Harry CampbellOne lesson to be learned from Goldman Sachs’s victory in a legal dispute over its role as the adviser in the sale of the speech recognition company Dragon Systems may be an old one. If you don’t know who the chump is, then you’re probably it.
For the rest of us, the biggest lesson may be to know your advisers. Deal-making is a high-pressure business where entrepreneurs sometimes believe they can manage the process as they do their own businesses. They not only fail to understand what the role of the banker is, but often seem heedless to the risks. This may have succeeded at the time to build their business, but they do so at their peril in pursuing a deal.
Both sides in the legal dispute would probably agree that the $580 million sale of Dragon Systems to Lernout & Hauspie belongs in the category of deals from hell. The main reason is that Lernout & Hauspie, a Belgian company, paid for Dragon with its own stock. The sale occurred in 2000, and when Lernout’s accounting was exposed in a year as a huge fraud, the company collapsed into bankruptcy.
As a result, Dragon’s shareholders, including James and Janet Baker, Dragon’s co-founders and holders of 51 percent of its stock, lost almost everything.
Of course, no deal from hell goes away quietly. The Bakers have spent the last 12 or so years largely consumed in litigation. Before their lawsuit against Goldman, the couple had sued roughly 30 other parties and collected $70 million, according to public reports.
By 2009, it was time to turn to one with big pockets, Goldman Sachs. The Bakers, along with two smaller shareholders, sued Goldman, claiming that the firm had, among other things, negligently advised them and misled them during the sale. The Bakers’ main claim was that Goldman was responsible for due diligence on Lernout and, despite warning signs, did not adequately advise the Bakers not to do the deal.
The Bakers’ argument was artfully spun for both the media and the jury. The plaintiffs’ lawyers told a tale of the “Goldman 4” — a D-team of inexperienced and young Goldman bankers who had botched their job, leaving the Bakers in the lurch and Goldman $5 million richer from its fee. All four subsequently left Goldman, as investment bankers are wont to do.
But Goldman defended itself with a much different story. First, the firm argued that its financial engagement letter, which was heavily negotiated by high-powered lawyers on both sides, required it only to provide “financial advice and assistance in connection with the transaction.” The firm argued that as an investment bank, its job was not to do the kind of searching due diligence into the accounting of Lernout that the Bakers should have done. That job was for Dragon itself and its accountants.
So what was Goldman supposed to do to earn its fee? Coordinate the sale, negotiate the price and evaluate the growth prospects for Lernout because the Dragon shareholders received stock (more on that later).
But beyond the dry technical talk of what investment bankers actually do, at trial and in its briefs, Goldman strenuously sought to rebut the Goldman 4 depiction. The firm presented testimony at trial that the Bakers and other executives at Dragon were in a rush to sell in part because Dragon was in financial trouble. (Dragon was later sold out of the Lernout bankruptcy for only $33 million.)
There were warning signs about Lernout that the Dragon executives ignored, including news reports that questioned Lernout’s accounting. But the Bakers wanted to do a deal with Lernout as quickly as possible, the Wall Street firm argued. Goldman even sent a memo to the company warning that for these reasons, it should conduct extensive due diligence on the accounting at Lernout. This, too, was ignored.
And there were other problems. Dragon chose to take an all-stock deal instead of half-cash and half-stock at a meeting that did not include its bankers. (Goldman says it was not invited, while the Bakers claim the bank was a no-show.) The deal occurred during the Internet bubble, so it is likely that the Bakers, like many other investors, had nothing but high hopes for the stock. Indeed, the Bakers did not take steps to hedge the Lernout stock they received when advised of their ability to do so.
Goldman’s tale was thus of headstrong executives who plowed ahead and ignored the investment bank’s advice.
After a 16-day trial, the jury agreed with Goldman. It found for Goldman on all counts, and also found that the Bakers had breached their fiduciary duties to the board in failing to inform it of Lernout’s issues.
Goldman’s case was helped by testimony from the president of Dragon at the time of the sale, who said that he didn’t blame Goldman. And one of the Goldman 4, Richard Wayner, testified voluntarily to clear his name, breaking down on the stand in the process. He also testified that after Goldman’s due diligence memo on Lernout, he had “a very heated conversation” with Ellen Chamberlain, Dragon’s chief financial officer, in which she said, according to Mr. Wayner, that “Dragon did not want to do this additional level of detail.”
There was even a moment worthy of “Perry Mason.” The Bakers’ testimony in earlier suits was that the fraud couldn’t have been spotted or that such diligence wouldn’t have been permitted because Lernout and Dragon were competitors — this was most likely intended to help them win their case against Lernout’s accountants and bankers. And it worked. But when they turned their sights on Goldman, they were haunted by this testimony. Goldman’s lawyers repeatedly harped on these points.
In truth, the Bakers always had an uphill fight. Engagement letters that clients sign with investment banks are beasts. These letters limit the banks’ liabilities to all but gross negligence, restrict who they are responsible to if things go bad and strictly detail what the banks’ duties are. There have been only a handful of cases where investment banks have been found to be liable to their clients for bad advice. So, even if the Bakers were able to prove Goldman’s misdeeds, there was always that engagement letter to frustrate them.
Alan K. Cotler, a lawyer for the Bakers, said that there was still one Massachusetts State law claim pending and that the “Bakers would continue to pursue that claim.”
Ultimately, there are a number of lessons here.
First, it is perhaps no coincidence that this suit was brought in 2009 — in the wake of the financial crisis, when Goldman’s unpopularity made it a good time to sue. These claims would go to a jury, and Goldman was hardly the most sympathetic defendant. But bashing Goldman or any other bank goes only so far when the hard truth spells otherwise.
And, as this case showed, the role of the investment banks can be quite narrow.
With the Dragon sale, you can’t help but feel that this deal was particularly influenced by the Internet frenzy. But while the testimony may have led the jury to conclude that the Bakers plunged heedlessly along, this doesn’t excuse Goldman.
It does appears that there was some dysfunction between the Wall Street firm and Dragon. After all, the price for this deal appears to have been negotiated without Goldman even being present and with its warnings being ignored. While Goldman may have been rightly found to be not liable, one has to wonder why the firm didn’t act more forcefully to push its client’s interests in exchange for its $5 million fee.
In the end, an adviser would say the client, no matter how foolish, is in charge. And that was the problem. The Bakers, who had built a $600 million business from scratch, appear to think that their advisers should have saved them from themselves and that they could negotiate a better deal than Goldman Sachs. That was a mistake.