Hedge Funds Responsible for Demise of Sears and Toys R Us

The recent retail bankruptcy filings of Sears and Toys R Us may appear to be symptomatic of the downturn in the brick and mortar retail environment, however, beyond the superficial excuses concocted by management for their business failures, there is a deep-seated contamination of the businesses by the company’s management, its lenders and/or equity holders which almost assures that not only will there be a business failure, but also the management, lenders and/or equity holders will profit from the failure.

Take Toys R Us. Approximately 10 years ago, the current owners acquired the business using a leveraged buyout.  There, the company borrowed in excess of $7 billion using all of its own assets as collateral in order to reward the then selling shareholders a healthy multiple of the then value of the company. This then required the company to service the new debt by the payment of principal and interest as part of its ongoing expenses, and there are very few companies, especially ones in retail, that can support debt service on a $7 billion debt.

During the 10-year interim from the acquisition until bankruptcy, the owners/management of the company who were able to purchase it for virtually no cash out of their own pockets were able to reap substantial management and other fees while the company continued to lose money, partially as a result of the large debt service.

When the bankruptcy ensued, Toys R Us was in such bad financial condition that it quickly abandoned any hope of reorganization, and went promptly into liquidation. It is reported that more than 33,000 employees lost their jobs, and none received any severance or other termination benefits. Each former employee was then expected to enter a shrinking retail job market.

Although the former employees are soliciting political support to force the owners and management personnel that had received the management and other fees during the approximately 10 years after the leveraged buyout to provide them with some termination benefits, it appears that their chance for success is poor. Under the payment scheme as mandated by U.S. Bankruptcy Code, it appears that only the secured lenders, some of whom appear to have an affiliation with the equity owners, may be the only ones to receive any distribution from the bankruptcy process.

With respect to Sears, the hedge funds manager Eddie Lampert, after acquiring Kmart out of bankruptcy, leveraged the purchase of Sears. It has been widely reported that over the last several years, in order to fund the ongoing hemorrhaging of cash from the losing operations of Sears, Lampert obtained millions of dollars of mortgages on real estate owned by Sears with loans from his affiliated ventures, and sold valuable assets, including brands such as Craftsmen, Kenmore and Lands End were sold (some to affiliates of Lampert). Now, with the bankruptcy filing of Sears, if the business is liquidated, Lampert affiliated entities stand to reap huge benefits of the insider transactions which will only benefit Lampert and his related hedge fund entities.

The Toys R US and Sears scenarios, while substantively different, are not unique. Over the last decade, there have been hundreds of lesser-known business failures where insiders (usually associated with hedge funds) have gained billions of dollars in profits and benefits while unsecured creditors, employees and common stockholders have been left out in the cold.

With the exponential increase in the economic disparity between the top 1% of the income scale and middle America, instead of hedge funds and similar investors using their money and position to benefit the populace at large, they continue to devise and implement schemes which are “no lose” situations for them and their wealthy investors, and an almost certain disaster for those caught in the vortex of the current business environment.

Here’s what needs to be done. Unless the private equity and hedge funds will voluntarily agree to adopt regulations which create a social responsibility, Congress needs to stop its continuous ignoring of the need to enact bankruptcy law reform, and enact strict creditor and employee protection provisions which will do what the hedge and equity profiteers refuse to do on their own.