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Kmart’s Rocky Road: $1B Creditors Reject Bankruptcy Exit Plan

Just when Kmart thought it had bankruptcy court approval of its reorganization plan all sewn up, a few creditors are throwing up roadblocks.

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NEW YORK — Just when Kmart thought it had bankruptcy court approval of its reorganization plan all sewn up, several creditors appear to be rocking its solvency boat.

Kmart said Monday that most of its creditors had approved its proposed plan to exit Chapter 11. However, a few creditors for some of Kmart’s subsidiaries voted to reject the plan. Most of those are owed money from supply deals or leases. They hold claims against Kmart that total nearly $3.9 billion, with creditors holding about a quarter of that amount rejecting the plan. Still, the retailer said in a statement that it didn’t believe those rejections were material and expected to exit bankruptcy proceedings by the end of the month.

But some creditors aren’t providing Kmart with the rubber stamp for a Chapter 11 exit that it might prefer.

As reported, ESL Investments Inc. and Third Avenue Trust, two major creditors, agreed to invest $300 million to bail the retailer out of bankruptcy in exchange for more than half of the equity in the reorganized Kmart. Upon consummation of the plan, ESL would become Kmart’s largest shareholder, with a 49 percent equity position. Third Avenue would own just 5 percent of the equity, according to Kmart in court documents.

The timing of Kmart’s planned exit is proving to be critical to its own survival. According to sources, Edward Lampert, who heads up ESL, has said that he would pull his investment in the discounter if it does not exit by the end of May. ESL officials could not be reached for comment. A Kmart spokesman said the retailer does not comment on rumors and speculation.

A challenge Kmart now faces includes an emergency motion filed by Capital Factors Inc. to block the exit plan from being confirmed before the bankruptcy court can decide issues relating to the $367 million that Kmart paid to certain so-called "critical vendors" after it filed for Chapter 11.

In some bankruptcy courts, judges have accepted the view that a critical vendor is a supplier that is so important to the continuation of the debtor’s business that if it doesn’t get paid, the supplier may discontinue shipments and jeopardize the debtor’s reorganization efforts. Payments made to vendors in such a manner put them ahead of others in the unsecured creditor food chain because they don’t have to wait until the end of the reorganization process to get paid.
There is a split among bankruptcy courts over whether the federal Bankruptcy Code permits pre-plan payments of pre-petition unsecured claims.

Chicago Bankruptcy Judge Susan Pierson Sonderby OK’d those payments to certain Kmart unsecured creditors, but Capital appealed that decision to the federal district court in Chicago. Last week, U.S. District Court Judge John Grady reversed Judge Sonderby’s decision.

In an opinion dated April 8, Judge Grady concluded that the Chicago bankruptcy court had neither the "statutory [nor] equitable power to authorize" the pre-plan payment of pre-petition unsecured claims, and sent the matter back to the bankruptcy judge for further adjudication.

The Kmart spokesman said, "Kmart has appealed Judge Grady’s ruling to the 7th U.S. Circuit Court of Appeals in Chicago. However, Kmart believes that Judge Grady’s ruling has no material effect on our confirmation of the company’s plan of reorganization."

While the reversal could have implications for how future decisions are made by bankruptcy judges, the immediate implication for Kmart is a possible delay in its desire to exit Chapter 11 as soon as possible.

According to legal documents filed by Capital Factors with the bankruptcy court, confirmation of the reorganization plan should be postponed until the court orders the vendors who received the payments to repay the $367 million. Those payments include $76 million paid to Fleming Cos. Inc., a food distributor that is now itself a Chapter 11 debtor. Capital also said the return of the $367 million would necessitate an amended reorganization plan, and consequently another vote by creditors.

Kmart has been proceeding as if it will exit Chapter 11 at the end of the month.

Julian Day, president and chief executive officer, said in court documents seeking confirmation of Kmart’s reorganization plan that the retailer over the last 15 months has rid itself of more than 950 real estate leases, and has renegotiated more than 80 leases for a cost savings of more than $12 million in annual rent concessions.

Kmart will operate 1,513 stores as a reorganized firm, with the average rent costing $3.99 per square foot, down from $4.42 before its Chapter 11 filing in January 2002. Inventory turns are projected to increase to 4.2 times from 3.7 times, according to court papers.
Day also said that Kmart has improved its inventory management practices, resulting in "noticeable progress" in keeping its store shelves stocked with popular items. As reported, maintaining ample inventory has been a major complaint among shoppers in the past. The ceo said the chain reversed the negative trend in part through "improved inventory replenishment forecasting, implementation of new controls on the inventory buying process, reduction in the number of corporate employees authorized to give final approval to purchase orders to just 30 from 220, and increased ordering discretion granted to store managers."

As part of its restructuring, Kmart has returned to its strategy as a "promotional" high/low retailer focused on exclusive brand offerings. Among those proprietary brands are Martha Stewart Everyday, Joe Boxer, Disney, Sesame Street, Route 66, Jaclyn Smith, Kathy Ireland and Thalia.

Last week, the unsecured creditors of Kmart Corp. nominated Douglas Smith of Chicago-based Huron Consulting Group to chair the Kmart Creditors Trust. Subject to bankruptcy court approval, Smith, a bankruptcy restructuring specialist, would be responsible for pursuing lawsuits that could arise from Kmart’s internal review of its former stewardship and maximizing recovery for the benefit of Kmart’s creditors and shareholders. Smith’s responsibilities would begin once the discounter exits Chapter 11.

After it leaves bankruptcy court, Kmart is set to pay nearly 8,000 employees emergence bonuses. The total cost of the program is expected to exceed $100 million. Kmart has paid out a portion of the payments in two installments during fiscal 2002 as part of its retention plan. Day said in a court affidavit that he would receive an emergence bonus of $1 million.