Case Studies

The Case of Dragon Systems vs. Goldman Sachs: A Lack of Diligence

Today I revisited Greg Smith’s open resignation letter in The New York Times. I reproduce excerpts, wherein he highlights his key concerns, particularly of a culture that puts its own profits before the clients.

“To put the problem in the simplest terms, the interests of the client continue to be sidelined in the way the firm operates and thinks about making money. Goldman Sachs is one of the world’s largest and most important investment banks and it is too integral to global finance to continue to act this way”

He continues further on “It might sound surprising to a skeptical public, but culture was always a vital part of Goldman Sachs’s success. It revolved around teamwork, integrity, a spirit of humility, and always doing right by our clients. The culture was the secret sauce that made this place great and allowed us to earn our clients’ trust for 143 years. It wasn’t just about making money; this alone will not sustain a firm for so long. It had something to do with pride and belief in the organization.”

He ends with these parting words “Make the client the focal point of your business again. Without clients you will not make money. In fact, you will not exist. Weed out the morally bankrupt people, no matter how much money they make for the firm. And get the culture right again, so people want to work here for the right reasons. People who care only about making money will not sustain this firm — or the trust of its clients — for very much longer.”

Mr. Smith was part of the hedge fund advising team, but the problem it seems has become a part of Goldman Sachs culture for a while now.

In yet another case of callous carelessness by Goldman Sachs, this time in the case of Dragon Systems, Greg Smith’s point has been reiterated. Jim and Janet Baker were acquired in a $580 million deal, all in stock of the acquiring firm Lernout & Hauspie. For its role in the deal as Dragon System’s investment banker, Goldman Sachs earned millions in fees. Unfortunately for the Bakers Lernout &Hauspie went down in an accounting scandal – popularly known as cooking the books, and the Bakers lost their money and business at one go. In order to analyze what went wrong the Bakers discovered Goldman Sach’s pivotal role in misleading them and are now claiming damages and other charges which could be about $1billion.

The Bakers started their company in order to develop voice recognition systems. They are credited with the development of Dragon Speak Naturally, a continuous speech recognition software, which is considered the pre-cursor of today’s voice activated software, including Apple’s Siri. They considered making Dragon go public. In the meantime their ground breaking technology company was attracting several suitors including Sony for a buyout. Rather than negotiate the pros and cons of the possible acquirers, they turned to the expert in the field of mergers and acquisitions Goldman Sachs. For $5 million in fees Dragon Systems hoped Goldman would conduct a thorough check on each of the possible buyers and get the best deal for Dragon Systems, using their existing procedures and systems. Dragon Systems could be termed as a small customer, yet one that entrusted them with the important task of finding them the best buyer.

Goldman Sachs on its part promised to provide “financial advice and assistance in connection with this potential transaction, which may include performing valuation analysis, searching for a purchaser acceptable to you, coordinating visits of potential purchasers, and assisting you in negotiating the financial aspects of the transaction.”(Source: NYT: Goldman Sachs and the $580 Million Black Hole by Loren Feldman)

Having shortlisted L&H, Goldman Sachs was as part of the due diligence supposed to look into its key financials, customers, forecasted and current revenues, its agreements and licenses. Concerns were raised regarding L&H’s revenue and licenses in Asia, but no further research was forthcoming for Mr. Baker to review.

Unfortunately, Mr. Baker’s concerns turned out to be true. The Korean company responsible for a large part of its revenue turned out to be non-existent. Sales were made to entities which turned out to be related to L&H. They were prosecuted and found guilty of accounting fraud in 2010. L&H had attracted several retail investors and biggies like Microsoft thanks to its seemingly spectacular growth. Their numbers seemingly had slipped scrutiny by its auditors KPMG.

Despite wanting to close the deal, Ms. Baker spoke of her concerns of erratic movement in the L&H stock. She was assured by the then Goldman analyst Charles Eliot that this was being seen in the market in general. Later during the trial Mr. Eliot conceded that he was unaware of L&H’ s Asian revenues at the time of making his findings, and had he been aware, he would have found it erratic indeed.

Eventually Goldman Sachs advised the Bakers to go for an all-stock deal as L&H’s stock continued its upward trend. The deal was closed. The Wall Street Journal during an investigative report on L&H uncovered its Asian customers, were in fact not its customers at all. Soon things unraveled at L&H, the stock became rubbish and the Bakers lost all the value in stock. ScanSoft bought most of Dragons technology and soon became a behemoth in the voice recognition industry, with a deal with Apple. They were bought out later by Nuance.

The Bakers later got to know that even as Goldman Sachs brokered the Dragon systems deal with L&H, they themselves had considered investing with L&H. However, Goldman had found as part of their due diligence several questionable figures and had decided not to go ahead with their $30 million proposed investment. They did not however consider it important to caution their customers about their findings. Goldman was also at the same time handling the IPO for Nuance, rivals to the Dragon Systems. The Bakers perhaps would have reconsidered dealing with Goldman Sachs if they knew this. In the end when L&H collapsed, the Bakers lost on the dream of continuing to work on their research, as the technology was acquired by another company.

They saw their lifetime’s dream and earnings go down the drain, thanks largely in part by the ineptitude and lack of professionalism by Goldman Sachs.

Goldman Sachs has in its part pointed fingers to the fact that only Dragon Systems (now defunct) and not the Bakers could sue them. It has also highlighted that a fairness opinion on the sale price was not sought as well as allegations that Ms. Baker attempted to stall the due diligence process. The case is expected to go to trial in Nov 2012. Goldman stands its ground despite mounting evidence that it probably did not protect its customer Dragon Systems, which it could in its professional capacity enabling for the Bakers a far happier result than it did.

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