Dragon Systems Founders Take Goldman to Trial Over Advice

By Bob Van Voris – Dec 9, 2012 9:00 PM ET

Jim and Janet Baker, pioneers in the field of computer speech recognition, turned to Goldman Sachs Group Inc. (GS) in late 1999 when they needed investment bankers to advise them on the sale of Dragon Systems Inc., the company they had spent 17 years building.

The Bakers, who started Dragon in their Boston-area home, had seen it grow into a company with $68 million in sales, more than 350 employees and operations in the U.S., Germany, U.K,France and Japan. They wanted to sell to a company that would let them continue to develop the technology they had spent their professional and married lives creating.

“This was the most important business decision of our lives,” Janet Baker said in an interview in the couple’s home in West Newton, Massachusetts. “We chose Goldman because of their global reach and their reputation as the world’s most important investment bank.”

In a federal lawsuit set for trial today in Boston, the Bakers claim that shoddy work by Goldman Sachs on the $580 million all-stock sale of Dragon to a Belgian competitor, Lernout & Hauspie Speech Products NV, cost them their company and their fortune.

Within months of the sale’s June 2000 close, Lernout & Hauspie collapsed in an accounting scandal and its shares that the Bakers took as payment for their 51 percent stake in Dragon were worthless. Worse, according to Jim Baker, they no longer had access to the speech-recognition technology they had created. The patents underlying Dragon products including their popular dictation program, Dragon NaturallySpeaking, were sold at a bankruptcy auction.

‘Like Our Child’

“Dragon Systems and the Dragon technology was like our child,” Jim Baker said in the interview in May.

Goldman Sachs says it isn’t to blame. The fraud at Lernout & Hauspie, which the bank said it couldn’t have been expected to discover, caused the Bakers’ losses, Goldman Sachs argued in court papers.

The bank also said its contract was with Dragon, which no longer exists, and argued that the Bakers themselves lack legal standing to sue. The New York-based bank said it advised Dragon to get its accountants, Arthur Andersen LLP, to probe Lernout & Hauspie’s financial status.

The four-man Goldman Sachs team assigned to the transaction provided Dragon with competent advice, the bank said in court filings.

Same Approach

“There’s no difference in the quality or the standard or the approach that we take in working on assignments for small companies or large companies,” Gene T. Sykes, Goldman’s head of mergers and acquisitions, said in a 2011 deposition in the case. “Every client, whether large or small, gets the same high- quality approach.”

The Bakers claim the opposite is true. The same year that the couple sold Dragon, Goldman advised mobile phone company Vodafone Group Plc (VOD) on its $185 billion takeover of Mannesmann AG and drugmaker Warner-Lambert Co. in its $120 billion sale to Pfizer Inc.

The Dragon deal, for which Goldman Sachs was paid $5 million, was “small potatoes” for the firm, the Bakers said in court papers. The four Goldman Sachs bankers assigned to shepherd Dragon through the sale were “unsupervised, inexperienced, incompetent and lazy,” they said in a court filing.

Mathematician, Biophysicist

James Baker and Janet MacIver met as graduate students and married in 1971. Janet brought a fascination with Asian dragons to the marriage.

Jim, a mathematician, and Janet, a biophysicist, said they methodically considered what area of research to spend their lives pursuing. They were looking for a field in which they could make a concrete contribution within 40 years or so — the span of a professional career, Janet Baker said. They chose computer speech recognition.

Much of the couple’s early work was done at the dining-room table in their Victorian home, which is still filled with dragons — dragon kites, a dragon sculpture by the door, the Bakers’ dragon-pattern wedding china.

After founding Dragon, the Bakers’ work proceeded apace with the development of desktop computers with ever-increasing memory and processing speeds.

Jim’s work in mathematics led them to apply a mathematical principle called Hidden Markov Models to predict what word would follow another.

In the 1980s, Dragon sold an early voice recognition program to a U.K. company called Apricot Computers Ltd. In 1990, the company introduced DragonDictate, a commercial dictation program.

“You had to pause … between … each … word,” Jim Baker said, describing the limits of the program.

From the start, the Bakers got feedback from early adopters of the technology, including many disabled people. They’ve kept letters from grateful customers who credited Dragon’s products with giving them new powers of communication.

NaturallySpeaking

The ultimate goal, a large-vocabulary, continuous speech recognition product that could register words as they were spoken, remained out of reach until 1997 when Dragon introduced Dragon NaturallySpeaking.

NaturallySpeaking had a dictionary-sized vocabulary and was available in six languages. Users could speak at a normal speed. Pauses were no longer necessary. Oscar-winning actor Richard Dreyfuss, a fan of the Dragon program, volunteered as master-of- ceremonies when it was introduced.

The product was a hit with consumers and won dozens of industry awards. The current version of Dragon NaturallySpeaking is sold by Burlington, Massachusetts-based Nuance Communications Inc. (NUAN)

The success of NaturallySpeaking brought Dragon into competition with companies includingInternational Business Machines Corp. (IBM) and Microsoft Corp. (MSFT), which were interested in developing their own speech-recognition products.

‘The Train Stops’

The Bakers, who were getting unsolicited offers to buy Dragon, knew they needed capital to develop their technology. That led to Goldman Sachs, the sale to Lernout & Hauspie and the loss of Dragon itself.

“It was devastating,” said Janet Baker. “You spend round the clock working on something for decades. And the train stops.”

Their case will be considered by a jury of six, with as many as six alternates, in the courtroom of U.S. District Judge Patti Saris. Saris, appointed by President Bill Clinton, has presided over civil and criminal cases, including one in which she accepted in April Merck & Co.’s agreement to pay a $321.6 million criminal fine and $628.3 million to resolve civil claims that it sold Vioxx for unapproved uses and improperly touted its safety.

Co-Founders, Witnesses

In a pretrial hearing, Saris said the Bakers case may take as long as five weeks to try. After a jury is selected, both sides may make opening statements today. The first witness will be either Jim or Janet Baker, their lawyer, Alan Cotler of Reed Smith LLP, told Saris.

The Bakers’ witnesses will include Paul Bamberg and Robert Roth, Dragon co-founders who held minority shares in the company. Bamberg’s and Roth’s claims against Goldman Sachs will be tried along with the Bakers’ in the trial.

Both sides said they will show jurors recorded testimony from Sykes. They also plan to present expert witnesses to testify about investment banking practices and to offer their opinions on Goldman Sachs’s conduct in the Dragon transaction.

Missed Meeting

Goldman Sachs didn’t take part in a crucial March 8, 2000, meeting set to put together final terms of the sale, according to the Bakers. The leader of the Goldman Sachs team was on vacation and said he couldn’t phone into the meeting, they said. It was at that meeting that Dragon agreed, disastrously, to the Belgian company’s request to change its half-cash, half-stock offer into one that paid only in Lernout & Hauspie stock.

The Bakers claim the Goldman Sachs team failed to investigate inconsistencies in Lernout & Hauspie’s financial statements that should have prompted them to steer Dragon away from the deal.

The Bakers point to press reports showing that Lernout & Hauspie’s reported revenue in Asiajumped from $9 million in 1998 to $138 million the following year.

Later, after the Dragon sale closed, the Wall Street Journal said reporters had contacted a group of Korean companies that Lernout & Hauspie identified as customers. Many of the companies said they didn’t do any business with the company.

And the Bakers may tell jurors that Goldman Sachs considered investing $30 million of its own money in Lernout & Hauspie in 1998, before it was hired to advise Dragon. The firm abandoned the idea, which it called “Project Sermon,” after pursuing due diligence, including calls to customers of the Belgian company. The Goldman team made no such calls in preparation for the Dragon transaction.

Fake Customers

“If Goldman had made even one such phone call to one of the many fake Asian customers that L&H was claiming were sources of huge amounts of new revenue, it would have raised a huge red flag that would have stopped the merger,” the Bakers argued in court papers.

According to the U.S. Securities and Exchange Commission, Lernout & Hauspie created bogus customers, booked circular transactions with shell companies and recorded loans as sales from 1996 to 2000. The company was forced to restate $373 million in earnings and filed for bankruptcy in November 2000.

The suit against Goldman was put on hold by agreement of both sides for years while the Bakers sued other participants and advisers in the deal. They’ve reached a total of about $70 million in settlements, their lawyer, Cotler, told Saris.

Based on the value of Dragon at the time of the sale, the Bakers’ lost as much as $288.8 million in the sale and its aftermath, they said in court filings. Bamberg and Roth have said they lost as much as $50 million.

In court filings, Goldman Sachs said the plaintiffs damages are less than the amount they’ve already recovered in settlements.

The case is Baker v. Goldman Sachs & Co., 09-cv-10053, U.S. District Court, District of Massachusetts (Boston).

To contact the reporter on this story: Bob Van Voris in New York at rvanvoris@bloomberg.net

To contact the editor responsible for this story: Michael Hytha at mhytha@bloomberg.net