Kmart: a Case For the Bankruptcy History Books?

David M Berkowitz covers the restructuring issues raised

David M. Berkowitz, Portfolio Director, Madison Captial Management

The Kmart bankruptcy brought to the surface key restructuring issues that will have long-standing ramifications on the Chapter 11 reorganization process. Most significantly, this case brought to light how dramatic errors in equity valuation can result in an inequitable wealth transfer among creditors, and how the allocation of this value can be influenced by an outside party who wields significant power through ownership of multiple voting classes.

Kmart (the "Debtor") filed for Chapter 11 bankruptcy in the Northern District of Illinois on January 22, 2002. The Debtor listed the primarycauses of its filing as intense competition among discount retailers, failed sales and marketing initiatives, economic recession and capital market volatility. The goals of the reorganization were to rationalize the capital structure and improve operations by closing unprofitable stores and reducing corporate overhead.

At the conclusion of the bankruptcy, Kmart had successfully improved profitability and de-levered its capital structure. The Debtor's investment bankers and financial advisors estimated the reorganized equity value to range from $753 million to $1.5 billion, which was deemed to be higher than its value through liquidation. As a result of this estimate, new common stock (reorganized equity) was issued at a price of $14.05 per share to the unsecured note holders and trade vendors in satisfaction of their claims, providing a recovery of 14% and 10%, respectively. Pre-petition lenders, who were structurally senior to unsecured note holders and trade vendors, received a cash recovery of 40%. All pre-petition equity was erased.

Although there were no fundamental changes in the reorganized Debtor's business, the common stock skyrocketed in value – up 65% over three months, 92% over six months and 543% for an 18-month holding period. This mis-valuation caused a wealth transfer from one class of structurally senior creditors, the lenders, to unsecured note holders and trade vendors.

Why did the Debtor's estimation of value so badly miss the mark? Was it a case of capital market speculation that bankruptcy professionals could not prudently value? There were no fundamental changes to Kmart's business nor any speculative valuation issues. The most likely explanation for the mis-valuation was that it was compromised due to the competing motivations of the constituents in the process who commanded the most power, and a lack of focus on accurate valuation by the various advisors involved – both on a going concern and liquidation basis.

This theory behind the poor valuation and insufficient valuation testing suggests that the bankruptcy professionals involved in this case missed the mark as a result of the motivations of a controlling stakeholder that had interests in multiple voting classes. Eddie Lampert (Kmart's chairman) not only aggregated a large position in the unsecured notes and provided equity financing for the Plan of Reorganization; but also held an executive position with the Debtor. These control positions likely influenced the ability of the bankruptcy professionals to accurately assess value in Kmart, as a going concern or in a liquidation scenario.

The substantive value of Kmart was the sale value of the prime real estate it owned (Kmart stores were within 15 miles of 85% of the US population), its brand equity and loyal customer base. Contrary to the bankruptcy professionals' valuation, the public equity market recognized this value and bid up the reorganized equity in the first trading day by 11%. The appreciation in the reorganized equity provided the unsecured note holders with an effective recovery of 24% over three months, 47% over 12 months and 93% over 18 months – a far cry from the 40% cash recovery that the structurally senior pre-petition lenders received.

Future implications

How has the Kmart incident impacted the bankruptcy reorganization process, and what are the future implications? Post-Kmart, Chapter 11 filings have seen more frequent creation of the Official Equity Committee and a sharper focus on the going concern valuation for reorganized debtors. For example, Official Equity Committees were created in High Voltage, Footstar and Mirant; debtors with enterprise values falling in small, mid and large company ranges. These Equity Committees have served to focus attention on going concern valuation in each case. In the Mirant case, the Equity Committee was successful in challenging the valuation provided by the debtor. The bankruptcy professionals in the Mirant proceedings also directed more focused attention on valuation, scheduling weeks of valuation hearings. After the hearings, the judge ordered changes to the valuation methodology.

The Kmart bankruptcy was a case for the history books, and it brought to light matters that will impact the Chapter 11 reorganization process for years to come. The inequitable wealth transfer that occurred in Kmart, and the drivers behind it, are already being addressed by Bankruptcy Courts and industry professionals. Recent measures, such as the Courts allowing pre-petition owner representation in the form of Official Equity Committees, and bankruptcy professionals' increased focus on valuation, are positive developments and may provide comfort to the various bankruptcy constituents. But one must also keep in mind the power wielded by control players, and their ability to influence the outcome of a case, such as Lampert in the Kmart bankruptcy.

David M. Berkowitz CFA is a Portfolio Director of Madison Capital Management, a New-York based firm specializing in niche distressed, real estate, natural resource, and special situation financial assets.