In re Kmart Corp.
| Decision Date | 14 February 2007 |
| Docket Number | No. 02 B 2474.,02 B 2474. |
| Citation | 362 B.R. 361 |
| Parties | In re KMART CORPORATION, et al., Debtors. |
| Court | U.S. Bankruptcy Court — Northern District of Illinois |
Craig Goldblatt, Wilmer Cutler Picker Hale & Dore LLP, Washington, D.C., William J. Barrett, Barack Ferrazzano Kirschbaum Perlman & Nagelberg LLP, Chicago, IL, Michael Snyder, WilmerHale, Washington, DC, for Objector.
Thomas J. Magill, Leonard S. Shifflett, Christopher Combest, Quarles & Brady LLP, Chicago, IL, for Claimant.
FINDINGS OF FACT AND CONCLUSIONS OF LAW
This matter comes to be heard on the objection of Kmart Corporation ("Kmart") to claims 50112 and 50863 filed by Philip Morris Capital Corporation ("Philip Morris") and claims 50110, 50111 and 50113 filed by its affiliate HNB Investment Corp. ("HNB") (collectively, the "Claims"). An evidentiary hearing was held and the court makes the following findings of fact and conclusions of law. For the reasons stated, the court will enter a separate order determining that the amount of claim number 50863 is $4,737,624 and allowing the same as an unsecured nonpriority claim entitled to treatment under Class 5 of the Plan. Claim numbers 50110, 50111, 50112, and 50113 will be disallowed.1
I. FINDINGS OF FACT
At the times pertinent hereto, Kmart was a Michigan corporation that maintained its principal place of business in Troy, Michigan. Philip Morris and its wholly-owned subsidiary, HNB are Delaware corporations. From at least 1985 through May 2003, Philip Morris was in the business of investing in structured financing primarily to generate tax deferrals. (Transcript of Proceedings ("Trans."), Vol. I, pp. 92-93). The court will collectively refer to Philip Morris and HNB as the "Claimants."
In May of 1995, Kmart, Claimants, and others entered into a leveraged lease transaction with respect to sixteen parcels of real estate improved with Kmart stores. (Joint Pretrial Statement of Claimants Philip Morris Capital Corporation and HNB Investment Corp. and of Debtor Kmart Corporation Regarding Claims Asserted Against Debtor by Claimants ("Joint Pretrial Statement"), Pt. III, ¶ 1).2 The stores are located in California, Georgia, Minnesota, New York, Ohio, and Texas. (Id., ¶ 2).
As part of the transaction, sixteen separate Delaware statutory business trusts (the "Owner Trusts"),3 with Wilmington Trust Company, as trustee, and either Chemical Trust Company of California or William J. Wade, as co-trustees (the "Owner Trustees"), purchased 89-year term estates-for-years interests in the sixteen properties (the "Estates-for-Years") from Kmart for a total of $169,492,251 (the "Purchase Price"). (Id., ¶¶s 1 and 5). The amount of the Purchase Price was arrived at by valuing the sixteen stores using certain "Pricing Assumptions" and "Depreciable Component Assumptions" set out in Exhibit E to the Agreement of Sale of Real Estate. (Id., ¶ 2).
An entity known as the RemainderMart Trust paid Kmart $583,104 for the fee simple interest in the land remaining after expiration of the Estates-for-Years. (Id., ¶ 1; see also, Trans. Vol. I, pp. 111-112).4 Wilmington Trust Company is the trustee and the RemainderMart Limited Partnership is the beneficiary of the Remainder-Mart Trust. (Claimants' Trial Exhibits ("Claimants' Ex.") 4, p. 1).
Claimants are the beneficiaries of the Owner Trusts. (Joint Pretrial Statement, Pt. III, ¶ 7). Before, entering into the transaction, Claimants ran a sophisticated complex computer program designed to identify the expected return. (Trans. Vol. I, pp. 96-99). The program generated reports upon which the pricing of the Properties was based (the "ABC Pricing Files"). (Id., pp. 127-129). After considering the results, Claimants collectively invested approximately $22 million in the Owner Trusts to fund payment of twenty percent of the Purchase Price. (Trans. Vol. I, p. 109), see also, Claimants' Initial Trial Brief, at page 3, ¶ 3, wherein Claimants describe these funds as being the equity to acquire the Estates-for-Years, This equity investment was allocated among the properties in accordance with information from the ABC Pricing Files. (See Id., ¶ 10). The remaining eighty percent of the Purchase Price was financed by the Bank of New York ("BONY") and Todd N. Niemy, as indenture trustees (collectively, the "Indenture Trustees"), through the acquisition of non-recourse public bond debt. (Id., ¶ 9). The obligations of the Owner Trusts to the Indenture Trustees, documented in a number of Mortgage Notes (see Claimants' Ex. 48, p. 13) (the "Notes"), were secured by sixteen separate Indentures, `Mortgages and Deeds of Trust, Assignments of Rents and Security Agreements (collectively, the "Indentures"). (Id., Exs. 48-57).
The Owner Trusts leased the properties back to Kmart pursuant to sixteen separate, but materially identical, leases of twenty-five year terms (collectively, the "Leases"). (Joint Pretrial Statement, Pt. III, ¶ 3). Kmart paid the rental payments called for in the Leases to the Owner Trusts. (Id., ¶ 11). The rents were then used by the Owner Trusts to pay down the Indentures and certain Owner Trustees' fees. (Id.). After those payments, the "free cash," was transferred by the Owner Trusts to the Claimants. (Id.).
The transaction afforded numerous benefits to those involved. Kmart received an immediate infusion of $170 million in cash to use for operational expenses, yet remained in and operated from the stores. (Trans. Vol. I, p. 112).
One of Claimants' goals from the transaction was to obtain a return on their investment from (i) the excess rents received throughout the life of the transaction and (ii) the remaining value of the properties when the Lease terms ended. (Joint Pretrial Statement, Pt. I, ¶ 5); (Trans. Vol. I, pp. 114 and 139). As explained by Steven Seagriff, Philip Morris's Vice President and Chief. Compliance Officer, Claimants assumed receipt of the remaining property value "if things are going well." (Trans. Vol. I, p. 120). This remaining property value is also referred to as residual value. (See Id.). The residual value of the properties involved here was projected by the parties at the outset of the transaction to be 17.5% of the total purchase price, i.e., approximately $20 million (the "Residual Value"). (Trans. Vol. IV, p. 29). Claimants recognized the risk that the projected and actual Residual Value may differ at the end of the Lease terms (Trans. Vol. I, p. 115), and thus, at the end of the transaction, Claimants would absorb the difference between their estimated Residual Value and a lesser actual value.
Claimants also expected tax benefits from the transaction. Persons in the position of Claimants use the deductions afforded by the transaction to shield corporate income from current tax. (Trans. Vol. I, p. 113); (Trans. Vol. II, p. 88). To understand the tax benefits, one must keep in mind that the Owner Trusts are "pass-through entities." As such, the Owner Trusts are not taxed on income generated by the properties. (Joint Pretrial Statement, Pt. III, ¶ 7). "Instead, [Claimants] bear the tax-related burdens and enjoy the, tax-related benefits associated with the Owner Trusts' ownership of the Estates-for-Years in the Properties." (Id.). In other words, Claimants are treated as the owners of the properties for tax purposes. Consequently, they are able to offset their gross income by the properties' depreciation. (Id.). Similarly, Claimants are considered to be the borrowers on the non-recourse debt, entitling them to take deductions for interest payments made on the Indentures. (Id., ¶ 13). These tax benefits are in the nature of deferral, not complete extinguishment, of tax liability. (Trans. Vol. II, p. 88-89); (Trans. Vol. III, p. 328-329).
The benefit to the Owner Trusts from the transaction is described by Claimants as the ability to receive rent under the Leases, pay the Owner Trustees' fees and Indenture obligations, and then distribute the excess rent to Claimants. (Joint Pretrial Statement, Pt. I(A), ¶ 5(b)).
A number of documents, in addition to the Leases and the Indentures, were involved in the transaction. (See, Claimants' Exs. 1-14, and 35-45). Of these documents, all of the parties, i.e., Kmart, the Owner Trusts, the Owner Trustees, Claimants, the Indenture Trustees and the RemainderMart Trust, entered into a Participation Agreement dated as of May 4, 1995 (the "Participation Agreement"). (Joint Pretrial Statement, Pt. III, ¶ 5). The Participation Agreement defines the roles of the parties and their respective obligations in the transaction. (See Claimants' Ex. 1). The Owner Trusts are defined in the Participation Agreement as the "Landlord," Kmart is the "Tenant," and Claimants are the "Owner Participants." (Id.).
Claimants entered into separate, but materially identical, Tax Indemnification Agreements dated as of May 4, 1995 with Kmart. (Joint Pretrial Statement, Pt. III, ¶ 5). The court will hereafter refer to both of the Tax Indemnification Agreements in the singular:
Pertinent Provisions of the Subject Documents
Claimants made a number of covenants in the Participation Agreement, including an affirmative covenant to "hold [themselves] out as [] legal entit[ies] separate and distinct from the Landlord, [i.e. the Owner Trust] ... not commingle [their] assets with those of the Landlord, ... conduct business with Landlord only on an arm's-length basis," maintain separate books, and file their own tax returns. (Claimants' Ex. 1, p. 11, § 5(b)).
Kmart agreed, inter alia, not to claim tax ownership benefits with respect to the properties. (Id., p. 14, § 6(h)). Kmart also agreed to a general indemnity, which provides,
(a) Tenant [Kmart] agrees, whether or not any of the transactions contemplated by [the...
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