Dragon, L&H, Goldman Sachs…
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Recommended reading: Loren Feldman, "Goldman Sachs and the $580 Million Black Hole", NYT 7/14/2012.
This story provides a shocking example of how little investment bankers often do to earn their money, and how badly they often do it; in short, how parasitic and destructive the culture of the financial industry has become.
By the end of the 1990s, there were many warning signs that the Lernout & Hauspie company was a sort of Flemish speech-and-language-technology Enron, basically in the business of kiting stock while pretending to be in the business of selling speech and language technology. I had heard strange and suspicious stories from acquaintances whose companies had been bought by L&H a few years earlier. A Dutch friend of mine with some knowledge of their activities had been referring to them for years as "the Flemish criminals". And apparently Goldman Sachs itself had previously considered investing in L&H, and decided not to do so.
Yet Goldman was happy to accept $5M to represent Dragon Systems in (what turned out to be) an all-stock $580M acquisition by L&H; for that sum, they assigned four 20-something I-bankers, who apparently did essentially nothing at all — and crucially, essentially nothing at all to verify the stability of the acquiring company.
Before the engagement letter was signed in late 1999, Goldman sent Dragon a memo indicating that its first steps would include beginning to conduct due diligence — Wall Street-speak for kicking the tires — on L.& H. The memo included specific areas of concern, including L.& H.’s sources of revenue, its major customers, its license agreements and royalty agreements, its expected growth, its partnerships and its financial statements.
But it now appear that essentially none of the promised "due diligence" was actually done.
Shortly after the Dragon acquisition was completed — and shortly before L&H collapsed in a swirl of international indictments — I remember hearing Paul Bamberg, then a Dragon vice president, explaining how the deal had changed from half stock, half cash to all stock, and thinking "uh oh".
[W]ho, if anyone, supervised these bankers — later called “the Goldman Four” in court documents — remains something of a mystery. One of the four, the most senior, 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.
Most of the Goldman Four didn’t stay long at the bank. 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. T. Otey Smith, then 21, left Goldman in 2000 and now works for RLJ Equity Partners. 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. Chris Fine, then 42, was a Goldman information technology specialist who was enlisted on the deal and is still with Goldman. (None of the four agreed to be interviewed for this article.)
So it seems that the people responsible for this disaster "failed upwards", as so often happens.
Update — The reaction to this story from all political and economic persuasions seems to be consistent, and consistently disgusted with the behavior of Goldman Sachs. Thus Scott McConnell, "Class Warfare, Romney-style", The American Conservative 7/16/2012 ("");
Goldman, for its $5 million fee, did zero due diligence. The couple which had developed the speech-recognition software lost everything. A Goldman banker quoted in the story said Goldman did a “great job” and “we guided them to a completed transaction.” […]
The tale seems so emblematic of the current age: the investment bankers reap large profits regardless of the impact of their work.
And mistermix, "Mooched and Looted", Balloon Juice 7/16/2012:
Remember this story the next time someone tries to tell you that Wall Street encourages entrepreneurs. This smart couple started a company in their kitchen, built it into an industry leader, turned to Goldman for financial advice, and Goldman sold them off to a company they knew had serious problems.
And "Deal of the Day", WSJ 7/16/2012:
The $580 million sale of Dragon Systems more than a decade ago raises question that go to the heart of how financial giants like Goldman operate and what exactly they owe their clients.
And Eapen Chacko, "Goldman walks over a client", Out of the Box 7/15/2012:
The Bakers are suing Goldman for about $1 billion. The objections by Goldman attorneys and spokespeople reported in the Times are arrogant and infuriating. The excuses are laughable.
Again, for this industry, we have FINRA, the SEC, and all manner of Federal agencies, and we can't get simple justice and fairness for entrepreneurs who were left high and dry by their bankers.
And "The Case of Dragon Systems vs. Goldman Sachs: A Lack of Diligence", Finance Train 7/16/2012:
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”
And "Goldman Sachs: We'll screw you however we can", CaroLINES 7/16/2012:
All in all, Goldman Sachs looks set to win this one. Just as they won with the financial crash – they helped precipitate it, profited from both ends and walked away shouting "Oh yeah, whatcha gonna do, little man?"
And Harry McCracken, "The Sad Death of a Great Company", Time Magazine 7/15/2012:
I’m not an expert on mergers and acquisitions and don’t have an opinion on the quality of Goldman’s advice. But I remember feeling uneasy about the Dragon sale at the time, and I wasn’t particularly surprised by the collapse of Lernout & Hauspie, an outfit whose specialties seemed to be generating hype and buying up other speech-technology companies.
Goldman's legal argument seems to be that their contract was not with the Bakers, but with Dragon Systems, which no longer exists, so that the Bakers have no standing to sue. That argument may very well be legally compelling — IANAL. But it's quite extraordinary that I haven't been able find a single article or blog post — left, right, or center — that substantively defends Goldman's actions in this case, or even argues that Goldman's treatment of the Bakers is atypical of the way I-bankers treat their clients in the U.S. these days.
The closest to an actual defense that I've found so far comes from "Al" in our own comments section, who accuses me of "uncritically regurgitating 'ooh, bankers are evil' newspaper stories", which implicitly argues that perhaps Goldman didn't do what the NYT article says they did, but rather did something else that would be less appalling, or perhaps even admirable, if we only knew what it was.
DaveL said,
July 15, 2012 @ 6:29 pm
And in the end, the only survivor was Nuance (formerly Scansoft), which owns all the intellectual property and all the smoking remains of L&H, Dragon, etc.
I wonder how many of the other mergers/acquisitions involved were "interesting"?
[(myl) As I understand the history, Nuance merged with Scansoft, which had bought the Dragon piece of L&H for $10M at the bankruptcy sale. In any case, Nuance now owns the Dragon name and the descendant of the Dragon Technology. As far as I know, there was no hint of any problem with either of those later stages of merger and acquisition. Nuance is certainly a serious company, in business to sell software and services.
L&H, in contrast, was primarily a scam, designed to make money by inflating its stock value — and it did achieve a total market valuation of some $10B by the end. In my opinion, there was plenty of evidence of that problem, for those with eyes to see. Of course, that was more or less standard practice during the dotcom bubble — except that on top of the then-usual smoke and mirros, L&H did some really egregious and outright illegal things, like setting up fake companies to book fake orders and pay it fake license fees. It was those illegalities that brought it crashing down.
its acquisitions were not fraudulent, as far as I know, except in the sense that the principals of the company were only interested in the acquired businesses as ways to inflate the value of the stock. The acquired companies were serious enterprises (at least the ones that I know about), if perhaps somewhat overvalued. But the company's leaders, though presumably not averse to making money the old-fashioned way, by inventing and selling stuff, seem mostly to have focused on methods for inflating their stock price by using a combination of PR and outright fakery.]
Al said,
July 16, 2012 @ 2:22 am
So very sad when a blog oscillates from beautifully perceptive analysis on language topics to uncritically regurgitating "ooh, bankers are evil" newspaper stories. How come the NYT gets to be read carefully and critically when writing on topic related to language, but taken as gospel otherwise?
[(myl) If you have some reasons to think that there are substantive or conceptual errors in the NYT story, feel free to explain them. All the background information that I have have about the situation — about the history of Dragon, the history of L&H, and the history of the acquisition process — is entirely consistent with the story's content. And although I have never had any financial involvement with any of these companies, I know many of the people involved, and I lived through the period as an interested close observer of the speech and language technology business.
I have no personal knowledge of the specific role of Goldman Sachs in the train wreck, but the charges made in the article are certainly consistent with what has been amply documented in other cases about the behavior of the financial industry in the dotcom and real estate bubbles, in the history of Enron, etc. Again, if you have some evidence about substantive or conceptual problems with that aspect of the article, you should tell us about them. Otherwise you seem only to be presenting a reflexive defense of the financial industry.
This is Language Log, not Finance Industry Log; but for a few detailed and quantitative papers and blog posts on relevant topics, see e.g. Thomas Philippon, "Are Bankers Overpaid?", Stern On Finance 1/20/2009 ("Overall, we conclude that bankers were paid about 40% too much in 2006."); "The Future of the Financial Industry", 10/16/2008 ("[T]he annual wage bill of the financial sector needs to shrink by approximately $100 billion."); "Has the U.S. Finance Industry Become Less Efficient? On the Theory and Measurement of Financial Intermediation", 2012 ("[T]he unit cost of [financial] intermediation in the U.S. economy has historically been around 2% (i.e., creating and maintaining one dollar of intermediation costs about 2 cents); (iv) surprisingly, however, the unit cost of intermediation is higher today than it was a century ago, and it has increased over the past 30 years [to about 8.4% today]. One interpretation is that improvements in information technology may have been cancelled out by increases in other financial activities whose social value is difficult to assess.")
This is not about "evil bankers" but about counter-productive socio-political choices.]
Edith Maxwell said,
July 16, 2012 @ 7:08 am
Interesting. I was employee #16 at Kurzweil Speech Systems, which morphed into Kurzweil Applied Intelligence (!). Dragon was our main competitor at the time (mid-1980s). After I left Kurzweil, they had their own little financial-mismanagement situation and were bought by L&H. I didn't really follow what happened to L&H after that – my once-sizeable stock shares had shrunk to the worth of the paper they were printed on.
Some of the original Kurzweil researchers are still at Nuance.
Liz said,
July 16, 2012 @ 4:28 pm
Actually, there is a fairly substantial language log aspect to the whole story – namely the language used in financial reports. L&H's fraud, being so substantial, was apparent even in that most fluffy of financial disclosures, the 20F which is what foreign firms file with the SEC instead of 10Ks. This document is much more comparable to the annual report – a few financial statements, a lot of blurbiage, plenty of white space, and some pretty pictures. The financial statements showed L&H making about 2/3 of its money in "consulting" which would make sense if buyers bought both the software and the services necessary to adapt the software to their highly specific needs. The problem was that the text in the 20F barely referred to those consultations. And that struck me as a writer to be very odd. How could there not be plenty to say about all this consulting work?
At the time I was analyzing these documents, a friend of mine asked if he should be investing in this company. I wasn't sophisticated enough to call what I saw fraud, but I did know enough to say "don't buy shares". About a month or two later – the arrests appeared in the Boston Globe, among other places. I was not surprised in the least.
[(myl) According to the NYT article:
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.
Although the Goldman Four never tried to call those customers, it emerged during litigation that other bankers at Goldman had done precisely that — about two years earlier, when Goldman itself considered investing in L.& H. in a plan known internally as Project Sermon. In it, Goldman’s merchant banking division took a closer look at L.& H. — but, apparently, never shared what it knew, and was never asked. Goldman was considering putting $30 million into L.& H., a step that, at the time, might have seemed conceivable, given the hype surrounding L.& H.
“Whenever we invest, we always want to talk to customers,” Luca Velussi, a Goldman analyst who worked on Project Sermon, later testified. Based on what Project Sermon’s team leader, Ramez Sousou, termed “preliminary” due diligence, Goldman declined to invest in L.& H.
And some of the Asian customers were shells, set up by L&H to channel fake orders and fake payments. That's what led to the indictments and the precipitated the final collapse.
My own reasons for doubt about L&H began in 1997, when the head of one of their early acquisitions told me about the experience of being acquired by them, and the things that happened (or more precisely, didn't happen, like any serious marketing or product development) afterwards. But by June 2000, it clearly wasn't necessary to go so far as to interview people like him in order to smell the problems at L&H.]
[links] Link salad looks back on Monday with rain in its eyes | jlake.com said,
July 17, 2012 @ 7:23 am
[…] Dragon, L&H, Goldman Sachs… — Ah, me. Investment bankers are so highly paid precisely why? […]