A Sears customer call centre is shown in Montreal, Thursday, Jan. 16, 2014.Ryan Remiorz/The Canadian Press
Editors note: This article erroneously states that Sears Holdings' spin off of Sears Canada would have been subject to Canadian take-over bid requirements, had it proceeded as a direct sale to ESL Holdings. In fact, it would have been exempt from the requirements.
It's been a week, but if you're the sort who reads tabloids, you've seen some pretty great celebrity Halloween costumes. This year, Beyonce and Blue Ivy Carter made an adorable team in Michael and Janet Jackson outfits, and Iggy Azelea dressed as Marlon Wayans from White Chicks. So clever, so funny.
If you read the financial pages, however, you probably miss out on much of the Halloween fun. Mostly, the scariest part of the evening comes when building security shuts off the lights in your office, forcing you to call down to the front desk so that you can finish your pitchbook under that sallow, neon glow. The only zombie is you.
But this year you're in luck. The best costume wasn't worn by Katy Perry (a life sized cheeto) or Neil Patrick Harris (the Joker, Cesar Romero Style), but by Sears Holdings, Sears Canada and billionaire investor Edward S. Lampert, who successfully dressed up a private M&A transaction as a rights offering, and barely anyone even noticed. I can't tell if it was a trick or a treat, but it was one heck of a costume.
On Oct. 16, Sears Holdings, the former U.S. parent of Sears Canada closed a rights offering. In general, a rights offering is a tool used by (often troubled) companies to sell equity and raise additional capital while avoiding certain securities disclosure requirements. In particular, when a company gives its own securities holders rights that allow those securities holders to buy more of that company's shares, the company, in general, does not have to issue a prospectus to make those shares tradable. This has obvious appeal. Troubled companies often don't want to go through the expense of preparing a prospectus, or further disclose their troubled condition, and a rights offering puts light pressure on current securities holders to take up the rights to avoid dilution. It's not perfect, but it can work.
The Sears Holdings rights offering, however, was unusual in that Sears Holdings could not avail itself of the disclosure exemptions because it wasn't offering its own shares. It was offering its shareholders rights entitling them to buy up to 39 per cent of Sears Holding's 51 per cent interest in Sears Canada.
So, why do this? Sears Holdings is 48.5 per cent owned by chairman Edward S. Lampert. Prior to the rights offering, Mr. Lampert, through his holding company (ESL Holdings), also owned 27.6 per cent of the common shares of Sears Canada meaning that, collectively, Sears Holdings and ESL Holdings owned about 78.6 per cent of Sears Canada. Up until the rights offering, Sears Holdings had been looking to recapitalize by unloading its stake in Sears Canada but struggled mightily to find a buyer.
There was, of course, one obvious buyer: ESL Holdings. Since ESL already owned a large portion of both Sears Holdings and Sears Canada, such a sale would have been moving an asset from one pocket to the other, in exchange for a much needed capital injection. Legally, such a sale would be a difficult task. In particular, a sale of 20 per cent of Sears Holdings' interest in Sears Canada risked being classified as a take-over bid under Canadian securities legislation.
Such a determination would have been difficult and expensive to deal with. If ESL Holdings had bought a large stake in Sears Canada by offering to buy Sears' securities, it may have faced severe restrictions on the resale of securities if ESL Holdings wanted to subsequently sell its stake, and would have been forced to make a bid to all holders of Sears Canada's stock, likely at a premium to the market price. The acquisition would have been complex and expensive, requiring special committees, fairness opinions and lots of professional advice.
A rights offering, on the other hand, requires comparatively little legal stick handling. Yes, a rights offering requires that Sears Holdings release a prospectus, which is not cheap. But, since Sears Canada was planning on listing its shares on the NASDAQ, such disclosure was going to be required anyway. And, because of Sears Canada's ownership structure, with ESL Holdings as the second largest shareholder other than Sears Holdings, a rights offering would mean a control block transfer to ESL Holdings at the market price with no premium. At the end of the day, after exercising its option to purchase unsubscribed securities, ESL Holdings would end up with 49.5 per cent of Sears Canada (staying under 50 per cent to avoid other legal consequences including Competition Act review) while Sears Holdings' share would be reduced to about 12 per cent and Sears Holdings would be $380-million richer.
And so that's what Sears Holdings and ESL Holdings did. The end result looks exactly like a private M&A transaction – ESL Holdings paid Sears Holdings some cash and received a 22.5 per cent control block. But the transaction mechanism was a rights offering; Sears Holdings accomplished the M&A deal by issuing rights through our securities listing laws. By saying the right words, Sears was able to turn one thing into another and make life much easier on itself.
This magic costume change isn't for everyone – this transaction was driven by the unique ownership structure of Sears Canada and Sears Holdings, with Mr. Lampert in effective control of almost every party involved – but it shows that capital markets transactions aren't just about numbers and paper, they're sometimes about a little bit of witchcraft too.