(FORTUNE Magazine) – WHEN BILLIONAIRE INVESTOR EDDIE Lampert forged his deal to merge floundering Sears with Kmart last fall, he tossed Alan Lacy a lifeline. As Sears' CEO, Lacy was so ineffective that many people were amazed he survived as long as he did. Now the $12.3 billion merger is complete, and Lacy is CEO of Sears Holdings. Already his lifeline looks more like a noose.

For one thing, it is Lampert, not Lacy, who is calling the shots. The hard-nosed hedge fund manager is digging deep into Sears, as he did at Kmart--squeezing suppliers, slashing spending, and cutting heads. How many, Lampert has not said. (He declined to talk to FORTUNE for this story.) But sources close to the company say he aims to cut 40% of the 5,000 employees at Sears' headquarters near Chicago, and he'll likely close Kmart's headquarters in Michigan. Lampert, 42, likes to ask senior executives, "Are you on the team?!" So far, ten of Sears' former top brass are not. Lampert has been replacing them with people from the Sears and Kmart benches. Or his own loyalists: Sears Holdings' CFO is Bill Crowley, Lampert's No. 2 at ESL Investments. Officially Crowley reports to Lacy at Sears, but given the relationship (Crowley and Lampert work together out of Connecticut), he's really reporting on Lacy as well as to him.

Meanwhile, judging Lacy in the boardroom is Sears director Julian Day, his former archrival. Five years ago Lacy and Day were executives at Sears, competing for the CEO job. After Lacy--who is said to loathe Day--won the contest, he unceremoniously pushed Day out. Day moved to Kmart as CEO and scored big. He brought Kmart out of bankruptcy in 2003 and stepped down as chief last October but remained on the board. Now Day is one of seven former Kmart directors on Sears Holdings' ten-member board. How tough he'll be in challenging Lacy, no one knows. But Day is Lacy's looming threat. One executive who knows Day says the setup is "Julian's sweet revenge."

While his enemy is at his back, Lacy, 51, has been marginalized. Lampert has put Aylwin Lewis, Day's successor at Kmart and now Sears Holdings' president, in charge of the $43 billion main business--Sears and Kmart stores, plus new the Sears Grand and Sears Essentials (renovated Kmart outlets that sell both stores' goods). Lacy oversees $12 billion in sideline operations such as Lands' End, Orchard Supply, and Sears Canada. Given that Lacy, a onetime CFO of Sears and Philip Morris, is generally better at pruning than growing businesses, he could work himself out of a job. Although he just signed a five-year contract, most people predict he'll be gone by next year. (Lacy declined to comment.)

Retail experts say Sears Holdings needs a merchant at the helm--rather than finance pros and a fast-food veteran. (Lewis was previously COO of Yum Brands.) One possible candidate: Vanessa Castagna, the well-regarded former No. 2 at J.C. Penney. Penney's board last year passed her over for the CEO job, contending that she lacked enough financial expertise. In April she joined Cerberus, a hedge fund with big interests in retail, and she aims to fill out her résumé so she can run a major retailer. So far Lampert has shown no interest in recruiting Castagna or other retail hotshots, but he may need to load up on that kind of talent sooner than he thinks. -- Patricia Sellers