July 18, 2012

What is the Financial Advisor’s Role in a Deal? The Dragon Systems Situation

Here are some interesting thoughts from Kevin Miller of Alston & Bird:

Recently, the NY Times published a provocative article regarding pending litigation against Goldman Sachs arising out of GS’s role as financial advisor to Dragon Systems in connection with the sale of Dragon Systems to Lernout & Hauspie in a stock for stock transaction in June 2000. The alleged facts as described in the NY Times article and a federal court decision on a motion to dismiss plaintiffs’ claims are taken from plaintiffs’ complaint – which for purposes of defendant’s motion to dismiss, are generally assumed to be true – and do not reflect judicial determinations of fact after a full trial.

Here are selected slides summarizing a 2009 decision – Baker v. Goldman Sachs – on a motion to dismiss plaintiffs’ claims as well as certain takeaways from that decision (see also John Jenkins’ blog about this case).

Questions to consider include:

1. If L&H’s auditors were fooled after expending substantially greater time and resources auditing L&H’s financial statements, should a third party’s financial advisor with more limited access have liability for failing to uncover financial fraud?

2. If two years earlier GS (or according to the 2009 decision, it’s client GE) had signed a CA in connection with its evaluation of a potential principal investment in L&H and that CA prohibited GS (or GE and its representatives) from using the information it obtained for any purpose other than their evaluation of a potential principal investment in L&H, was that GS team legally permitted to disclose the confidential information it obtained and the views it formed thereon to the GS M&A team advising Dragon Systems or, directly or indirectly, to Dragon Systems itself two years later?

In addition to the takeaways in the slides, some financial advisors have added language along the lines of the underlined last sentence below following more typical language in their engagement letters to emphasize that their financial advisory services do not include performing financial diligence on behalf of their clients:

“[Financial advisor] will rely upon and assume the accuracy and completeness of all financial and other information furnished by or discussed with the Company, any other party to the proposed Transaction and their respective representatives, or available from public sources, and [financial advisor] does not assume responsibility for the accuracy or completeness of any such information. It is understood and agreed that [financial advisor] will not and will have no obligation to verify such information or to conduct any independent evaluation or appraisal of the assets or liabilities of the Company, any other party to the proposed Transaction or any other party and [financial advisor] will assume that any financial projections or forecasts (including cost savings and synergies) that may be furnished by or discussed with the Company or any other party to the proposed Transaction or their respective representatives have been reasonably prepared and reflect the best then currently available estimates and judgments of the Company’s or such other party’s management. The Company understands that [financial advisor] is not a legal, accounting or tax expert and is not undertaking to provide any legal, accounting or tax advice in connection with the proposed Transaction. [Financial advisor]’s role in reviewing any information is limited solely to such review as it deems necessary for purposes of its analysis and advice and shall not be on behalf of the Company.

See also the 7th Circuit’s 2008 decision in HA-LO:

“CSFB followed the norm in this business–more to the point, it followed the rules in its contract with HA-LO–and relied on management’s numbers. It told HA-LO to hire someone to check those numbers. Separating number-creation from number-evaluation is not illegal and may make business sense. The division of labor between number verifiers (Ernst & Young) and number crunchers (CSFB) is not to be sneezed at; the division of labor has large benefits for an economy, as it allows specialists to do what they are best at . . . . This suit is nothing but an attempt to find a deep pocket to reimburse Investors for the costs of managers’ blunders. But CSFB did not write an insurance policy against managers’ errors of business judgment. Compelling investment banks to provide business-risks insurance as part of a fairness opinion would just make investors worse off, as that would increase the price of each opinion. Investors would pay ex ante for any benefit received ex post–and the bar would pocket a substantial portion of the transfer payments.” HA2003 Liquidating Trust v. Credit Suisse Securities (USA) LLC, 517 F.3d 454 (7th Cir. 2008)