On May 17, 1998, a jury in the U.S. District Court for the Northern District of California found Bear Stearns professionally negligent in advising Daisy Systems Corporation regarding its acquisition of Cadnetix, Inc. and awarded $108 million in damages against Bear Stearns. The case has disturbing implications for investment banking firms, particularly with respect to the expansion of duties implied by the case. This article discusses the implications of the Daisy case for investment banking firms and suggests various ways that investment banking firms may attempt to limit their exposure in light of the case.
The case arose out of the efforts in 1988 of Daisy, a public company specializing in the development of computer aided engineering systems, to acquire Cadnetix, another public company in a similar line of business. Daisy retained Bear Stearns as its "exclusive financial advisor" and agreed to pay Bear Stearns $75,000 plus 1% of the value of the consideration received by Cadnetix if the merger were completed.
After friendly overtures were rejected, on the advice of Bear Stearns Daisy embarked upon a hostile takeover and began acquiring Cadnetix shares. Bear Stearns and Daisy then amended the terms of the engagement to provide that Bear Stearns would also assist Daisy in obtaining financing for the transaction. Daisy agreed to pay Bear Stearns 3/8% of the principal amount of the financing if Bear Stearns were to issue a "highly confident letter" with respect to financing for the transaction. Shortly thereafter Bear Stearns issued two highly confident letters, one for $50 million and one for $100 million, in connection with two offers made by Daisy.
After learning that Bear Stearns intended to finance the acquisition even if it were hostile, Cadnetix began negotiating a "friendly" takeover. Daisy and Cadnetix eventually reached agreement on a two-step merger pursuant to which Daisy would first purchase 50.1% of the Cadnetix shares for cash and then six months later purchase the remaining shares for a combination of cash and convertible debentures.
After completion of the first step, Daisy began arranging financing for the second step but encountered difficulty in light of the hostile nature of the transaction and the general difficulty of obtaining financing for high tech companies. Another engagement letter between Daisy and Bear Stearns was then executed which provided for Bear Stearns' retention as "exclusive agent in connection with raising all financing necessary to complete Daisy's acquisition of Cadnetix."
While seeking sources of long term funding, Daisy requested a bridge loan from Bear Stearns. Although the Bear Stearns Commitment Committee approved a $45 million bridge loan, the Bear Stearns managing director handling the transaction told Daisy that the Commitment Committee had turned down the bridge loan. At the same time, he advised Daisy that Heller Financial, Inc. would be willing to finance the second step. At trial, Heller representatives stated that the pricing proposed to Heller by Bear Stearns for the Daisy loan "far exceeded what we would normally receive in any other type of transaction."
After completion of the merger, Daisy's financial condition deteriorated and its creditors put Daisy into involuntary bankruptcy. Daisy's Chapter 11 trustee brought suit against Bear Stearns, alleging that Bear Stearns' advice to embark upon the hostile takeover was negligent, that it created severe financial problems and that it led Daisy down the path to financial ruin.
The trustee claimed that "the lack of publicly disclosed financing caused Daisy's major customers to defer their orders, and that at the same time, competitors were attempting to lure key employees away from the company." Consequently, the trustee argued, "Daisy was unable to meet its sales projections and was unable to refinance the company." The trustee argued that Bear Stearns, as professional financial adviser, should have known that a successful hostile takeover in the 80s of a high tech company would be unlikely and obtaining financing of such a transaction, at least in the 80s, would be both difficult and risky for the company. In short, the trustee argued that the highly confident letters and inadequate advice regarding risks led the company down a primrose path to financial ruin.
Legal History
Daisy's Chapter 11 trustee filed suit against Bear Stearns for professional negligence and negligent misrepresentation, and subsequently sought leave to amend the complaint to state a claim for breach of fiduciary duty. The district court denied leave to amend the complaint and granted summary judgment against Daisy on the other two claims. On September 24, 1996, the Ninth Circuit affirmed the district court's grant of summary judgment on the negligent misrepresentation claim, reversed the court's grant of summary judgment on the professional negligence claim and reversed the denial of leave to amend the complaint to state a claim for breach of fiduciary duty.
The Ninth Circuit rejected Bear Stearns' argument that Bear Stearns' duties were narrowly circumscribed by the duties enumerated in the engagement letter, accepted an expansive interpretation of Bear Stearns' duties proposed by Daisy's expert, as discussed below, and held that a genuine question of fact existed as to whether Bear Stearns breached its professional duty. In addition, the Ninth Circuit held that whether Bear Stearns had a fiduciary duty was a question of fact.
On remand, the jury found Bear Stearns professionally negligent, that Daisy suffered total damages of $277 million, that the percentage of damages attributable to Bear Stearns' professional negligence was 39%, and that the amount of damages to be awarded to the trustee was $108 million. Limiting the award to 39% of total damages was based on California's theory of comparative negligence, which essentially provides that if conduct by a plaintiff or any other person contributes in bringing about an injury, then the total damages to which the plaintiff is otherwise entitled is reduced to the percentage of total damages caused by the conduct of the defendant. The jury did not find a breach of fiduciary duty, but it is not clear from the record whether they found that no fiduciary duty existed or whether they found that a fiduciary duty existed but that it was not breached.
Bear Stearns then moved for a judgment notwithstanding the verdict, for a new trial as to liability and for a new trial as to damages. On August 7, 1998, the district court denied Bear Stearns' first two motions, but granted Bear Stearns' motion for a new trial for damages unless the trustee agreed to accept a reduced award of $36 million. The judge rejected the formula suggested by the trustee's expert (and apparently used by the jury) which based damages upon the pre-merger value of both Daisy and Cadnetix minus the assets in bankruptcy, and instead only used the pre-merger value of Daisy ($106 million) minus the bankruptcy assets ($14 million), multiplied by the jury's determination of Bear Stearns' share of the damages (39%).
Implications
Market Reviews and Use of Industry Experts. At the heart of the case is the claim that Bear Stearns was negligent in advising Daisy, without conducting an adequate market review, to embark upon a hostile takeover of a high tech company. The difficulty and risks inherent in a hostile takeover of a high tech company, where the key assets go home each night, are well known. It is not clear on what basis Bear Stearns suggested that Daisy proceed with the hostile acquisition nor what protections, if any, Bear Stearns proposed to minimize the risks.
The trustee argued that the Bear Stearns managing director handling the transaction lacked relevant experience and expertise, and suggested that this led to negligent advice. The Ninth Circuit stated that "Bear Stearns does not appear to argue that it conducted anything but a post-hoc analysis of the possibility of financing a hostile Daisy/Cadnetix deal" and that there was "no indication that Bear Stearns sufficiently analyzed market conditions before issuing the [highly confident letters]." The case highlights the importance of checking market conditions before advising a client to proceed with a transaction and the importance of providing an industry or transaction expert to handle a transaction. With sufficient recent experience with similar transactions, only a very limited market survey would be necessary. But with any financing that has novel or unusual aspects, initial discussions with potential lenders may be necessary.
Advice Regarding Risks. In describing Bear Stearns' presentation to the Daisy Board of Directors, the court made no reference to any specific discussion with the Board of Directors of risks inherent in the proposed strategy. It appears that Bear Stearns may have been able to avoid liability or limit its exposure if it had discussed alternative strategies and thoroughly explained the risks and potential problems with the proposed course of action. One hopes that this case does not force investment bankers to include prospectus-like risk disclosure statements in board presentations, but some investment bankers are moving in this direction and prudence suggests that more focus on this is appropriate.
Express Limitations on Scope of Services. The case underscores the importance of careful drafting of the description of services in an engagement letter. The Bear Stearns engagement letter, like many engagement letters, first stated that Bear Stearns would serve as financial adviser and then stated that the services would "include" several specific items. At trial, Bear Stearns argued that they had narrowed the scope of services to the specific services listed. The Ninth Circuit rejected this argument, noting that the letter did not state that Bear Stearns' role would be limited to the listed items. In the interest of obtaining an engagement, investment banking firms are understandably hesitant to narrowly circumscribe the scope of their services. The Daisy case, however, suggests that the price of using open-ended descriptions of services may be too high, and that where possible engagement letters should use limiting language (such as "shall consist of" rather than "shall include") and disclaim responsibility to provide related services that might otherwise be implied.
Risks Inherent in Appointment as "Exclusive Financial Adviser." The Ninth Circuit indicated that appointment as an "exclusive financial adviser" brings with it a broad range of responsibilities that might surprise some bankers. The court accepted the argument of Daisy's expert that:
as Daisy's "exclusive financial advisor," Bear Stearns should have assessed the risks and benefits of alternative structures for the transaction and the probable impact of the transaction on the market for the companies' stock, analyzed the effects of the transaction on Daisy and Cadnetix's business operation, determined financing alternatives and sources, analyzed operational impacts, and provided the necessary expertise to assess the feasibility of alternatives.
This description of services, which includes such items as analyzing the effects of a transaction on both companies' business operations, extends beyond the services many investment banker would assume are included in the role of "exclusive financial adviser." Would this include, for example, analyzing the compatibility and currency of software, which in fact was one of the major causes of the failure of the merger? Again, this suggests that the precise scope of services should be carefully described and limited in the engagement letter, particularly when the term "exclusive financial adviser" is used.
Potential for Fiduciary Duty. Even though the jury did not find that Bear Stearns had committed a breach of fiduciary duty, it is significant that the Ninth Circuit held that the question of whether a fiduciary duty exists in an investment banking relationship is a question of fact. The court indicated that in determining whether a fiduciary duty existed, the jury would need to consider whether Bear Stearns was in a superior position to exert unique influence over Daisy, whether Daisy reposed trust and confidence in Bear Stearns, and whether Bear Stearns acted as an agent of Daisy.
At trial, Bear Stearns argued that this was a transaction between two sophisticated business entities and that, as such, Bear Stearns did not have the requisite position of superiority inherent in a fiduciary relationship. Indeed, Bear Stearns noted that Daisy's board included high-tech industry experts such as an Intel board member and the founder of Scientific Data Systems and a corporate partner at a major law firm who was experienced in hostile acquisitions. This argument was countered by the trustee's claim Daisy management was unfamiliar with financial markets and public acquisitions, and therefor hired Bear Stearns for its expertise in these areas.
In its decision, the Ninth Circuit stated:
even though both parties were sophisticated corporations, the fact that Bear Stearns was retained to advise Daisy in a type of transaction with which Daisy had no experience suggests that the requisite degree of 'superiority' may have existed.
It is somewhat surprising to hear a fiduciary duty argument in a case like this between two highly sophisticated companies. Indeed, the dissent in the Ninth Circuit opinion stated:
Nothing in this case suggests that there was any fiduciary relationship whatever between these sophisticated entities or that [the trustee] can honestly plead one. [The trustee's] attempt to clothe Daisy in the weeds of a poor put-upon consumer of professional services borders on the ludicrous; I suspect that it is only in conditions of litigation that Daisy's high-powered executives would be willing to say that they were mere lambs under the protection of the shepherds at Bear Stearns.
The decision suggests that the level of sophistication of clients should be taken into account in structuring advice, but perhaps more importantly makes it clear that investment bankers cannot assume that even very sophisticated clients are knowledgeable about mergers and acquisitions and related financing matters.
To help reduce the possibility that a court will find that a fiduciary duty existed, it may be helpful to expressly disclaim any fiduciary duties. It is not clear, however, whether and under what circumstances such a disclaimer would be effective. In addition, because a finding that an agency relationship exists can support a finding of fiduciary duty, it is advisable for engagement letters to expressly state that the investment bank is not acting as an agent (unlike the Bear Stearns letter, which included a provision stating that Bear Stearns would be acting on Daisy's behalf).
Achieving Client's Objective Insufficient. Bear Stearns argued that Daisy's objective in retaining Bear Stearns was to acquire Cadnetix, that it was charged with "getting it done," that Bear Stearns' advice made that possible, and that therefor Bear Stearns fulfilled its duties. This is an appealing argument. The Ninth Circuit, however, determined that Bear Stearns' responsibility went beyond simply achieving the client's stated objective, and included a broader duty "to provide Daisy with reliable information based upon diligent and thorough analysis."
Disengagement Letters. Bear Stearns argued that it was not responsible for assisting the company in raising funds for the second step of the merger because this was outside the scope of its duties. Despite this claim, Bear Stearns began seeking financing for the second stage and then discontinued its efforts when it learned that Daisy was independently seeking financing from other sources. The Ninth Circuit not only rejected Bear Stearns' argument that its responsibilities did not include assistance with the second stage financing, but also rejected the notion that Bear Stearns' responsibilities had terminated because of Daisy's actions. If Bear Stearns believed that any of its responsibilities had terminated, it would have been well advised to have so notified its client, and, if appropriate, to have obtained a disengagement letter.
Indemnification Provisions. After judgment, Bear Stearns argued that it was entitled to indemnification under the terms of the engagement letter. The engagement letter provided for broad indemnification, but stated that indemnification did not apply to any loss resulting "primarily and directly from the negligence or willful misconduct of Bear Stearns." Bear Stearns argued that because the percentage of damages the jury found attributable to Bear Stearns was 39%, Bear Stearns was not the "primary" cause of the loss and therefor was entitled to indemnification. The District Court rejected this argument noting California's longstanding rule of "substantial" causation and essentially stated that the indemnity would need to be worded much more explicitly to reach the result argued for by Bear Stearns. It also is interesting to note that the indemnification exception was for negligence, not "gross negligence." One can only speculate whether a gross negligence standard would have affected the outcome.
Arbitration/Jury Trial
The case also raises the question of whether the outcome would have been different if it were heard before an arbitrator or if the parties had agreed to waive a jury trial. Consideration should be given to these matters when preparing engagement letters.
Conclusion
The Daisy case sends a clear warning to investment banking firms: carefully circumscribe your services or risk letting a court make that determination. This may be a good time for investment bankers to review their standard form engagement letters.
Endnote
* Unless otherwise noted, the information in this section was obtained from the Ninth Circuit court opinion, In Re Daisy Systems Corp. and Daisy/Cadnetix, Inc., Bear Stearns and Co., Inc., 97 F.3d 1171 (Ninth Cir., 1996). RETURN