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Dragon Systems Shareholders Can't See The Bright Side In Well-Managed M&A Transaction That Wiped Out Their Life's Savings

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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.