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SAN FRANCISCO-Mervyn’s LLC this week sued its former owners for more than $1 billion. The suit alleges that they structured a transaction that “stripped” the Hayward, CA-based department-store chain of owned properties and below-market leaseholds, then heavily leveraged the assets and jacked up Mervyn’s rent by $80 million annually to cover it, effectively forcing the western US retailer into bankruptcy.

Among others, the defendants include Target Corp., and Cerberus Capital Management and Sun Capital Partners, two of the private equity firms to which Target sold Mervyn’s four years ago.

The lawsuit was filed on Sept. 2 as part of its bankruptcy case, which was filed on July 29. The story begins four years earlier when a group including Cerberus and Sun Capital acquired Mervyn’s from Target for $1.26 billion in a deal that was structured as two separate transactions, one for the real estate and another for the company itself. The lawsuit claims the structure of the deal and the private equity firms’ subsequent actions unduly enriched them at the expense of Mervyn’s solvency.

“Mervyn’s began the day of the closing with more than $1 billion of real estate and, within the blink of an eye, it was gone; Mervyn’s received nothing in return,” states the lawsuit. “The 2004 transaction is a transaction that ultimately led to Mervyn’s bankruptcy and is a fraudulent transfer that cannot withstand scrutiny.”

Representatives of Cerberus and Sun Capital have said the lawsuit is without merit; Target sent the following statement to GlobeSt.com: “Target emphatically disagrees with the claims against Target in this lawsuit. Our 2004 sale of Mervyn’s was an arms-length transaction that was the result of a competitive bidding process.”

Prior to the bankruptcy filing, Mervyn’s operated 177 stores averaging 80,000 sf in California and six other states in the southwestern US. It employed 18,000 people. In its fiscal year ended Feb. 2, it recorded a net loss of $64 million on net sales of $2.5 billion. As part of its reorganization, the company, operating as debtors in possession, has announced plans to close about 15% of its stores and let go about 10% of its workforce.

The 2004 acquisition of Mervyn’s from Target was structured as a leveraged buyout, whereby the acquirer borrows against the assets of the target company in order to finance the purchase of the target company’s shares from the selling shareholder. In such a deal, much of the equity in the acquired company is typically replaced with debt, and the acquired company’s capital structure is altered such that former shareholders of the company are replaced with secured creditors.

In a traditional LBO structure, the lawsuit claims Mervyn’s would have retained its assets and incurred the debt normally associated with a leveraged transaction, and Mervyn’s also would have retained, for its own benefit, the residual value of the assets in excess of the debt placed against those assets and, in addition, those assets would have remained with Mervyn’s following repayment of the debt.

“Here, however, while the financing did not directly result in debt being placed on Mervyn’s, its real estate assets were stripped away from Mervyn’s and Mervyn’s incurred substantial additional obligations in order to pay the substantial debt that was incurred to finance the transaction,” states the lawsuit. “After repayment of the debt, those assets will not be returned to Mervyn’s. Those assets are gone.”

Mervyn’s claims in the lawsuit that the private equity sponsors formed bankruptcy remote entities and, at the closing of the 2004 transaction, caused Mervyn’s to transfer virtually all of its real estate assets (leasehold interests and fee interests) to those entities, which then encumbered the assets in exchange for loans.

“All or substantially all of those [loan] proceeds were paid over to Target,” states the lawsuit. “The remaining real estate assets, consisting of certain leases that were not assignable, stayed with Mervyn’s.”

As part of the leveraged buyout, all of Mervyn’s retail store locations – including its previously owned properties — were made subject to three Unitary Leases with rents “substantially greater” than Mervyn’s was paying immediately prior to the transaction, when due to it owning the property or being a key anchor tenant it enjoyed below-market rent or no rent at all, according to the lawsuit. In addition, the lawsuit claims that on top of the rent Mervyn’s paid for the unassigned leases it is now required to make additional “notational” payments to bring the rent payments in line with what it would be paying had those leases been part of the three unitary leases.

“Although the rents charged to Mervyn’s under the Unitary Leases are alleged by the private equity sponsors to be “market rates,” this statement ignores the fact that before the [leveraged buyout] Mervyn’s either owned its store locations and paid no rent or it leased its store locations at lease rates that in many instances were below market,” states the lawsuit.

As a result of the increased rent burden, Mervyn’s claims in the lawsuit that it now has aggregate annual rent expense in excess of $172 million, “which far exceeds [by as much as approximately $80 million] what its annual occupancy expense would have been had its real estate assets not been transferred, bundled and leased back to it at higher rates as described, and had the notational rent not been imposed on it,” and that the increased burden combined with the slowing sales amid the weakening economy forced it to file for bankruptcy protection.

“The foregoing actions were orchestrated by the [private equity] sponsors for the benefit of themselves and the [private equity] owners, with the knowledge, participation, or acquiescence of Target and the Real Estate Secured Lenders – - all of whom profited or benefitted from such actions,” states the lawsuit.

Under Bankruptcy Code Section 550, if the defendants in such a case as this are found to be at fault, a plaintiff may recover the value of the real property transferred – in this case, about $1.17 billion, according to the lawsuit – from those defendants. Mervyn’s lawsuit is seeking to either have the transfer of its assets rescinded, or to be paid the value of the assets by Target and/or the private equity firms. It also is seeking to have the liens of the real estate secured lenders and the fees it paid related to the transactions rescinded, or to be paid by the value of the liens and fees by the defendants.

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