Bankruptcy asset sales are always controversial, but trailblazers Warren Buffett and Capmark may have pushed controversy to a new level. With their $1 billion put option, Berkadia and Capmark have created a pseudo-stalking horse. Yet with it arguably signed in the zone of insolvency, Capmark’s bankruptcy judge has pulled back on the reins, at least for now. It should come as no surprise that the parties, ever-innovative as financiers, are pushing the envelope – and both bankruptcy asset sales overall, and the real estate markets, have much riding on this particular horse.

The full drama of now-bankrupt Capmark is only understood when you realize that Capmark was, and remains, a commercial real estate powerhouse. It is an updated version of GMAC Commercial Mortgage. Goldman Sachs, KKR, Dune Capital Management LP and Five Mile Capital Partners LLC bought 78 percent of Capmark, which traded as GMAC Commercial Mortgage, from General Motors Co. for $8.8 billion.

Capmark’s bankruptcy filing, made on Oct. 25, 2009, is proof of smart lawyering in more ways than one. First, the bankruptcy filing is interesting both for who it includes, and who it does not. Capmark currently consists of a wholly-owned industrial bank; servicing companies; and a robust division that actively originated one billion dollars commercial real estate loans, annually. The Delaware docket includes parent company Capmark Financial Group, as well as several subsidiaries, among them the Capmark Affordable Properties Division, Capmark’s REO Division, and Capmark Capital. Just as notable, Capmark Bank, an important subsidiary, is not part of the kitchen-sink bankruptcy filing.

In its heyday, Capmark was known for inventive financing. It was driven by a commercial mortgage origination division that aggressively navigated the office, multifamily, and retail markets. In doing it, it played side-by-side with top of the line debt shops like HFF LP, CBRE Capital Markets, and Meridian Capital.

Innovation is a hallmark of this bankruptcy asset sale as well, and a recent ruling in its bankruptcy case proves it. In particular, consider the postponement by Judge Christopher Sontchi of the motion to approve bidding procedures. Capmark tried to set a deadline of October 31, 2009, for objections to the Sale and Asset Put Agreement on October 27, 2009. Judge Sontchi delayed the motion for setting a deadline and alternatively allowed a creditors' committee to be formed which could review the Asset Put Agreement between Capmark and Berkadia.

Capmark seems to be in a real rush, and the question is why. While it’s understandably looking to clear the bankruptcy process, other factors may be driving as well. Capmark could be driven to expedite procedures for a variety of reasons, among them momentum with regulators regarding the sale of a servicing business or the desire to sell the loan portfolio before real estate values dissipate more. However, the question remains whether the asset put agreement’s execution prior to Capmark’s bankruptcy filing avoided the need for 2/3 majority vote from the creditors? Capmark had their plan on track and wanted to be the one “driving the bus” towards a completed sale. Judge Sontchi is essentially slowing Capmark’s progress, similar to a student driving instructor bringing in the reins on an aggressive teenager speeding ahead.

Speedsters, even of the careful adult variety, may be frustrated by the slower, court-moderated progress of a 363 asset sale. Not every asset sale is a Section 363 sale. Under Section 363 of the Bankruptcy Code, this type of sales has a legally choreographed flow. Essentially the debtor needs approvals and some measure of creditor consensus or concession to facilitate it. The 363 process involves a standard cast of legal characters, among them the stalking horse, bidding procedures and court approvals – and each of these is somewhat different than the steps taken in an ordinary course sale.

This frustration may have led, in Capmark’s case, to its $1 billion put asset deal with Berkadia III. The documents related to this transaction sound uncannily similar to a 363 asset purchase, allowing for slight tweaks to verbiage to avoid using words like “break-up fee” and other bankruptcy terminology. That said, break-up fees and other devices familiar to 363-watchers are absolutely part of the put option.

Berkadia is a joint venture entity owned 50% by Warren Buffet's Berkshire Hathaway Inc. and 50% by Leucadia National Corp. The joint venture did something rather unique drafting an Asset Put Agreement. The agreement set up a put option giving Capmark the contractual right to sell at a given price within 60 days of the Chapter 11 filing. Capmark paid $40 million to reserve this right. If Capmark decides to sell the servicing division and mortgage portfolio to another party it loses the put option premium. Alternatively, if Berkadia backs out of the transaction relying say on a technical default such as Capmark not meeting its Qualified Escrow requirement it forfeits $20 million of the $40 million premium back to Capmark. Hence, a potential break-up fee.

The put option in question is exercisable by Capmark Financial in its discretion by delivery to Berkadia of notice, among other things within 60 days after notice of an insolvency proceeding. If Capmark exercises its put right, Berkadia will (i) acquire the mortgage origination and servicing businesses from Capmark for total consideration of $490 million (subject to adjustment as provided in the APA), a portion of which is payable in Berkadia notes, and (ii) acquire from Capmark, at par, Capmark’s owned mortgage loans and servicer advances outstanding on the closing date for cash consideration currently estimated to be approximately $600 million.

Leucadia and Berkshire have each provided a guarantee in respect of Berkadia’s obligations under the APA. The consideration supplied by Berkadia is $188 million from both Berkshire and Leucadia, the $40 million put price and debt financing to be provided by Berkshire, currently estimated to be $650 million.

When stalking horse agreements are at play, other buyers do have the option to jump into the fray. The Berkadia “put” allows for the same. Toward that end, Lazard Freres & Co. and Beekman Advisors continue to shop the servicing unit and loan portfolio with many interested parties but no other offers have been announced.

The Berkadia deal is unlike 363 asset sales in at least one other, quite key respect: 363 stalking horses emerge in bankruptcy, while the Berkadia deal happened just before it. Asset sales perilously close to a bankruptcy filing routinely lead to concerns of “fraudulent conveyance,” essentially the improper transfer of assets out of a company during a vulnerable time. By contrast, asset sales in bankruptcy are less controversial. Though they do raise concerns around the terms of the sale, these 363 sales have become commonplace in the bankruptcy world. Advantages of a Section 363 sale include relative speed, transfer of assets free and clear of encumbrances and interests, transfer of restricted contracts and avoidance of exposure to claims under fraudulent transfer laws.

For a seller like Capmark, the Section 363 process eliminates director and officer exposure for the sale and limits exposure for breach of representations and warranties. And these benefits are simply the legal benefits. The economic benefits of engaging in a 363 sale resemble a card game from the Old West with a stalking horse receiving a break-up fee for setting the first bid on a hard-to-value asset. This floor-setting intends to create an auction for the assets not unfamiliar to denizens of eBay.

Stalking horses serve to set the initial value of an asset. However, these valuations can be dubious at best. For example, Neuberger Berman, an asset manager, was considered the crown jewel of Lehman Brothers. It had been estimated, pre-bankruptcy, to fetch up a price of up to $8-billion. In actuality, it sold for $813-million in preferred stock and 49% of the company's equity, a marked comedown. Neuberger did drum up some early interest from competing bidders. PE firms Bain Capital and Hellman & Friedman made a stalking horse bid valued at $2.15 billion for the unit. The offer was, however, highly conditional. Lehman decided that management's bid was better, and creditors took $813-million in preferred stock and the other 49% of Neuberger. No surprise, in Lehman’s case, intense scrutiny followed. After all, with fluctuating deal values, a victorious low-ball bid, and management as that victor, skepticism reigns.

Capmark creditors may attempt to grab hold of the proceedings around the Asset Put Agreement, but their ability to do so rests on some narrow legal grounds relating to the colorfully named “zone of insolvency.” To explain, this zone saw its still-hazy borders defined in 1999, when Trace International Holdings, a private company, began their bankruptcy proceedings. When a company enters this "zone," also sometimes referred to as the “vicinity of insolvency,” its primary duty is to maximize benefit for creditors. Though laws vary from state to state, actions that benefit shareholders rather than maximize recovery for creditors can give rise to liability and in recent years, have given creditors clear ground to stand on when staking their claims.

Whether or not a company is “in the zone” depends on two tests used by the courts: the balance sheet and cash flow tests. In the balance-sheet test, a company is insolvent if its liabilities exceeded its assets. In the cash-flow test, the measure is the inability of the company to meet continuing obligations, such as payroll and operating expenses, as they came due.

In Capmark’s case, the company and its filing subsidiaries had in excess of $500 million of cash and cash equivalents (excluding cash held by Capmark Bank) available to fund its operations. Capmark believes that it has sufficient current liquidity to continue to satisfy customary obligations associated with ongoing operations of its business, including payment of employee salaries and benefits in the ordinary course, payment of post-petition obligations, servicing advances, and funding of loans.

So, was Capmark in the Zone of Insolvency at the time of the Berkadia Put? Based on Capmark’s assertions, they can meet their cash-flow obligations. On the other, balance sheet test, however, things are murkier. Capmark’s property-related balance sheet has a severe valuation problem- their assets most likely are worth a lot less than their 7.1 billion of liabilities. Assuming they are in the Zone of Insolvency, what behaviors are in the best interest of the creditors? Capmark maintains the position that the sale of the North American servicing business and monetization of the remaining non-bank asset portfolios will maximize recoveries for creditors.

A perhaps-analogous equitable debate arose with the Lehman Brothers bankruptcy, as well as many other bankruptcies, as well. In Lehman’s case, creditors sought to establish earlier entry into the “zone of insolvency” in order to assert control over payments it deemed objectionable. Essentially, creditors sought to put a foot down regarding the bonuses executives received during the period leading up to the bankruptcy.

Entry into the zone of insolvency was questionable due to the amorphous value of the CDO and CMBS assets. If the bank was not solvent when the bonuses were awarded, the payout could be considered a fraudulent conveyance. A key for creditors in the Lehman case was to prove that the bonuses were not paid out in the ordinary course of business. If they were out of the ordinary, they could rise to the level of a preference payment, and disadvantage one creditor over another and violate the 2005 Bankruptcy Abuse and Consumer Protect Act.

A laughable, seeming side note as to the arm’s length nature of the Capmark transaction: Were there lingering doubts as to this being a transaction set up for the purpose of unjust enrichment of management, look no further than the agreement itself. A sign of the distrustful, arm’s length nature of this transaction: Section 5.4 of the Put Agreement has Capmark represent that the loan tapes showing the asset terms will not “self-destruct”- seriously, Capmark had to represent they will not have trojan horse-like software that will disable access to data once conveyed to Berkadia. On its face, having nothing to do with bankruptcy law, this representation is somewhat telling.

All told, Capmark’s case appears to be distinguishable, as no one asserts that Capmark is scraping assets out of the company to line management’s pockets. However, if Capmark Bank remains a going concern and a lion’s share of the proceeds benefits the remaining entity, one could speculate current management would be handsomely rewarded once they reach the “other side” of this organization.

Concerns about the use of proceeds in Capmark’s case don’t exist in a vacuum. Capmark Financial, the parent, injected $494 million in cash and $106 million in servicing advances on September 30, 2009, into Nevada-incorporated Capmark Bank arguably to placate the FDIC. Parent Capmark Financial is also now proposing to inject another $600 million into the Bank by December 31, 2009. These funds most likely would be funded by the Asset Sales of their North American Servicing Unit and their Capmark Financial Group mortgage portfolio.

This flow is, in essence, a mirror image of the bankruptcy concept of downward substantive consolidation, Capmark is attempting downward financial flows outside the bankruptcy process. That contribution now will be subject to bankruptcy reorganization proceedings begging the question whether it is legitimate for Capmark the Parent to earmark such a large portion of the proceeds for its underling Capmark Bank when the creditors have not even been invited to the tea party? For more on the concept of “substantive consolidation” please see General Growth: Bankruptcy and the Downfall of Securitization as We Know It, available in the Related Resources panel.

Rightfully enraged, Capmark and its units owe $7.1 billion to their thirty largest creditors. The three biggest are Citibank NA, as administrative agent under the $5.5 billion credit agreement, with a claim of $4.6 billion; Deutsche Bank Trust Co. Americas, as trustee for the 5.875 percent senior notes and the floating senior notes due 2010, with claims of $1.2 billion and $637.5 million, respectively; and Wilmington Trust FSB, as successor trustee for the 6.3 percent senior notes due 2017, with a claim of $500 million.

Capmark’s timing of the Asset Put Agreement smacks, in the minds of some, as an end-run around the creditor approval process of the sale of its assets. To be sure, asset sales around bankruptcy are always controversial, as they force creditors (and disappointed equity holders) to recognize the actual value of the assets underlying the business they control.  With financial services companies, especially in deteriorating markets, valuing assets can be troublesome.

In a credit market like this, it is easy for a bank or a non-bank bank to point towards regulators as the motivating third party alibi justifying every decision. Capmark’s rationale for expediting the timing on their bidding process: placating regulators. Yet balancing the equities, no pun intended, is what bankruptcy court is all about. Whether this premature conveyance to a pseudo-stalking horse was appropriate, or more importantly the attempt to circumvent creditor approval was acceptable, will rightfully be decided by the Courts. As a policy, do we want to create a situation where the player who navigates the technical rules most deftly wins regardless of the result of stakeholders?