Can J.C. Penney be saved?

J.C. Penney Co. kicked off a court battle last week in an effort to defend itself from claims arising from a credit line that debt holders allege puts the retailer in default.

The default is so technical, however, that industry watchers are wondering whether something else is going on behind the scenes -- perhaps even another chapter in the public fight between investors William Ackman and Carl Icahn.

A late January letter from James W. Stoll, a partner with law firm Brown Rudnick LLP, started the legal fight. Stoll, saying he represented more than 50% of holders of the retailer's 7.4% debentures due in 2037, claimed that a $1.25 billion credit line J.C. Penney opened in January 2012 breached a negative covenant that restricted the company's right to grant liens against certain property.

That letter set off a legal firestorm. The Plano, Texas-based department store chain promptly went into Delaware Chancery Court on Feb. 4, seeking a declaration that it was not in violation of its covenants and requesting an injunction against the debt holders.

The original January 2012 $1.25 billion credit facility was in the form of a typical asset-backed revolver that retailers use for operations. Shortly after it was issued, the size of the facility was increased to $1.5 billion on Feb. 10, 2012. Most recently, J.C. Penney used the accordion feature of the ABL revolver, increasing its borrowing capacity by $250 million on Jan. 31, 2013. It received commitments of $62.5 million from JPMorgan, Bank of America Merrill Lynch, Barclays plc and Wells Fargo.

J.C. Penney first argued that the debt was secured by inventory, not to be considered part of real property, which it said wasn't the same thing as the principal property covered by the credit agreement covenants. Anyway, the company said, it didn't matter because it hadn't borrowed any money under the facility. As Skadden, Arps, Slate, Meagher & Flom LLP litigation partner George Zimmerman put it in an e-mail to Brown Rudnick on Feb. 3, "Simply put, there has been no 'money borrowed' and therefore Section 5.08's [relating to the negative covenant] provisions have not been triggered."

The retailer's aggressive posture on the debtholders' claim, however, underscores one of the big issues the company faces as it tries to restructure under the guidance of its new CEO Ron Johnson: Liquidity.

Johnson was handpicked by Ackman after the hedge fund manager settled a potential proxy fight and took two seats on the board, as well as a 17.8% stake in the company. (Under his standstill agreement with the company, Ackman, founder of Pershing Square Capital Management LP, has the right to go up to about a 26% stake.)

Liquidity has been a concern for J.C. Penney as the company has struggled to reverse declining numbers across the board. Investors undoubtedly took note of the speed with which the company went to court at the suggestion of even a potential technical default.

It was only months ago that industry watchers were saying that J.C. Penney had a noncore real estate portfolio that could be sold off, enough to fund the retailer's transformation of its department stores into a series of shops-within-a-shop.

J.C. Penney found a winner in the shop-within-a-shop format -- which has in essence transformed major department stores such as Macy's Inc. from retailers into landlords -- when it introduced the Sephora USA Inc. beauty chain into its stores in 2006. Sephora is a unit of Paris-based luxury conglomerate LVMH Moët Hennessy Louis Vuitton SA. Even brands sold by Sephora, like those made by leading skincare company Murad Inc., saw double-digit increases in sales in the J.C. Penney installations.

Since Ron Johnson took over, though, the effort to transform the retailer gradually has resulted in the conversion of only about 10% of all of the chain's square footage. Analysts say the full conversion could take three years.

For the third quarter ended Oct. 27, the company reported a net loss of $123 million and an adjusted net loss of $203 million when net gain on sales of noncore assets are excluded, as well as restructuring and management changes and noncash primary pension plan expenses.

That loss was fueled by a 26.1% decline in comparable store sales, while total sales plummeted 26.6% to about $2.9 billion compared to nearly $4 billion for the same period a year earlier. Piper Jaffrey & Co. estimates same-store sales fell 32% in the fourth quarter.

During the third quarter the retailer continued to open shops under brand names such as Levi's, PVH Corp.'s unit Izod, and J.C. Penney's private label brand Liz Claiborne. The company also sold off noncore assets during the third quarter, which generated $279 million, but the cash burn continued: cash and cash equivalents for the third quarter was $525 million down from $839 million in the second quarter.

That third quarter loss exacerbated dismal first and second quarters.

In the second quarter ended July 28 total net sales fell to about $3 billion from about $3.9 billion, comparable store sales decreased by 21.7%, and the company had a net income loss of $147 million compared to a net income gain of $14 million for the same period a year earlier. Cash and cash equivalents as of July 28 was $888 million.

For the first quarter ended April 28 total net sales fell from about $3.9 billion to nearly $3.2 billion, comparable stores sales decreased 18.9%, and the company had a net loss of $163 million compared to a net income gain of $64 million a year earlier.

Industry experts who requested anonymity said they now are concerned that J.C. Penney is burning through cash so quickly that it may run out of time and money before it can convert a vast majority of its square footage into the more successful format.

Ackman and J.C. Penney have declined to comment in the past on the value of the retailer's noncore real estate holdings and whether it would be enough to fund the retailer's turnaround.

A Feb. 1 report from JPMorgan questioned J.C. Penney's ability to fund its turnaround solely on its free cash flow. Despite having $1 billion of cash on hand -- and possibly more if the company sold noncore assets -- and assuming a cash flow burn of $500 million the first half of 2013, JPMorgan viewed drawing down the revolver as "increasingly likely" during that time.

Morgan Stanley echoed these thoughts in a Feb. 5 note. "We think it's increasingly likely JCP will draw its revolver by 3Q13, which could cause a [negative] stock price reaction, or worse, vendors could pull back credit, limiting product access."

Drawing on the revolver would undermine the company's argument for its injunction. However, J.C. Penney is also relying on its construction that the ABL lending capacity is a lien only on inventory, other than real estate or other tangible property. That, the retailer claimed, would allow it to secure new debt without breaching covenants.

"The granting of a security interest in inventory pursuant to the Credit Agreement does not constitute an event of default under the Indenture," said the company in a Feb. 4 statement. J.C. Penney pointed out that this had not been a problem in the past with debt holders. "The Company has publicly disclosed for some 10 years that it has had various undrawn credit facilities secured by inventory with no bondholder allegations of violation of the Indenture."

Piper Jaffrey published a report on Feb. 5 contending that J.C. Penney's ability to use inventory as collateral is "essential" to the company's turnaround.

"We believe JCP would lack sufficient liquidity to fund its 2013 store remodel plan if it were forced to pull inventory from the borrowing base on its credit facility, which would cast serious doubt on the financial viability of JCP's turnaround strategy," the firm stated.

Piper Jaffrey also noted that any concession made to the 2037 debenture holder would likely set a precedent for the rest of its secured debt holders. The company had about $2.9 billion in long-term debt in the form of various bonds and debentures that matured between 2015 and 2097.

So far, the identity of the restive bondholders has not been revealed, although J.C. Penney requested that information from Brown Rudnick. Chief Financial Officer Ken Hannah asserted that the notice of default was "intended to create self-interested trading opportunities in the market."

A large slug of debentures changed hands on Jan. 25, according to data from Bloomberg -- the largest single volume of the year. Coincidentally, perhaps, that was the same day that Icahn faced off against Ackman in a spirited debate on CNBC over Ackman's public short position on Herbalife Ltd. Icahn's animosity dates back to a real estate deal gone sour between the two hedge fund managers.

An industry source pointed to Brown Rudnick's involvement in the J.C. Penney dispute. The firm had been Icahn's lawyer in other matters. Stoll also previously represented GB Holdings, an Icahn company, in a securities dispute with Sands Casino, according to the law firm's website.

J.C. Penney declined further comment on the lawsuit. Neither Ackman nor Icahn's offices responded to requests for comment.