If Sears Holdings (SHLDQ) ends up going bankrupt, as its recent annual filing with the SEC admits is a possibility, there's the potential the sale of its Craftsman tool business it cemented with Stanley Black & Decker (SWK 1.70%) could become undone.

For the moment it doesn't seem as though it's going to happen, but it underscores just how tenuous Sears' position is and how far the effects a bankruptcy filings would reach.

Man using a Craftsman circular saw

Image source: Sears Holdings.

A telling admission

Sears caused a tumult when it filed its 10-K report that said based on how bad its financial performance has been, it indicated "substantial doubt exists related to the Company's ability to continue as a going concern." That was like a fire bell clanging in the hall, because even though almost everyone knew Sears was careening downhill, it was the first time the retailer itself acknowledged the potential it could implode.

And what was even more revealing was the fact that if it did declare bankruptcy, the courts could unwind the Craftsman deal with Stanley if it found Sears was already insolvent at the time of the deal, became insolvent because of it, or the deal left it with insufficient assets to continue operating because they could all be construed as violating laws of "fraudulent conveyance and transfer."

Not only that, but it could also apply to other transactions it made in the recent past, including the spin offs of Land's End (LE 0.76%) and Seritage Growth Properties (SRG 3.25%), as well as the properties Sears sold to the real estate investment trust. Essentially, any deal Sears made or might make in the future could be called into question.

Actions speak louder than words

While Sears has pulled back from the brink after that initial bit of drama, and has in fact rallied strongly in the aftermath -- not least because chairman and CEO Eddie Lampert has once again put his own money on the line with the retailer and bought, in conjunction with fellow hedge fund investor Bruce Berkowitz of Fairholme Capital Management, more than $10 million of Sears stock -- there is still real risk these deals could come undone. And because the Craftsman sale is the most recent of the bunch, it stands to reason it would have the greatest chance of being unwound.

Craftsman tools and toolbox

Image source: Sears Holdings.

The Craftsman transaction was a smart bit of dealmaking that not only gave Sears an immediate cash injection of $525 million, but also allowed it to retain the right to manufacture and sell Craftsman tools royalty-free for 15 years while giving Sears a 2.5% to 3.5% cut of Stanley's sales of Craftsman products for 15 years. Should Sears survive that long, Stanley will pay another $250 million to Sears in three years' time.

That's some innovative thinking right there, though it does set up the possibility Sears will be competing against itself as well as giving customers yet another reason not to shop at Sears stores. Still, for a company in the dire straits the retailer finds itself, those were some pretty good terms.

Crossing their fingers

Yet Sears' financial condition was also a matter of concern for Stanley while it was negotiating the transaction. Stanley took pains to note that it made sure to create a wall of separation between itself and Sears' woes, pointing out it assumed no contractual credit risk from Sears because of the deal, there were no ties to Sears' "growth trajectory," and it was under "no incremental obligation" to supply Sears.

During the January conference call with analysts discussing the transaction, Stanley's CEO and president Jim Loree acknowledged there were risks with the deal: "You know, there's also a risk of, in the event that Sears, as an organization, was not an ongoing concern at some point in the future, there would be some warranty expenses that, or claims that might be promulgated against us by consumers but we're not contractually obligated in that regard."

Man looking at Stanley Black & Decker's DeWalt line of tools

Image source: Stanley Black & Decker.

He also admitted that a bankruptcy judge could unwind the deal at a cost to Stanley if he found that Sears was bankrupt at the time of the deal or became bankrupt because of it. Still, he didn't think that was the case or that Sears would have entered into the deal if it felt so, either.

Certainly Lampert (and Berkowitz) have a vested interest in keeping Sears afloat for as long as possible because of the amount of debt they own in the retailer, and the rally in Sears stock shouldn't be confused with a better financial performance in the near future. There are still grave risks in front of Sears, and one of the outcomes could be that its sale of Craftsman tools (and the other deals, too) could all end up coming undone.