Deutsche Settlement Warns Of Penalties for Conflicts: SEC Slams Bank and Asset Management Arm In Fallout of Hewlett-Packard Controversy

Buyers, sellers, and their advisers are on red alert that they must keep their relationships from getting too cozy during m&a transactions. In settling a messy action against Deutsche Bank AG and its Deutsche Asset Management Inc. (DAM) unit, in August, the SEC fired a warning shot that it would come down hard on any future conflicts that taint the deal process, according to m&a lawyers and market observers. The agency’s stance, they say, turns up the heat on key players to avoid conflicts of interest when they hire advisory and financial superpowers that can sell multiple services to participants in the same deal. The settlement is an epilogue to the highly controversial 2002 acquisition of Compaq Computer Corp. by Hewlett-Packard Co., a $24 billion deal bitterly opposed by several large stockholders, including Walter Hewlett, son of an H-P founder. Hewlett filed suit in Delaware to stop the deal, charging that investment manager DAM was pressured into voting most of its H-P shares in favor of the deal because Deutsche Bank provided other services to the computer products firm. Vice Chancellor William B. Chandler III says Hewlett fell short of proving the case, but raked officials of the bank, DAM, and H-P for the way they discussed the vote in a long-distance conference call. More than a year later, the SEC action surfaced evidence that some experts say might have won the day for Hewlett had it been known last year. Securities regulators reported the existence of a confidential agreement committing H-P to pay Deutsche Bank for investment banking services in connection with the acquisition – $1 million down, another $1 million if the deal went through. As the result, the SEC says, DAM was guilty of a “material conflict of interest.” Not only should the agreement have come to light, but DAM also had a fiduciary obligation to poll the actual owners of the shares and determine how they wanted to vote on the acquisition of Compaq, the agency says. At first blush, Deutsche appears to have gotten off easy – a $750,000 fine and no admission that it did anything wrong. But the experts say this is the way the SEC works. If there is a next time, for the Deutsche interests or anyone else that buys or sells multiple services in secret and raises a possible conflict, the agency will lower the boom. “I think it’s a warning shot,” says Charles Elson, professor of finance and director of the Corporate Governance Center at the University of Delaware. “Often the SEC will work this way.” The message apparently hasn’t been lost on many company boards, already galvanized by investigative demands of the Sarbanes-Oxley law. “Six months ago, people may have pooh-poohed this, but directors understand this stuff now,” says David Kauffman, a Chicago-based partner of Duane Morris. “People have to look real hard and look for the bogeyman in a lot of different places. Maybe they didn’t think about it much before.” The SEC case fingered the most obvious source of conflict – the adviser or financial supplier also can be a shareholder of either or both companies in an acquisition through its investment management arm. The connection offers potential for coercing the investment unit to vote as the client’s management wants. Richard Rowe, a partner at Proskauer Rose in Washington, says that typically the asset manager has a fiduciary relationship with clients and the discretion to vote stock. “But if there is a conflict, the SEC has said, they should have disclosed that relationship. They are not precluded from having that relationship, but it is something that should have been disclosed.” Elson says that Deutsche had a “firewall between these operations but the firewall broke down, and when they break down, trouble results.” “If you’re a fiduciary, your objective is to make money for your clients, not for yourself,” he adds. “When you combine those two roles, you are acting in your own interest, not in the interest of your clients. They should have disclosed the conflict and asked the clients how they wanted to vote.” But the fiduciary-adviser tension is only for starters on the conflict front. The reality is that a large advisory or financial institution can offer investment banking advice, lend money, market securities, restructure finances, write fairness opinions, calculate values, and sell insurance in the same transaction, while at the same time hold stock through asset management work. Although the regulators have yet to deal specifically with most of these interconnections, corporate legal advisers say it’s a good idea for their clients to take the initiative in treating all as potential trouble spots. A buying or selling company is not precluded from purchasing multiple services from the same adviser, as long as there is a good reason for it and the potential for conflict is made public. Indeed, the corporation may find “one-stop shopping” convenient or save money by dealing with one financial or advisory house. But the company may be headed for trouble if it can’t show real benefits in giving one adviser a virtual monopoly. “The company should ask why it has hired a particular advisory firm,” Kauffman advised. “The reason should not be just because it does other business with the firm. That smells to begin with.” Rowe notes that the “influence” of investment bankers over other parts of financial advisers “is something regulators are looking at carefully,” with the examination already yielding new regulations for financial analysts. “By rule, they now have to separate investment bankers and analysts,” he says. “This Deutsche case is just another aspect of that.” A blow for transparency Increased disclosure pressures may ultimately do away with most or all confidential agreements, but it’s an open question on whether and how they can be used in the future when a company contracts for advisory services. Again, deals lawyers suggest that secret agreements be challenged inside managements and boards to see if they must be kept under wraps. Lawyers contacted for comment were frankly astounded that Deutsche and H-P had signed the confidential agreement. They say confidential agreements sometimes are used when investment banks get search-and-screen, strategic advice, or valuation assignments. But the banks usually want to brag about straightforward investment banking consultations. “I think transparency is critical in cases like this,” Elson says. “Why would you want to keep it a secret that you were engaged by H-P and why would H-P insist that you keep it a secret if it was involved in a proxy contest where everything should be disclosed? All information placed before the voters could be relevant. The fact that they asked for a confidential agreement in and of itself raises questions. It gives credence to Hewlett’s allegations.” In Kauffman’s view, “it’s too early to tell” how secret agreements will fare. “Every instance is different, but you just have to think about it when you sign one,” he says. Companies and advisers should weigh the “risk” of conflict when they sign a confidential agreement, Rowe advises. In the Deutsche-H-P case, “if they would not have had a conflict, there would have been no issue.” The lawyers expect to carry the ball in seeing that their clients on all sides steer clear of conflicts. “You have to make sure the lawyers are looking at it from a 360-degree view and really know this stuff,” Kauffman advises. “Otherwise, they may not see the potential conflict ahead of time. Find good counsel and keep them. Then you have to think about ways of doing things that haven’t been thought about before. Why are people doing things this way? What are the alternatives? Why may we be going off the wall?” Rowe says legal counsel for advisers and asset managers probably should press them to reveal any conflicts, adding, “I do think it (the Deutsche settlement) is a warning shot. If you have these conflicts, you have to be careful and you can’t let your investment bankers run the company.” The SEC brought the case against DAM under the Investment Advisers Act. Moreover, an SEC official involved in the case noted that the agency would take action even if the conflict does not influence the outcome of a proxy vote. Helane L. Morrison, the agency’s district administrator in San Francisco, says the SEC order did not suggest that DAM’s shares put the deal over, but “…the order emphasizes that the proxy voting process was tainted by the failure to disclose the conflict. The message is that the process matters.” Copyright 2003 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com