June 25, 2003

Investment Bank Faces Fraud Suit Due to Statements as Buy-Side Advisor in Negotiation of Acquisition

In connection with acting as financial advisor to an acquiring company, SG Cowen was sued for fraud by the shareholders of the selling company for SG Cowen's statements and materials during negotiations.

In Bamberg v. SG Cowen Securities Corp., the U.S. District Court for the District of Massachusetts denied SG Cowen's motion to dismiss claims of fraud under Section 10(b) of the Securities Exchange Act of 1934 made by shareholders of Dragon, Inc. SG Cowen represented Lernout & Hauspie Speech Products ("L&H") in its acquisition of Dragon in a stock-for-stock merger. During the merger negotiations, SG Cowen provided various information to Dragon's shareholders to convince them to accept L&H stock as consideration in the merger. Such information included references to "L&H's strong revenue growth" and a deal book containing financials and projections for L&H. In addition to materials specifically given to the plaintiffs, SG Cowen also wrote analyst research reports and maintained a "strong buy" recommendation on L&H during the merger negotiations.

The Dragon shareholders fraud claim was based on the allegation that L&H improperly recognized inflated revenue from strategic partners who were not unaffiliated customers, but related parties. According to the complaint, SG Cowen representatives and analysts were aware of, approved, and even devised some of L&H's related party transactions.

Prior to the signing of the merger agreement, Dragon shareholders raised concerns regarding an article in The Wall Street Journal that questioned L&H's representations regarding its customers in Korea. In response to these concerns, an SG Cowen analyst told the Dragon shareholders that he had visited L&H's Korean operations and that L&H's customers were real. In fact, most of these customers did not exist.

In denying SG Cowen's motion to dismiss, the court stated that the financial reports, deal book, "strong buy" recommendations and oral representations regarding past revenue were more than just puffery by SG Cowen. The court concluded that this information was the kind of hard information that a reasonable investor could find important.

The court emphasized the close relationship between SG Cowen and L&H in determining that there was an inference that SG Cowen knew or was reckless in not knowing that the statements it made about L&H were not true. In addition to the alleged role of SG Cowen in structuring the related party transactions and denials of the allegations raised in The Wall Street Journal article, the court considered SG Cowen's long, lucrative advisor relationship with L&H over the years.

What to do?

There are a number of simple things that a financial advisor should do to reduce its liability for statements made during negotiations:

  • avoid direct representations to investors;
  • include disclaimers regarding source and completeness of information that a selling memo usually contains; and
  • if you must make affirmative statements, do the diligence necessary to assess reasonable accuracy and completeness of those statements.

In addition, a financial advisor should check the indemnification and contribution provisions of their engagement letter. One specific item to confirm is that contribution will apply even if the financial advisor is grossly negligent, because the financial advisor's client may still be significantly at fault even if the financial advisor is grossly negligent. An additional precaution is to insist that the investment bank is included in the "merger" clause in the merger agreement. A merger clause generally states that the merger agreement contains the entire agreement between the parties and that it supersedes all prior agreements, understandings and representations made by the parties. Courts have given weight to merger clauses and a financial advisor should consider requesting language in the merger agreement that states that the merger agreement supersedes prior agreements, understandings and representations made by the financial advisor.

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