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WSJ: Mervyn's LLC Sues Its Former Owners

When a high-profile group including Cerberus Capital Management and Sun Capital Partners purchased Mervyn's for $1.26 billion in 2004, the deal was structured as two separate transactions -- one for the retailer and a second one for the retailer's real estate. This complicated structure, the suit alleges, enriched the private-equity firms while leaving the retail operations insolvent.

"The 2004 transaction is a transaction that ultimately led to Mervyn's bankruptcy," the suit claims, calling it a deal that "cannot withstand scrutiny."

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As more private-equity-backed companies file for bankruptcy protection, creditors and the companies themselves are expected to increase attacks on the financial structures used in the buyout deals.

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The case against Sun and Cerberus is especially fraught for the private-equity industry, which is trying to shake off decades of criticism that the funds "strip" healthy companies with little regard for employees or institutions. It is that dynamic that forms the basis of the company's complaint.

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Mervyn's was originally sold by former parent Target Corp. for $1.26 billion. The new owners then leased many of the stores to Mervyn's and sold or leased some properties to other retailers. These transactions and the overall appreciation of real-estate values helped the private-equity buyers more than double their money.

But Mervyn's, which sells clothes, housewares and jewelry, alleges that the arrangement strangled its profitability, and that it was a "helpless pawn." That was because the new arrangement nearly doubled the company's annual lease payments, to $172 million. In addition, it was required to pay a special dividend to the real-estate company. Furthermore, the lawsuit says, Mervyn's couldn't close unprofitable stores without the consent of the private-equity firms and the real-estate company.

While the transaction didn't directly result in a greater debt load for Mervyn's, the lawsuit alleges that the real estate was stripped away "in order to pay the substantial debt that was incurred to finance the transaction."

Once company sales began to falter amid a weakening economy, the retailer had little recourse but to file for bankruptcy protection.

These kinds of suits aren't typically filed by the company itself but by creditors, said bankruptcy experts.

"It's a sign of the times," said Andrew Rahl, a bankruptcy lawyer for Reed Smith LLP. "We are going to see more litigation in bankruptcy due to the credit crunch and the effects of that."

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