Mervyn's LLC v. Lubert-Adler and Klaff Partners, LP; An Attack on the Use of Special Purpose Entities to Finance a Leveraged Buyout

The complaint filed September 2, 2008 in the Delaware bankruptcy of Mervyn’s (Adversary Proceeding No. 08-51402-KG) represents a frontal attack on a strategy commonly employed in financing a leveraged buyout, namely, the use of special purpose entities to isolate the assets used to finance the buyout. Targets in this action include three buyout funds and their affiliates, Sun Capital Partners, Inc., Cerberus Capital Management, LP, and Lubert-Adler/Klaff Partners, LP. The lawsuit challenges the leveraged buyout of Mervyn’s LLC from Target (Symbol: “TGT”) on September 2, 2004. Ignoring the complicated minutiae of the deal structure, laid out ad nauseam in the complaint, the complaint makes for colorful reading. The defendants have yet to respond.

A. The Transaction

Mervyn’s was sold for all cash, in the amount of $1.175 billion. The form of the transaction was a “stock” purchase whereby Target sold all the equity of Mervyn’s, converted shortly before the closing from a California corporation to a California LLC, to a newly-organized Delaware LLC — Mervyn’s Holdings, LLC (“Mervyn’s Holdings”). In form, at least from Target’s standpoint, the transaction was straightforward, as is reflected in the plain vanilla Equity Purchase Agreement Target entered into with Mervyn’s Holdings on July 29, 2004. The complexity of the deal derives from how the buyers financed the acquisition. They did so in large part through $800 million in financing, secured by Mervyn’s real estate. To isolate the real estate, the complaint alleges that Mervyn’s Holdings, at closing, apparently contributed to its now wholly-owned subsidiary, Mervyn’s, the equity in two newly-organized LLCs, with the result that the newly-organized LLCs became subsidiaries of Mervyn’s. Mervyn’s, now as the parent of the newly contributed LLCs, in turn contributed to the LLCs (which, in turn, contributed several of the properties to subsidiary LLCs) its fee properties and transferable real property leases. Mervyn’s Holdings then caused Mervyn’s to distribute the equity interests in the LLCs to Mervyn’s Holdings, which in turn distributed the LLCs to LLC holding companies controlled by the buyers. Presto: The real estate formerly owned by Mervyn’s was now separated from Mervyn’s and owned by buyers through separate LLC holding companies.

The complaint further alleges that once Mervyn’s was separated from its real estate, the buyers caused Mervyn’s, now a lessee of its stores, to pay additional rent to the property owning LLCs to finance the purchase money indebtedness and to make distributions to the buyers. Mervyn’s was also charged “notional rent” on those leases that could not be transferred out of Mervyn’s (to bring the rent payable under these non-transferable leases to market) in the form of distributions to Mervyn’s Holdings. As a result, Mervyn’s rent burden, by these machinations, increased, according to the complaint, by some $80 million annually.

Since the buyout, the complaint alleges that the buyers “have taken more than $400,000,000 in payments or distributions from Mervyn’s.” Complaint ¶ 66 (footnote omitted).

As summarized by the complaint:

“73. In sum:
· Mervyn’s real estate assets were transferred from Mervyn’s to the Realty Owners [the separate LLCs form to own Mervyn’s real estate].
· The Realty Owners are owned and controlled by the Realty Parents [the real estate LLC holding companies].
· The Realty Parents are owned and controlled by the PE [private equity fund] Sponsors.
· The PE Sponsors own and control MH [Mervyn’s Holdings].
· MH owns and controls Mervyn’s.
· Mervyn’s was paid nothing for the transfer.”

As the complaint editorializes, reflecting on the complexity of the transfers that occurred at closing:

“These multiple transfers and transactions are complex machinations that seem to have no purpose or effect other than to attempt to secure the blatantly fraudulent transfer that occurred at the closing of the 2004 transaction.

… Mervyn’s began the day of the closing with more than $1,000,000,000 of real estate and, within the blink of an eye, it was gone. Mervyn’s received nothing in return.”

Complaint ¶¶ 75-76.

B. The Legal Attack

The debtors, Mervyn’s Holdings and its subsidiary, Mervyn’s LLC, bring this action against the buyers, their affiliated funds that participated in the buyout, the lenders that provided financing for the buyout, and Target. The complaint alleges that the stripping away of Mervyn’s real estate and the increase in its rental obligations deprived Mervyn’s of valuable assets, for no consideration, and significantly increased its operating costs. Moreover, by bundling properties that were previously owned in fee by Mervyn’s or separately rented into only three master leases, the deal made it more difficult for Mervyn’s to close stores, thus restricting its operating flexibility. As summarized by the complaint:

“Rather than simply maintaining Mervyn’s retail operations and the integrated real estate assets at which the retail stores were operated intact within Mervyn’s and leveraging the real estate assets as would have been done under a traditional LBO transaction, instead, the PE Sponsors insisted upon physically separating the real estate assets from Mervyn’s at the moment of the closing of the EPA thereby converting Mervyn’s from a retailer with valuable below market leases and valuable owned real estate into a shrunken operating company whose remaining capital consisted largely of inventory, cash, credit card receipts, and intellectual property.”

Complaint ¶ 93.

The debtors’ counsel, Friedman Kaplan Seiler & Adelman LLP, New York, New York, and Bayard, P.A. (Delaware) make interesting use of the legal opinion rendered by the property holding LLCs (the “Realty Owners”) to the buyout lenders. The opining counsel, not identified in the complaint, rendered a “true lease” opinion to the lenders on the three consolidated real estate leases entered into at closing between the (now separate) real estate holdings LLCs and Mervyn’s. The complaint quotes at length from the opinion to establish that the buyers were well aware of the economic aspects of the transaction and its consequences upon Mervyn’s. No doubt the extensive quotations from its opinion is causing opining counsel some discomfort (the quotations from the opinion occupy some five pages of the complaint).

To establish that the transfers of Mervyn’s real estate assets to the special purpose LLCs and their separation from Mervyn’s represented fraudulent transfers, the complaint alleges that Mervyn’s did not receive reasonably equivalent value or fair consideration in exchange for transferring its real property interests to the property holding LLCs. As a result, Mervyn’s, so the complaint alleges,

“… (a) was engaged or was about to engage in a business for which its remaining assets and/or capital were unreasonably small in relation to [its] business; (b) intended to incur, or reasonably should have believed that it would incur, debts beyond its ability to pay as they became due; and/or (c) was insolvent or would be rendered insolvent by the transactions undertaken in connection with the 2004 buyout.”

Complaint ¶ 109.

The debtors also allege that the transfers were in violation of the Uniform Fraudulent Transfer Act, violating at least six of the eleven factors to be considered in assessing a transfer as fraudulent under that Act. Complaint ¶ 112.

The debtors also allege breach of fiduciary duty, including against Target, asserting that, by reason of the buyout transaction, Mervyn’s became insolvent or entered the “zone of insolvency,” thus triggering fiduciary duties by Target to Mervyn’s unsecured creditors. Complaint ¶¶ 142, 151.

The debtors seek, by their prayer for relief, the avoidance of the real estate transfers made by Mervyn’s in the buyout or, alternatively, the value of the real estate assets transferred by Mervyn’s or, alternatively, an amount equal to the purchase price paid by buyers to Target for the real estate assets ($1,166,700,000) or the proceeds of the loan made by the lenders ($800,000,000).

This will be an interesting case to follow if it is not quickly settled. Given the nature of the allegations and the amount demanded as damages, a quick settlement would appear unlikely.