I find the story of Dragon Systems hilarious and horrifying so I'm never going to miss an opportunity to tell you about it and one occurred today. The story, quickly, is (1) Dragon Systems, a closely held speech-recognition company, hired Goldman to advise it on a merger with Lernout & Hauspie, (2) Goldman assigned Dragon an extremely JV team of bankers, (3) Dragon sold itself to L&H in June 2000 in an all-stock deal, (4) L&H soon turned out to be a massive fraud, and (5) L&H filed for bankruptcy in November 2000 and Dragon's shareholders lost $300 million. Dragon sued, Goldman won a trial in January, and today they won some more, for reasons I'm not clear on. That is, I'm not sure why they had to win again - the judge issued an opinion finding in favor of Goldman, even though a jury did the same thing in January. Also it's not much of a stirring win:
Based on plaintiffs’ credible expert testimony, I conclude that the Goldman team’s work on the transaction was professionally negligent by not adequately analyzing the Asian revenues, reviewing the licensing agreements, and scrubbing L&H’s projections. ... Goldman points out that Dragon did not pay extra money for a fairness opinion. However, it still had a duty to use reasonable care in conducting financial due diligence consistent with standards of care in the profession. The reasons why small startup companies like Dragon go to a place like Goldman to assist with hatching their golden eggs is because they don’t have their own expertise to analyze revenue projections by asking tough questions to potential merger partners.
Still, I give weight to the fact that the jury found for the defendant on this claim and there was sufficient evidence to support that finding even if I conclude otherwise.
Sweet! And, true, in hindsight Goldman's diligence seems pretty weak, consisting as it did mainly of sending Dragon a memo saying "hey you might want to have an accountant do some accounting diligence." (Dragon didn't, it seems.)1
The sense you get from the opinion is that Dragon's prickly owners and their absent-minded Goldman handlers did not really trust or enjoy spending time with each other. For instance, when Dragon founder Janet Baker agreed to the all-stock deal, it was on a napkin far from Goldman's prying eyes:2
On March 8, 2000, Dragon CEO Don Waite of Seagate, the Bakers, L&H, and L&H’s advisors SG Cowen held a meeting to discuss the terms of the proposed merger. No one from Goldman attended the meeting. ... By the end of the meeting, Janet Baker and Roel Pieper of L&H signed a handwritten agreement setting forth a fixed exchange ratio for an all-stock acquisition of Dragon. This same exchange ratio was included in the definitive merger agreement on March 27, 2000. Janet Baker made this napkin agreement without consulting Goldman.
And in turn the Goldman team decided to keep their thoughts to themselves:
Goldman was dissatisfied with respect to L&H’s answers on many due diligence questions up until the last moment. The transaction would likely not have gone forward if Goldman had voiced its ongoing concerns about financial due diligence. In his deposition, [Goldman VP and team leader Richard] Wayner said he did not disclose any concerns he had about due diligence at the March 27 meeting because “the client did not ask.” At trial, Wayner added that he had already expressed his concerns to Chamberlain and Janet Baker, and it was Dragon’s responsibility (not his) to ensure due diligence was complete. So he remained mum.
A platitude that lots of senior investment bankers like to say is that the best thing a banker can do for a client is tell them what they don't want to hear. There's a reason that senior bankers have to say that a lot! It goes against junior bankers' natural instincts. Wayner, remember, was a fairly junior VP running a deal that was going to bring in a $5 million fee if it closed, and zero if it didn't. Can you imagine the conversation he'd have with his MD if it didn't?
Q. What happened?
A. Well, we just didn't feel great about the answers we got about the buyer. We thought they might be a huge fraud.
Q. Wait, the buyer is a public company, right?
Q. Does the stock price suggest that the market thinks they're a huge fraud?
Q. Do their auditors think they're a huge fraud?
Q. Does our research coverage think they're a huge fraud?
A. No. Though, I mean, the coverage analyst left a few weeks ago. But the sector analyst is optimistic.
Q. So ... you and your team of two analysts just decided that they were a fraud, on your own?
A. Yeah, pretty much.
Q. And you killed a deal with a $5 million fee, for a client who really needs a merger to get out of financial difficulties, just on your own hunch?
A. That's about the size of it.
Q. SON, TODAY YOU ARE A MAN, I AM SO PROUD OF YOU.
Maybe, I dunno. Anyway I bet this was a really awkward board meeting:
On March 27, Dragon held a meeting to consider the proposed acquisition of Dragon by L&H. In attendance at the meeting were: the Bakers, [and various Dragony people]. Goldman was represented by [technology strategist Christopher] Fine and [TWENTY ONE YEAR OLD IBD ANALYST T. Otey] Smith. They all sat around a table. Wayner called into the meeting from Argentina, where he was on vacation. During the meeting, Janet Baker asked the Goldman team to comment on the transaction. According to the minutes of the meeting, the Goldman team “noted that the combination of [Dragon] and [L&H] would create a significant critical mass of technology leadership. They noted that the currency for the Merger, the [L&H] shares, was rather volatile, but noted that market conditions in Europe for [L&H] were quite favorable.” ... The Board subsequently voted to approve the transaction, and the plaintiffs signed the merger agreement and the voting agreement.
Hahaha "well we told you that the L&H shares were volatile" etc. etc. That is some wishy-washy shit.
What's nice about this decision is that, though Goldman "won," the judge's decision that they were "professionally negligent" should seep through investment bank lawyers to influence actual investment banking. The opinion notes that
Goldman Sachs has a written policy manual describing in detail the due diligence obligations of bankers who work on financing transactions. To meet their due diligence obligations for financing transactions, Goldman bankers “will interview a number of persons connected with the issuer to discuss marketing, manufacturing, financial and other business matters. In particular instances, they may also interview the issuer’s customers, suppliers, competitors, bankers, and other lenders.” While this manual is a helpful guidepost, Goldman has no such manual to provide guidance to investment bankers who provide financial advice, assistance and valuation services in mergers and acquisitions transactions.
Why is that? Because "due diligence" is a legal concept that has real liability implications in underwriting deals: if you underwrite an offering that goes south, a "due diligence defense" can save you from liability. Due diligence in M&A is just an analogy, a pseudo-technical phrase to describe generally helping a client understand a merger partner; there's no actual legal requirement for it. Though I guess now maybe there will be.3
Which will probably be good for junior bankers. Part of the training that turns a 22-year-old Excel jockey into a trusted corporate advisor is learning when to tell the client what she doesn't want to hear - when to say no to a deal, and a fee, because it's not in the client's best interests. That's something that gets a lot of lip service, but it's tough for a junior banker out on his own to actually do it. "I relied on my years of experience and my professional judgment to tell the client a hard truth and turn down money for the firm" sounds lame when your years of professional experience are, like, four. A decision like this creates legal obligations, which leads to lawyerly nervousness, which leads to policy manuals, which provide cover for junior bankers to push back on clients and MDs who just want to get a deal done. "I relied on my professional judgment and also this mandatory policy manual to insist on more due diligence" might actually work.
Baker v. Goldman, Sachs & Co. [D. Mass. via Bloomberg]
1.Also they set up a conference call with Goldman's European software research analyst:
[Goldman banking VP Richard] Waynera arranged a teleconference call for the plaintiffs with Charles Elliott, Goldman’s European software research analyst. The purpose of the call, set up at [Dragon founder] Janet Baker’s request, was to update Dragon about Goldman’s research on L&H and the L&H stock. Wayner said the call with Elliott was “one of the more important things” Goldman did to help the Bakers assess the value of L&H’s stock. Elliott discussed how L&H accounted for goodwill, L&H’s stock movements, L&H’s growth through acquisition, and the effect on the European technology market of the decision by German pension funds to shift from fixed income to equity investments. Elliott was optimistic about how the stock market would react to the combination of Dragon and L&H.
So that's helpful, right? A green light from the analyst covering L&H? Except that in fact he wasn't the analyst covering L&H at all. He was just a guy. A guy with an amateur interest in Asian languages:
Elliott was not covering L&H at the time of the phone call. In fact, no Goldman analyst had been covering L&H since Robert Smithson, an analyst who reported to Elliot, had departed Goldman weeks earlier in December 1999. While Wayner was aware that Goldman did not have an analyst covering L&H, he did not communicate that to anyone at Dragon. Because Elliott was not covering L&H, he did not listen to the company’s February 9 earnings call or review relevant press coverage. Indeed, no one at Goldman had listened to the earnings call, which revealed the huge growth of Asian revenue. Elliot was “totally unaware of Lernout & Hauspie having any revenue in Asia” and would have been “very skeptical” if he had known of the revenue because he “kn[ew] something about Asian languages, and . . . the phonetic structure makes it incredibly difficult to take a European dictation software system and apply it . . . to Asian languages.” As will be seen, the false reporting of the Asian revenue was the heart of the fraud.
Oh man if only someone had told the guy who knew something about Asian languages about L&H's fraudulent Asian language dictation system, or something.
a.Quick team wheel:
Goldman assembled a group of four people to work on the transaction – three investment bankers (T. Otey Smith, Alexander Berzofsky, and Richard Wayner) and one technology strategist (Christopher Fine). Smith was a 21 year old banker who just graduated from college. Berzofsky, 25 years old, was actively pursuing other employment opportunities during the Dragon assignment. Fine focused largely on the technology aspects of the deal. Wayner, 31 years old, was the leader of the team. No senior Goldman Sachs investment banker did any work on the Dragon transaction.
2.Also there's a footnote:
Wayner claims he was not invited, but this seems unlikely since SG Cowen, L&H’s investment banker, was present.
Unless, y'know, L&H liked their banker, and Dragon didn't.
3.Goldman and Dragon each offered an expert witness to testify as to professional standards for M&A due diligence. Goldman's expert, Ian Fisher, "pointed out that the client is ultimately responsible for mergers and acquisitions due diligence on a counterparty" and opined that Goldman fulfilled its due diligence obligation "by drafting the due diligence list and sending the February 29 memo" telling Dragon to get an accounting firm to do accounting diligence. So: M&A bankers' due diligence obligation is limited to putting together a due diligence questionnaire. How expert was that expert anyway? From the opinion:
Fisher went to the MIT Sloan School of Management and worked in mergers and acquisitions at Merrill Lynch from 1975 to 1995. Fisher then started his own one-man “major Wall Street firm” located in California, which gave advice to only two clients in 2011. He had never testified as an expert in court before.