the stock. Of course, the core of our SRG thesis (and all of our theses) continues to be focused on the fact that we believe the market price of the shares is meaningfully below their intrinsic value. We now have two different SRG short theses on VIC and 157 comments on the name. The one thing we still don’t have from the short sellers (grizzly and Den in particular) is a decent valuation of Seritage’s assets.

------------------------------

Grizzlybear:

We do not agree with your thesis which, as we understand it, is summarized as follows:

1.       The Seritage transaction was a fraudulent transfer.

2.       The associated liability for Seritage is somewhere between $500mm and $1.5bn.

3.       Whatever this amount turns out to be, it is an existential threat to Seritage.

We will set aside the loose talk of “overhang” and speculation as to how the market might react when fraudulent transfer litigation is brought. We have no interest in beating a dead horse, but those of you that have followed our comments in other Seritage threads will know that we do not invest based on speculation as to how the market will trade on headlines. We prefer to conservatively estimate intrinsic value (which would include an evaluation of the merits of fraudulent transfer risk), something that apparently has gone out of style on VIC.

Having said that, the argument that the market is unaware of fraudulent transfer risk rings hollow to us. Seritage has been written up as a long or short six (6!) times on VIC and four of those write-ups mention fraudulent transfer. Fraudulent transfer features prominently in the risk section of the Company’s filings and is an extremely common consideration for anyone who is even tangentially familiar with distressed investing. As we mentioned in the comment thread to our own Seritage write-up, Stanley Black & Decker addressed fraudulent transfer on a call following their acquisition of the Craftsman brand from Sears and highlighted that they had done significant work on the issue ahead of the deal and came away with no concerns. The suggestion that Warren Buffett either does not understand what fraudulent transfer is or is unaware of the risk seems similarly bizarre to us.

Fraudulent Transfer

It is logical to begin with the first part of your thesis which is that the Seritage transaction was a fraudulent transfer. Interestingly, you largely seem to assume that this is the case without a thorough examination as to whether or not this is actually true as a matter of law. The downfall of Sears, once one of the most iconic brands in the country, is the sort of thing that captures the imagination. For those of us in the investment community, the involvement of a billionaire investor whose once unimpeachable reputation has largely been destroyed, is cause for further speculation. “What was Eddie thinking?” This then proceeds to idle talk of what “everyone knows” about “asset stripping.” It’s salacious stuff. Fortunately, this sort of thing is generally resolved as a matter of law, not innuendo.

With respect to whether or not a transfer was fraudulent and subject to avoidance in bankruptcy, there are no material differences between state and federal law. You wrote:

The code that you posted is federal fradulent transfer statute. There's a big difference and a completely different standard for state claims including a four year lookback for New York. I've had a few calls with attorneys pitching the UCC and they were in agreement that this is one of the best fraudulent transfer set of facts they've seen; both concurred that state claims would be applicable.

It is correct that state laws may have a longer lookback (4-6 years) than federal law (2 years under Section 548), but the differences largely end there. This is by design. All but four states have enacted some version of the Uniform Fraudulent Transfer Act (“UFTA”), which was heavily influenced by the Bankruptcy Code. New York’s law is modeled after the Uniform Fraudulent Conveyance Act, which was the predecessor to the UFTA and materially similar. Regardless, we would expect creditors to bring litigation in whichever jurisdiction is most advantageous. We have spoken to a number of lawyers (none of whom are soliciting Eddie Lampert for his business) that have worked in restructuring and none could identify a material advantage to filing in any one state over another or any advantage for plaintiffs under state vs. federal law, beyond the lookback period.

As we wrote in our original Seritage write-up, there are two types of fraudulent transfer: (i) actual and (ii) constructive. This is true under both state and federal law (if you think that New York is the likely jurisdiction, the relevant sections of the Code are available here, and you will find versions of the UFTA and Section 548 to be broadly similar).

Actual Fraud

Actual fraud involves demonstrated intent to “hinder, delay, or defraud” creditors. In practice, this means that plaintiffs must show that the defendants acted with willful intent to defraud creditors via either explicit evidence of intent to defraud or a significant amount of circumstantial evidence pointing to the same (you will see people refer to “badges of fraud”). As you might imagine, the bar here is quite high. It is not common for management teams to leave written paper trails discussing asset protection schemes or plots to defraud creditors. As others have pointed out, Eddie is not a stranger to distressed situations. We cannot say what will ultimately be unearthed in discovery, but it would surprise us to see a memo on asset stripping.

Tronox Inc. et. al. v. Kerr McGee Corporation is a recent example of a case in which actual fraud was found. At the risk of oversimplifying, Kerr McGee was formed in the 1920s and involved in a range of businesses including E&P, chemicals manufacturing, wood treatment and uranium mining. By 2005, Kerr McGee was involved only in E&P ($1.8 billion in operating profit) and the manufacture of titanium dioxide ($100 million in operating profit). As a result of the legacy businesses, however, Kerr McGee had significant environmental liabilities. The court highlighted that the firm had spent in excess of $1 billion on environmental costs in the 5 years leading up to the filing and hadbeen spending more than $160 million annually on remediation. Anadarko had been courted as a prospective buyer of Kerr McGee but a transaction was never consummated as a result of the magnitude of the potential environmental liability, which was internally described as, “$BILLIONS” with “no end in sight for at least 30 more years.”

The Kerr McGee management team, with the assistance of crafty bankers, came up with a plan to spin the highly-profitable E&P business out of the titanium dioxide business (to become known as Tronox), leaving behind the billions in legacy environmental liabilities. For good measure, they also left behind $442 million in pension and OPEB liabilities about which the court noted, “the record is devoid of any explanation as to why these liabilities were assigned to Tronox (other than that Tronox was allocated all the other liabilities that New Kerr-McGee did not want).” At the time of the spin, Tronox was further saddled with $550 million in funded debt and left with just $40 million of cash. The bankruptcy court ascertained that the primary purpose of the spin was to separate creditors from significant and valuable assets:

In the present case, there can be no dispute that Kerr-McGee acted to free substantially all its assets -- certainly its most valuable assets -- from 85 years of environmental and tort liabilities. The obvious consequence of this act was that the legacy creditors would not be able to claim against "substantially all of the Kerr-McGee assets," and with a minimal asset base against which to recover in the future, would accordingly be "hindered or delayed" as the direct consequence of the scheme. This was the clear and intended consequence of the act, substantially certain to result from it. 

The records from Lehman's files make clear the centrality of the liability issues to the transactions undertaken and that the effect on creditors was well understood. Lehman recognized that the environmental liabilities being left with Tronox were unique. As Lehman's principal witness, [**102] Watson, testified, "other chemical companies didn't have legacy liabilities of other businesses that were attached to a chemical business in addition to environmental liabilities which were attached to ... the ongoing operations." …  Lehman's documents disclose that the potential effect of the liabilities on Tronox and its creditors was also the subject of mordant humor. During the negotiations leading up to the spinoff, Watson more than once drew a picture of a pot containing a flower (the Tronox TiO2 business) and a weed (the legacy liabilities) strangling the flower. (Watson Dep., 2/8/2011 at 441:3 15). Watson explained that "the problem is, there is a weed at the base of this flower and it is going to choke off the company's ability to be prosperous."

The numbers involved highlight the egregiousness of the transaction. There was little dispute that Tronox had received inbound consideration of $2.6 billion, but plaintiffs argued that the value of the E&P assets transferred out were worth anywhere from $7.5 - $17.0 billion, depending on valuation methodology. The court broadly agreed with this conclusion and highlighted that Anadarko’s ultimate acquisition of the E&P assets for $18.0 billion (just months after the spin) validated the plaintiff’s assertions. The bankruptcy court also noted that it was remarkable that there appeared to be no analysis at the time of the spin as to whether or not Tronox would be able to support all of the liabilities it had been saddled with:

The real question is whether Defendants had a good faith belief that Tronox would be able to support the environmental and other legacy liabilities that had been imposed on it. The record on this point is extraordinary because it does not exist. A document survives in which General Counsel Pilcher raised the question whether Kerr-McGee should prepare "a commercial analysis of/conclusion re: impact of Project Focus on position of each creditor." JX 53 at 2. However, if any such analysis was prepared, it has not been preserved. (See Tr. (Walters) 8/16/2012 at 6029:9-6032:12 (noting that the board of directors neither saw nor knew of the existence of any such analysis)). Thus, one of the most compelling [**119] facts in the enormous record of this case is the absence of any contemporaneous [*286] analysis of Tronox's ability to support the legacy liabilities being imposed on it.

This fact pattern was further aggravated by the fact that the environmental liabilities largely resided with the Navajo Nation, EPA and other federal state and local agencies responsible for environmental site remediation. Bruce Berkowitz, among other unsecured creditors, will make for a less sympathetic plaintiff than the Navajo and EPA.

You correctly note that lawyers for Fairholme seemed to allude to the inevitable fraudulent transfer litigation at the opening day hearings. While we believe the case will be decided largely as a matter of law, we can’t help but think the judge will find the Fairholme position to be somewhat disingenuous. Berkowitz became a director at Sears in 2016 and was intimately involved in the Seritage transaction (to the point that he got his own class of economic, non-voting shares). He further defended his investments in Sears and Seritage in his 2015 letter to shareholders:

Sears Holdings Corporation (“Sears”) common stock, warrants, and bonds comprise 13.2% of Fund assets. Our ongoing valuation work reinforces our longstanding belief that Sears is worth multiples of its current market price (as evidenced in the chart below), largely based on its vast real estate empire and disparate businesses configured to sell, deliver, connect, control, service, and replace all manner of consumer products. Throughout the year, the Fund took advantage of price declines to increase its stake.

Last year’s sale of 266 properties for $3.1 billion unlocked one-fourth of the company’s real estate square footage. The properties included in the transaction were not exclusively the crème de la crème of the company’s real estate portfolio as many have falsely asserted. Instead, the quality of the properties included in the transaction closely mirrors the approximately 170 million square feet of real estate retained by Sears today as depicted in the following chart. 

Proceeds from the sale were used to reduce corporate debt by $936 million, and the company must now accelerate its return to profitability in order to rebuild confidence with customers, creditors, vendors, employees, and other investors. Doing so should enable Sears to optimize the value of all its assets.

For Berkowitz to argue that this transaction was actually fraudulent, he would implicitly be acknowledging that he was either knowingly participating in (or at least condoning) a fraudulent asset stripping scheme to enrich himself or that he was lying to investors in his funds. Berkowitz knows this looks bad and we suspect this is why his lawyer qualified his remarks at the opening hearing by saying, “We’re not going to carry the water as Fairholme, but we do look forward to the formation of a fiduciary committee for creditors.”

Constructive Fraud

The second type of fraudulent transfer is constructive fraud, which does not require a finding of intent. The reason constructive fraud exists as a concept is precisely because it is very difficult to establish the intent necessary to unwind a transaction as actually fraudulent. For a transaction to be constructively fraudulent it must meet BOTH of two tests. The first is that the asset(s) sold or the obligation(s) incurred were not sold or incurred at a reasonably fair valuation. The second is that the transaction was done at a time when the debtor was (i) already insolvent, (ii) became insolvent as a result of the transaction or (iii) was left with insufficient capital to conduct its business. Again, this concept is materially the same under both state and federal law.

You have primarily focused on what you believe to be an extensive “paper trail” demonstrating the insufficiency of the consideration received by Sears for the Seritage portfolio. We’ll address this but would like to begin with the question of solvency, which we believe will be the largest problem for the UCC in recovering damages from Seritage. The question before the court will be whether or not Sears was (or became) insolvent in June 2015. All available market data suggests, overwhelmingly, that this is not the case. Critically, the ultimate fate of Sears is irrelevant to the question of solvency in June of 2015, the time of the Seritage transaction.

Immediately following the spinoff, Sears had a publicly traded market capitalization of approximately $3.0 billion. At the end of 2015 it had a publicly traded market capitalization of $2.2 billion, and the market capitalization did not dip below $1.0 billion until 2017, more than 2 years following the Seritage transaction. Sears did not file for almost 3.5 years after the Seritage transaction. Debt markets broadly agreed, with SHLD debt trading at single digit yields following the spin. CDS spreads, while not comparable to your run of the mill IG company, were lower in 2015 than they were for long stretches in 2014. Although Sears had modestly negative balance sheet equity in 2015, all fraudulent transfer laws require assets to be carried at a “fair valuation” for purposes of determining solvency. The New York Code defines solvency thus:

A person is insolvent when the present fair salable value of his assets  is  less  than  the  amount  that  will  be required  to  pay  his  probable liability on his existing debts as they become absolute and matured.

As we all know, carrying value under GAAP is not the same thing as fair value, particularly for companies where the asset base is comprised of things like real estate. And, of course, there was substantial evidence at the time of the spin that the balance sheet materially understated the fair value of Sears’ assets. Sears had been monetizing assets for some time and recognized $667 million in gains on sale in 2013 and $207 million in 2014. The Seritage and associated JV transactions, for which Sears received $2.7 billion from SRG and $0.4 billion from SPG, GGP and MAC, came with a $1.4 billion gain on sale ($508 million of which was recognized immediately and $894 million of which was deferred). This would imply that the carrying value of those assets understated fair value by over 80% (more if you believe those properties were sold for insufficient consideration). There were another $235 million in gains in 2015 beyond those associated with the Seritage and JV transactions.

Indeed, this was precisely the bull thesis advanced not only by Bruce Berkowitz but by dozens of other funds that have trafficked in SHLD shares for years, and likely the reason Sears had a large market capitalization even as the outlook for the operating business deteriorated. As we noted above, Berkowitz highlighted in his 2015 letter that he believed Sears to be worth “multiples of its current market price.” While he eventually acknowledged that he was wrong about the operating business, he continued to assert that he got the asset side of the equation right nearly 3 years later in his 2017 letter:

Although markets reached new highs in 2017, there was not much to celebrate as the securities of Sears Holdings Corporation (“Sears”) and Sears Canada wrecked the Funds’ performance. Sears realized billions of dollars from asset sales, as we predicted, but I did not foresee the operating losses that have significantly reduced values. Getting the asset values largely correct, but missing the company’s inability to stop retailing losses, has been hugely frustrating and fatiguing for me to watch.

Case law on the issue of solvency has gravitated heavily toward treating market data as dispositive in the absence of any compelling reason to disregard it. A notable case here is Iridium Operating LLC et. al. v. Motorola, Inc., decided in 2007 in the SDNY, which summarized the state of play concisely:

Upon application of the familiar litigation [**183] paradigm of burden of proof, the outcome here is relatively routine -- the plaintiff Committee has not proven insolvency by a preponderance of the evidence. That failure of proof is due principally to the existence of conflicting market evidence that could not be credibly explained away and that throughout the relevant period (even as bankruptcy was imminent) pointed to a positive enterprise value for Iridium. 

The fact that Iridium failed in such a spectacular fashion stands out as a disturbing counterpoint to the market's optimistic predictions of present and future value for Iridium, but in the end, the market evidence could not be denied. The capital markets synthesized and distilled what all the smart people of the era knew or believed to be true about Iridium. Given the overwhelming weight of that market evidence, it may be that the burden of proving insolvency and unreasonably small capital simply could not be met under any circumstances, regardless of the evidence adduced, in the wake of the Third Circuit's VFB decision, an influential case that has helped to illuminate the proper way to resolve the valuation questions presented here.

The Iridium decision relied heavily on a previous case, VFB LLC v. Campbell Soup Company that was decided against creditors in the District Court for the District of Delaware and upheld on appeal by the Third Circuit. The Third Circuit laid out the obvious illogic of disregarding market pricing, which involves large numbers of participants distilling all available and accepting the risk of uncertainty, in favor of motivated, post-hoc analysis from paid experts:

Some portions of VFB's brief seem to argue that Courts should never [**17] measure the value of a business by its market capitalization because the market price of a corporation's stock "is based on expectations (projections) of future income," which may turn out to be inaccurate. (Reply Br. for Appellant at 11.) That contention is clearly wrong. [HN6] Equity markets allow participants to voluntarily take on or transfer among themselves the risk that their projections will be inaccurate; fraudulent transfer law cannot rationally be invoked to undermine that function. 

Absent some reason to distrust it, the market price is "a more reliable measure of the stock's value than the subjective estimates of one or two expert witnesses." In re Prince, 85 F.3d 314, 320 (7th Cir. 1996); see also In re Hechinger Investment Co. of Del., 327 B.R. 537, 548 (D. Del. 2005); Peltz v. Hatten, 279 B.R. 710, 738 (D. Del. 2002); Metlyn Realty Corp. v. Esmark, Inc., 763 F.2d 826, 835 (7th Cir. 1985) ("[T]he price of stock in a liquid market is presumptively the one to use in judicial proceedings."). 

VFB has consequently not shown clear error in the district Court's finding that the Specialty Foods Division was worth far more than its $ 500 million in debt acquired at the time of the spin. We stress that, given the arguments VFB has made, the question is not even close. [**24] [HN10] Valuing an asset is a difficult task that depends upon detailed factual determinations, which may be overturned only if they are "completely devoid of a credible evidentiary basis or bear[] no rational relationship to the supporting data."

It’s worth briefly getting into the details of the Iridium case to address any notion that Sears is somehow different because so many people “knew” Sears was doomed or because its operating business has been uniquely disastrous. Iridium was an absolutely massive corporate failure that, like Sears, many people did anticipate. In 2009, Time Magazine included it on a list of “The 10 Biggest Tech Failures of the Last Decade.”

Iridium was spun out of Motorola in the early 1990s to execute on a business plan to create a communications network that would rely on dozens of satellites in low earth orbit. The Iridium network was originally conceived in 1985 to address the limitations of early cell phones, which could not get signals in remote locations. The problem for Iridium, simplistically, was that its network did not launch until November of 1998, more than a decade later. By that time, terrestrial cellular networks had vastly improved to the point that the Iridium service was either useless or uneconomical in all but the most specialized of applications. At launch, handsets that could access the Iridium network cost $3,000 per unit and had limited indoor functionality. In addition to the hardware cost, calls on the Iridium network cost anywhere from $3 to $8 per minute, rates which were not competitive in areas with terrestrial cellular coverage. People that could afford the service lived in areas where they didn’t need it and those in areas without cellular coverage were unlikely to be able to afford access to the network.

After spending $5 billion to develop the network over more than a decade, Iridium filed for bankruptcy just 9 months after the network launched for commercial service. Iridium had 55,000 subscribers at the time of its filing, well short of the million it had estimated were necessary for the network to break even. Iridium’s assets were sold out of bankruptcy for just $25 million. At issue in the fraudulent transfer litigation was $3.7 billion in payments that Iridium had made to Motorola for its services in rolling out the network. Creditors argued that Iridium had been insolvent and that those payments were subject to being unwound in bankruptcy.

Creditors brought in multiple experts that argued, intelligently, that Iridium’s business had always been doomed to failure. The experts testified that Iridium’s projections were unrealistic and submitted discounted cash flow analyses showing that Iridium was nowhere near solvency for years. Motorola brought in its own paid experts that argued the opposite. It is almost a certainty that something similar will play out in the Sears bankruptcy. Despite all of this, Judge Peck (who, we highlight, has sat on a bench with Judge Drain, who is overseeing the Sears case) set aside the analysis of the experts in favor of observable market data. Between 1997 and 1998, Iridium stock traded at levels that implied a market capitalization of between $2.3 and $10.0 billion.

Foundationally, Iridium creditors were making the same argument that Sears creditors will attempt to make: it was obvious that the business was going to fail. And it may very well seem “obvious” in retrospect. Why would anyone have expected millions of people to buy $3,000 handsets and pay $3 to $8 a minute for cell service in 1998? Similarly, given we all knew about Amazon in 2015, how could anyone have believed Sears was solvent? This then raises an obvious question, which is “why were people buying Iridium stock at an implied equity valuation of $10.0 billion if it was insolvent?” and “why were people buying Sears stock at an implied equity valuation of $3.0 billion if it was insolvent?” The answer is simple. They thought it was worth more. The fact that they were ultimately wrong is irrelevant. Courts are increasingly acknowledging that markets, which involve large numbers of participants weighing all available information, are a better gauge of solvency than a court considering post-hoc testimony from paid/motivated experts. Judge Peck:

The Committee's case relies, in part, on the common sense proposition that Iridium's failure is a strong indication of its insolvency and capital inadequacy during the period when the challenged transfers were made. [HN16] Courts in this jurisdiction may consider postpetition events to some extent under certain circumstances, but reject the use of improper hindsight analysis in valuing a company's [**163] pre-bankruptcy assets. See In re Coated Sales, Inc., 144 B.R. at 668. When determining the value of a company's assets prepetition, "it is not improper hindsight for a court to attribute 'current circumstances' which may be more correctly defined as 'current awareness' or 'current discovery' of the existence of a previous set of circumstances." Id. Such value, however, must be determined as of "the time of the alleged transfer and not at what [assets] turned out to be worth at some time after the bankruptcy intervened."

While there is case law supporting the contention that a significant business [**165] failure may indicate insolvency a short time prior to filing of the bankruptcy petition, (see In re Washington Bancorporation, 180 B.R. at 333 (holding gross insolvency of $ 32 million on the petition date may permit an inference of insolvency on a date preceding the petition date, but that same inference cannot be applied to a date six months prior to the petition date)), there is no case law that supports extending that finding over a four-year prepetition period, as the Committee asks the Court to do here, without other supporting evidence. [HN17] The failure of a business, even a monumental failure, does not alone prove the insolvency of the business in the months and years prior to its demise.

The courts have only indicated a willingness to set aside market data in instances where there are compelling reasons to believe that market participants were working with fraudulent, misleading or incomplete information. In the Tronox case, for example, constructive fraud was weighed in addition to actual fraud and Judge Gropper cast some doubt on publicly traded market value as a gauge of solvency. While Gropper highlighted that a positive market capitalization was the strongest evidence that Tronox was solvent, he noted that Tronox’s financial disclosures were potentially false and misleading. There was credible evidence that Kerr McGee had improperly applied accounting standards for estimating the size of the legacy environmental liabilities (and that disclosures around those liabilities were insufficient). Tronox’s filings also omitted important information, such as demand letters the EPA had sent Kerr McGee for hundreds of millions owed in connection with environmental remediation. A class-action lawsuit alleging that Tronox’s Registration Statement was false and misleading was separately settled.

As far as we are aware, there is no such fact pattern here. Unless something has gone entirely undisclosed, Sears does not have any complex or contingent liabilities. Despite poor operating performance, the business is relatively straightforward. Further, insiders such as Berkowitz, who presumably have as much information as anyone, were buying Sears stock both before and after the Seritage spin.

In sum, we think that it is exceedingly unlikely that creditors will be able to demonstrate that Sears was insolvent in June of 2015 or became insolvent as a result of the Seritage transaction. The publicly traded equity implied a significant market capitalization and its bonds did not trade at levels that would imply imminent default. As far as fraudulent transfer laws are concerned, solvent companies may conduct their business with impunity. If Sears was solvent, it does not matter if Sears received fair value from Seritage. They may run into issues elsewhere (Sears and Seritage settled a derivative suit brought by Sears shareholders alleging a breach of fiduciary duty for $40 million) but the transaction would not be subject to avoidance under fraudulent transfer laws.

Reasonably Equivalent Value

We turn now to the question of whether or not Sears received “reasonably equivalent value” (the approximate language used in most statutes, New York uses “fair equivalent”). The wholly-owned properties were sold for $2.3 billion and the JV properties were sold for $400 million. It is worth first reviewing the analysis done at the time of the transaction. Two independent appraisals were prepared by nationally-recognized firms (Cushman & Wakefield and Hilco) that each concluded in-place valuations for the wholly owned properties of $2.3 billion.

Further, Duff & Phelps was retained to provide a fairness opinion that took into account not just the appraisals but also the unique features of the master lease  agreements, which allowed Sears the right to terminate unprofitable stores at its election and Seritage the right to recapture space. Those rights were very valuable to each of Sears and Seritage, respectively, and valuing those rights is a highly subjective exercise that would require, among other things, assumptions about the outlook for Sears’ profitability and the pace at which Seritage would be able to identify and fund redevelopment projects.

You’ve said that Sears was short changed by $500 million which we understand you to have calculated by multiplying the economic share count by the difference between SRG’s closing price on the first day of trading and the rights offering price. We calculate this number to be $420 million (~$7.52 multiplied by 55.8 million economic shares). Regardless, we find it puzzling that people will look to the trading value of SRG as proof of fraud but at the same time brush off billions in Sears market capitalization is irrelevant to the question of solvency. There are a whole host of reasons why a separate Seritage entity might trade up, not limited to a new management team focused solely on redeveloping the property as well as an ability to cleanly raise capital to fund redevelopment projects outside the Sears structure.

There is also a threshold question of “reasonableness.” Assuming that the property was worth $3.1 billion (an additional $420 million), this would imply Sears was short changed by just 13.5% of the total value. In the cases we’ve reviewed, transfers that have been unwound or settled for significant damages are orders of magnitude off of fair value. It’s true that shares have traded materially higher since the spin, but today they stand at just $38, representing an implied enterprise value of just $3.1 billion, despite SRG having invested $460 million of cash since the spin. Shares may have modestly outperformed other REITs, but they have badly underperformed the market.

It’s also worth highlighting that Seritage wasn’t able to get particularly attractive financing at the time of the spin. At the appraised value, they were only able to get financing representing 51.6% LTV at market rates with market covenants. If the true value of the property was materially higher, you would expect Seritage to have been able to secure a significantly higher LTV on the appraised value. Similarly, they would have had a much easier time refinancing the mortgage debt. They were in the market for a long period of time after the spin and unable to get a better deal done, ultimately completing a $75 million preferred deal to secure some short term funding for their redevelopment activities.

Although we have argued that Seritage shares represent an attractive investment opportunity, there is a bear case. There is risk to the stated redevelopment economics and, most notably, there is risk associated with having Sears as your largest tenant. We have argued these points at some length with others on VIC that are short SRG (one person’s valuation of Seritage in particular might be relevant to the question at hand, sadly they have exercised their first amendment rights to keep this proprietary information confidential). The real question is whether the totality of the evidence points toward fraud. We’d argue that the performance of the stock, the willingness of creditors to lend to Seritage and the work done by Cushman, Hilco and Duff & Phelps suggests that this is not the case.

Separately, you argue that beyond the value of the properties, the $530 million in rent that Seritage has received from Sears since the spin would be subject to claw back. This ignores the time value of the $2.7 billion that Seritage conveyed to Sears, which would offset all (or likely more) of any liability here. The $530 million paid over 3 years would work out to an average rate of 6.5% on the $2.7 billion paid to Sears, which it used to pay down almost $1.0 billion in debt, allowing Sears to avoid hundreds of millions in interest payments. The excess cash further was of use to Sears as a source of capital to continue to execute its turnaround business plan (again, regardless of whether such plan was successful).

A final stray observation: fraudulent transfer litigation takes a long time. Tronox filed for bankruptcy in January of 2009 and the litigation against Anadarko wasn’t settled until November of 2014. Iridium filed for bankruptcy in September of 1999 and the litigation against Motorola wasn’t settled until May of 2008. Discovery will take years in this case. In the interim, the creditors won’t be able to enjoin Seritage from continuing its business as usual. It will be a distraction, of course, but the work to redevelop the portfolio will continue. Given the SRG value proposition, it’s unlikely that a $420 million judgment will bankrupt SRG in 5 or 10 years.

While we’re not likely to get anyone to agree on exact numbers, Seritage will be generating significant cash flow in just a few years if it is able to execute on its business plan. Even if you assume that Sears were to shutter all of its stores tomorrow, those lost rental payments and tenant reimbursements will be replaced by already signed SNO leases and future redevelopment activity. As of the third quarter, SRG was roughly break-even from an AFFO perspective. They reported $90.8 million in rental income attributable to Sears and $75.0 million in SNO leases. The SNO leases aren’t likely to cover all the tenant reimbursements that SRG will lose if Sears disappears completely, but much of that cost will be mitigated via asset sales of lower-priority properties and cost cutting measures. After completing the existing slate of projects, which are fully funded, we expect Seritage to be only modestly cash flow negative.

Given that SRG has been recapturing in excess of 3 million square feet per annum for the last few years and assuming that they will continue to find willing capital projects for contracted projects with attractive returns, Seritage will be generating hundreds of millions in AFFO by the time any fraudulent transfer litigation is finally resolved. At that point in time, damages (if any) are unlikely to represent a meaningful multiple of Seritage’s cash flow let alone “render Seritage insolvent” as grizzlybear wrote in his short thesis.

In short – we think that the short thesis for Seritage predicated on fraudulent transfer is not strong for the following reasons:

1.    Because actual fraud is exceedingly difficult to prove, creditors will have to demonstrate that the Seritage transaction was constructively fraudulent in order for it to be avoided (or damages awarded) in bankruptcy.

2.   In order to demonstrate constructive fraud, creditors will have to show that Sears did not receive reasonably equivalent value from Seritage AND that Sears was insolvent at the time of the transaction or became insolvent as a result of the transaction.

3.    It will be almost impossible for creditors to satisfactorily demonstrate Sears was insolvent in June of 2015 given that it had a $3.0 billion market capitalization and debt with yields in the single digits. Case law on this matter is overwhelmingly deferential to the market absent any indication that the market was fed fraudulent or misleading information.

4.   Even if you don’t buy the solvency argument, the performance of SRG stock, the terms on which lenders were willing to lend to SRG and independent appraisal work done at the time of the spin all suggest that Sears did not receive consideration that was wildly divergent from fair value.

5.  In the unlikely event that damages are assessed, we believe that they are not likely to be significant but, more importantly, given the time it takes to settle fraudulent transfer litigation they are highly unlikely to be existential risks to Seritage. 5 or 10 years in the future, when such litigation is likely to be settled, Seritage will be generating meaningfully higher AFFO.

It is true that, in the short term, SRG shares may trade down as a result of scary headlines. However, as some guy once said, “in the short run, the market is a voting machine but in the long run, it is a weighing machine.” We do not invest based on how shares may trade over the next few days, weeks or months, but rather based on a conservative estimate of intrinsic value. We feel confident in SRG’s ability to overcome fraudulent transfer litigation on the merits, but also believe that the Company’s intrinsic value and the value proposition of its platform will allow it to weather reasonably calculated settlements to the extent a court determines we are mistaken in this matter.

We will conclude by leaving you with some select remarks made by Bruce Berkowitz on the 2016 Fairholme call (after the Seritage spin):

Daniel Schmerin: Let’s move on, we received the most questions about Sears. How do you evaluate your investment in Sears today? 

Bruce Berkowitz: Our thesis on Sears cannot be disproven: Sears has a vast real estate empire complemented by unique businesses. Sears also has constraints, and we understand those constraints. As part of our investment process, we developed progress checklists concerning Sears’ fixed obligations, balance sheet strength, footprint, pension fund obligations, the repurposing of real estate, and spinning off companies that would benefit from independence. We thought about all of the possibilities and the potential. 

In making the case that the Seritage spin was a fraudulent transfer, Berkowitz will be arguing not only that his thesis (which, as he noted, “cannot be disproven”) could have been disproven, but that it was obviously false. He will have to argue that not only was his valuation too high, but that Sears was in fact obviously insolvent. We are unsure which will be worse for Berkowitz: making this case in front of a judge or explaining to his (likely former) LPs that he lost their money doubling down on a company that was obviously insolvent at the time.

Catalyst

Time