Sour Deal Offers Lesson on Banks' Limits

By Davidoff, Steven M | International Herald Tribune, January 31, 2013 | Go to article overview

Sour Deal Offers Lesson on Banks' Limits


Davidoff, Steven M, International Herald Tribune


One lesson to be learned from Goldman Sachs's victory in a legal dispute over Dragon Systems may be an old one: If you do not know who the chump is, then you are probably it.

One 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 do not know who the chump is, then you are 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 of the risks. That may have succeeded as they built 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 about 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 had been 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 team of inexperienced and young Goldman bankers who botched their job, leaving the Bakers in the lurch and Goldman $5 million richer from its fee. All four subsequently left Goldman.

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 had been 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 make a deal with Lernout as quickly as possible, the Wall Street firm argued. Goldman even sent a memo to the company warning that for those reasons, it should conduct extensive due diligence on the accounting at Lernout. That, too, was ignored.

And there were other problems. …

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