This Dragon Systems lawsuit that’s bopping along in a Boston court gives me the absolute heebie-jeebies; it is the investment banking version of the dream where you show up to school and there’s a test that you forgot to study for. One day the youngish team of Goldman bankers is patting themselves on the back for guiding their client, family-owned speech-recognition software maker Dragon Systems, to a $580 million sale to a Belgian acquirer. The next:

the 2000 all-stock deal was quickly followed by an accounting scandal that led to the collapse of suitor Lernout & Hauspie Speech Products NV. Goldman Sachs, which advised Dragon on the deal, called witnesses to counter allegations by Dragon founders Jim and Janet Baker that its negligence cost them their life’s work. … Dragon’s founders, who are seeking hundreds of millions of dollars in damages, claim that four Goldman Sachs bankers assigned to the transaction committed gross negligence by failing to pursue questions about Belgium-based Lernout & Hauspie’s finances that should have led them to avoid the deal.

Oops! I really do feel for the bankers here. It’s Friday afternoon and nobody’s reading so I feel comfortable making this confession: when I was a banker I once underwrote some convertible bonds for a company that we’ll call Company X, and later when I was a blogger Company X went bankrupt and those bonds are … those bonds are not doing so hot, these days. That keeps me up at night, sometimes.1 But in my defense it took like a year! And Company X wasn’t a giant fraud, either, it just turned out to suck at making money. The Dragon team doesn’t have those excuses:

The deal closed on June 7. By Aug. 8, the merged companies were in crisis amid reports that L.& H. had cooked its books. Reporters for The Wall Street Journal did something the Goldman Four did not: they picked up the phone and called L.& H.’s supposed customers in Asia. They found that companies in South Korea and elsewhere that L.& H. had claimed were its customers weren’t doing any business with it at all. L.& H. had pulled sales figures out of thin air.

This Bloomberg story will give you the bringdown due diligence, as it were, on the lawsuit, but for the full flavor you need to read July’s mammoth New York Times article that lays out the two sides of the story pretty starkly. There’s the Bakers:

“The Goldman [bankers] were unsupervised, inexperienced, incompetent and lazy investment bankers who were put on a transaction that in the scheme of things was small potatoes for Goldman.”

And there’s Goldman:

[T]he bankers, as Mr. Wayner testified, gave the Bakers “great advice.”

Mr. Berzofsky, too, testified in his deposition that the Goldman Four did a “great job.”

Even though Dragon lost everything?

“Yes,” Mr. Berzofsky said. He was given several opportunities to clarify. And then he was asked one more time — the fact that the Bakers and Dragon’s shareholders lost everything doesn’t affect your opinion?

“Correct,” Mr. Berzofsky responded. “We guided them to a completed transaction.”

The wonders of that passage are legion but you have to start with references for those names:

Richard Wayner, who was 32 when the Dragon deal was cut, struck out on his own in 2002 and eventually landed at the Keffi Group, an investment firm. … Alexander Berzofsky, then 25, left Goldman at about the same time and is now a managing director at Warburg Pincus, the big private investment company.

So a VP and an associate (analyst?) ran the deal, with essentially no supervision.2 That’s not that surprising. How are you gonna learn how to run an M&A deal except by running some M&A deals? And I’m sure that Wayner and Berzofsky have some justification for their belief that they did a great job. They checked off, like, 99 out of the 100 boxes on the “successful M&A engagement” checklist. It’s just unfortunate that the missed box was “make sure all-stock acquirer isn’t a giant fraud.” How often is that relevant?3 Chalk it up as a learning experience.

Of course that box isn’t for them alone to check off. They’re not auditors. And per Bloomberg’s article today there’s plenty of testimony that they did raise some warning signs to Dragon, and push for more extensive accounting and other diligence, and that Dragon said no.4 There’s also conflicting evidence, and some signs that Dragon didn’t understand who was responsible for what. Here’s Dragon’s CFO:

Chamberlain, who testified Dec. 18, told the jury that Dragon expected Goldman Sachs to conduct due diligence. … “I had a level of expectation of bankers driving a process, making due diligence happen, being very active, detailed and that was not the way Goldman Sachs operated,” she said.

That seems unfair: as the Goldman bankers would be happy to tell you, they were very active in driving a process. Meetings occurred, contracts were exchanged, board books were produced. Due diligence “happened,” in the sense that a list of questions was generated and someone checked a box on a checklist somewhere. They got the deal done. That’s what they got paid ($5 million) for.

Why would you hire an investment bank to advise you on an M&A deal? It’s sort of an uncomfortable question. Many bankers would be perfectly happy for you to believe that they’ll sagely guide you through all aspects – financial, operational, tax, accounting, legal, public relations, game-theoretical, psychological, emotional, oenological, etc. – of a transaction, that they know your industry and your potential acquirers better than you know them yourself, that you’re hiring them for their superior judgment and intellect in all things. Others are more modest: they’re a particular sort of contractor, familiar with the nuts and bolts of the merger process, with phone numbers for potential acquirers and a guy who can whip up a valuation spreadsheet or two.

Clients vary, too, in much the same way. Some hire bankers for commoditized fairness opinions and light Excel outsourcing. Others want their bankers to tell them whether to sell, how to run their business, and what to get their kids for their birthdays.

But you know who’s clear and consistent and unchanging? Bank lawyers. The lawyers will tell you as often as you like, in writing, that the bank has no responsibility to anyone for anything. And so besides its substantive defenses – “we told you to do more diligence and you didn’t,” etc. – Goldman has what seem to me on casual inspection to be some pretty good legal defenses. Their engagement letter makes them responsible only to Dragon Systems the company (which no longer exists), not Dragon’s aggrieved shareholders. And “Lawyers for New York-based Goldman Sachs have argued that due diligence wasn’t the bank’s responsibility under a five-page engagement agreement.”

This makes sense. Five million dollars is a nice fee for a few months of very junior-level labor, but it’s not enough for Goldman to guarantee the soundness of an acquirer or the success of a deal. Goldman stood to make $5 million on this deal, and they put in effort that … well, at a hefty markup maybe you could say it was worth $5 million. (They got a deal done!) Dragon had $580 million dollars on the line, and the buck stopped with them.

Should Dragon have known that? Were they reasonable in trusting that they could outsource everything to Goldman, without worrying about accounting or diligence themselves? Meh. I mean, no, but I also suspect the Goldman bankers – who I imagine as junior guys excited to have a client of their own and eager to make a good impression5 – were happy to give the impression that they knew what they were doing and would take care of everything. But why rely on that impression? Dragon could have looked at the engagement letter – which I’d guess was one page of fees, one page of very limited enumerated activities that Goldman would do, and three pages of “YOU CAN’T SUE US FOR ANYTHING AND IF ANYONE SUES US FOR ANYTHING YOU WILL DEFEND US FOR EVERYTHING” – for a more sobering, and as it turns out more accurate, assessment of Goldman’s services. But that’s not what they wanted to hear.

Goldman Sachs Tells Jury Dragon Rushed Toward Doomed Deal [Bloomberg]
Goldman Sachs and the $580 Million Black Hole [NYT]

1. It doesn’t? Am I a bad person? A bankster, even?

2. But this, from the Times, is the very best part of the Dragon story:

One of the four … testified later that their supervisor was Gene T. Sykes, a Goldman partner who at the time specialized in technology and who this year was promoted to head of M.& A. at the firm, one of the most powerful jobs on Wall Street. In a deposition, Mr. Sykes disavowed any involvement.

Can you not picture this poignant scene?

VP: Hey boss, I think I’ve got an M&A mandate from Dragon Systems.
Partner: [without looking up] Great, well done.
VP: Thanks. Do you want to be involved?
Partner: How big is it?
VP: Around $500 or $600 million.
Partner: All yours.
VP: Thanks. I really appreciate your faith in me. I won’t let you down.
Partner: Who are you again?

3. I feel like everyone has forgot-one-thing war stories. In my line of work “make sure there are enough authorized shares” was a popular one. That’s caused trouble for Treasury too, actually.

4. Also that they said no because, as Dragon’s president put it, “the company’s financial situation was getting worse instead of better.” So … they were trying to swindle L&H? Joke was on them.

5. Though another great part of the Times article is that Wayner, the VP, was on vacation for pretty much every important event in the deal process, leaving Berzofsky in charge.

32 comments (hidden to protect delicate sensibilities)
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Comments (32)

  1. Posted by Guest | January 11, 2013 at 5:42 PM

    I disagree with the picture caption. Everyone knows the internet is for cats, not dragons.

    I know it's Friday, but come on, Matt. You're better than this.

  2. Posted by Guest | January 11, 2013 at 7:04 PM

    Why is it that the financial reporters covering these types of messes always bitch up a storm about how lazy the bankers or lawyers were to not call up customers or other business relations of the companies involved and "kick the tires"? I would love to see what they would have to say if a banker or lawyer blew the lid on a deal by actually doing this.

    - Guy who is mad as hell and can't take it any more

  3. Posted by guest | January 11, 2013 at 8:07 PM

    how the hell can there be a he-said-she-said about gene sykes? his name either appears on emails and committee memos for this deal or it doesn't. only a complete idiot would lie about something with a paper trail that long…

  4. Posted by SEC Blog Quant | January 11, 2013 at 9:56 PM

    We're reading Matt, and our highly advanced algorithms have determined your the most insidious trader yet, we did Ctrl+F of your posts and found more mentions of materiality and "insiderishness" then anywhere, we've also decrypted that "meh" means "material extra hot." Just wait until we find out what company X is, then we'll get you!

    -So don't make any vacation plans for 2019 or so, we'll get it by then.

  5. Posted by Jon | January 11, 2013 at 10:05 PM

    Matt, I know that you love footnotes, but "the very best part of the Dragon story" gets included only as footnote 2?

  6. Posted by Guest | January 12, 2013 at 3:49 AM

    I think you misunderstand the article. He's more or less defending them (on legal grounds at least), and at the very least ambivalent…

    If you think Matt is a 'lazy' financial reporter, go take lap, and when you're done, go read 10 more of his posts. By the 28th intricately detailed chart, if you're still singing the same tune I'd be very surprised.

    I think the general assessment of the bankers' performance here is 'meh'. I'm sorry if you were expecting a victory parade an blow-jobs for all involved… but honestly they didn't exactly do a stellar job, even if they weren't technically negligent.

    -Hope this helps

  7. Posted by guest | January 12, 2013 at 6:30 PM

    Genuinely sad story for the founders, but whenever something like this happens, I have to ask – you couldn't negotiate for some cash? Just a little, like $100 million dollars? If a company can give you $500m of stock but can't scrounge up 20% of that in cash, that's a red flag. Otherwise pre-sell it in a forward or ask goldman to find a buyer of it at some discount or something. Anything so you can't be left with zero.

  8. Posted by mag | January 13, 2013 at 8:00 AM

    This thing about sell-side M&A advisers only being responsible to the legal entity and not the shareholders is a little ugly – that basically means there can never be standing for an after-the-fact you-screwed-up suit because the seller, except in the case of larger companies selling off a division, always by definition ceases to exist when the deal closes, right? Whether the contract does or does not specify the amount of diligence, whether Goldman advised more questions asked be or not – those seem like important questions that should be discussed in court. Whether the founder/shareholders who sold their built-from-the-ground company to a fraudulent house of cards on advice of an expensive fancy investment bank have standing to make an accusation and investigate the matter seems like it shouldn't be really in question, to me. If a doctor advises a patient to take poison and the patient dies, we don't say, "Oh, well, now no one living has standing to sue." We say, first off the surviving relatives get to sue, and second the government steps in to levy criminal charges.

  9. Posted by UFO | January 13, 2013 at 12:53 PM

    Thank you for a non-chemically-imbalanced interpretation of reality.

    - Guy who really appreciates the ability to see things as they are

  10. Posted by buboe | January 13, 2013 at 6:29 PM

    read the Times story and come back – Goldman advicve was to go for a shares only deal

  11. Posted by Guest | January 14, 2013 at 9:26 AM

    OK, so Goldman has it in writing that " the bank has no responsibility to anyone for anything", so they're covered from the legal side.

    So how do you clear up the reputational mess?

    Is there a clause in the contract that leaves the client responsible should the Goldman bankers be revealed to be "unsupervised, inexperienced, incompetent and lazy", and that ensures that the client makes Goldman whole for the potential revenue they certainly will lose as a result of this debacle?

  12. Posted by guest | January 14, 2013 at 10:44 AM

    Anyone who has ever worked at a decent bank has watched a starstruck client give GS a mandate for a type of deal they don't do well and had the frustration compounded by seeing GS assign the C team to it. It's just one of those things that happens, but usually with consequences that are less disastrous.

  13. Posted by PermaGuestII | January 14, 2013 at 12:21 PM

    This whole thing went down 13 years ago. Ancient history.

  14. Posted by Guest | January 14, 2013 at 5:14 PM

    Actually if you read the article it seems that Goldman didn't offer them any advice at all on the issue because during the meeting when L&H and Dragon changed the terms from 50/50 to all stock the Goldman bankers didn't even show up. I'd like to know who were Dragon's M&A lawyers though.

  15. Posted by Guest | January 14, 2013 at 6:14 PM

    I wasn't referring to Matt, and I didn't say anything about financial reporters being lazy. I was referring to this quote specifically, but I thought it would be clear from the context:

    "Reporters for The Wall Street Journal did something the Goldman Four did not: they picked up the phone and called L.& H.’s supposed customers in Asia. They found that companies in South Korea and elsewhere that L.& H. had claimed were its customers weren’t doing any business with it at all. L.& H. had pulled sales figures out of thin air."

  16. Posted by Robin | March 14, 2013 at 11:01 AM

    Yes I have heard a lot about Goldman and most of the things were positive but here its seems like they didn't gave any advise.

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  20. Posted by Chris | August 9, 2013 at 7:44 AM

    I think whether the contract does or does not specify the amount of diligence, whether Goldman advised more questions asked be or not – those seem like important questions that should be discussed in court.

  21. Posted by güzel sözler | August 15, 2013 at 10:14 PM

    Lernout & Hauspie Speech Products NV. Goldman Sachs, which advised Dragon on the deal, called witnesses to counter allegations by Dragon founders Jim and Janet Baker that its negligence cost them their life’s work. … Dragon’s founders, who are seeking hundreds of millions of dollars in damages, claim that four Goldman Sachs bankers assigned to the transaction committed gross negligence by failing to pursue questions about Belgium-based Lernout & Hauspie’s finances that should have led them to avoid the deal.

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  23. Posted by eca kombi servisi | September 12, 2013 at 3:26 AM

    This thing about sell-side M&A advisers only being responsible to the legal entity and not the shareholders is a little ugly – that basically means there can never be standing for an after-the-fact you-screwed-up suit because the seller, except in the case of larger companies selling off a division, always by definition ceases to exist when the deal closes, right? Whether the contract does or does not specify the amount of diligence, whether Goldman advised more questions asked be or not – those seem like important questions that should be discussed in court.

  24. Posted by vestel klima servisi | September 12, 2013 at 3:40 AM

    I wasn't referring to Matt, and I didn't say anything about financial reporters being lazy. I was referring to this quote specifically, but I thought it would be clear from the context:

    "Reporters for The Wall Street Journal did something the Goldman Four did not: they picked up the phone and called L.& H.’s supposed customers in Asia. They found that companies in South Korea and elsewhere that L.& H.

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    We're reading Matt, and our highly advanced algorithms have determined your the most insidious trader yet, we did Ctrl+F of your posts and found more mentions of materiality and "insiderishness" then anywhere, we've also decrypted that "meh" means "material extra hot." Just wait until we find out what company X is, then we'll get you!

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