Big Stakes High and Hangover

How much would you pay for a high tech startup with an unproven online sales system that was consuming capital at $3 million per month but had never made a sale? Before you answer, step into the time machine. It's 1999. Internet mania is everywhere and everyone wants a piece of the web. John Kelley was CEO of HA-LO Industries, an old tech manufacturer of promotional swag: coffee mugs, sun visors and the like emblazoned with a company logo and destined for giveaway ignominy. John Kelley decided that HA-LO would pay $240 million to acquire Starbelly.com, Inc. That's how the story started. The story ended last week in The HA2003 Liquidating Trust v. Credit Suisse Securities (USA) LLC, before Judge Easterbrook and the Seventh Circuit Court of Appeals. What happened in between is a sobering look at big stakes high and hangover.

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HA-LO agreed to purchase Starbelly for about $100 million in cash with the balance of the purchase price to be paid to Starbelly shareholders in HA-LO stock. HA-LO didn't have that kind of cash laying around so it did what everyone was doing. It hired Credit Suisse First Boston (CSFB) as its investment banker and Ernst & Young (EY) as its business consultant. Kelley got himself a seat at the cool kids' table.

CSFB went to work. It tried to renegotiate the price. It figured out how to structure HA-LO's payments to avoid violating HA-LO's pre-existing loan covenants. It found new lenders willing to finance HA-LO's acquisition cash requirements. It reached a standstill agreement with Starbelly shareholders to prevent them from exercising control over HA-LO as its new stockholders. CFSB also issued a "fairness opinion" in which it stated that the "merger consideration is fair to HA-LO from a financial point of view." Fairness opinions like the one issued by CFSB were and are required (or at least strongly recommended) by the Delaware Supreme Court since 1985 as a means by which corporate management can assure corporate shareholders that a proposed acquisition is in their best interests.

CSFB's fairness opinion was issued pursuant to a contract with HA-LO, styled an engagement letter. The terms of the engagement letter required CFSB to issue its opinion based on a valuation of Starbelly provided to it by HA-LO management. HA-LO asked EY for its independent assessment of the value of Starbelly. EY told HA-LO that HA-LO management's projections as to the value of Starbelly were " unrealistic" and that Starbelly was unlikely to generate anything close to the revenue stream HA-LO management had projected for it. Kelley ignored EY's valuation and instead supplied his own valuation for CSFB to use as the basis for its fairness opinion.

CSFB's fairness opinion was dated as of January 27, 2000. In April 2000, it was sent to shareholders who approved the merger which closed in May 2000. One year later, after the dot.com bubble had burst, HA-LO filed for bankruptcy. Starbelly's technology had flopped as EY predicted. HA-LO buckled under the strain of Starbelly's relentless losses and its own gigantic acquisition debt service. All that survived HA-LO's bankruptcy was a liquidating trust that set about to sue on behaof of HA-LO just about every solvent thing HA-LO had ever touched.

The Trust sued CSFB. It alleged that CSFB was negligent in issuing its fairness opinion based solely on HA-LO management's valuation of Starbelly. The district court held in favor of CSFB and the Seventh Circuit affirmed. CSFB did what the engagement letter required it to do-- issue its opinion based on the valuation data provided by HA-LO management. Its contract in the end protected it from liability.

Judge Frank Easterbrook for the Seventh Circuit cut to the quick-- contract beats tort any day of the week:

"CSFB did not write an insurance policy against managers' errors of business judgment. Compelling investment banks to provide business-risks insurance as part of a fairness opinion would just make investors worse off, as that would increase the price of each opinion. Investors would pay ex ante for any benefit received ex post -- and the bar would pocket a substantial portion of the transfer payments. "

The question left unanswered at the end of the story is the one I find most compelling. Why did Kelley do it? What drives a man to ignore Ernst & Young's bottom line in favor of a dream of dot.com corporate swag domination?

The case is available on the Seventh Circuit's website. Enter case number 06-3842.