The Bible isn’t nice to giants. Goliath goes down to a single stone from a slingshot-tossing boy.
And Samson, whom the ancient Hebrews thought was so strong he could lift two mountains and rub them together like lumps of earth, fell for the temptress Delilah; she got him to go to sleep, then sapped his strength by cutting off his hair. JP Morgan (JPM), the largest investment bank in the US, likes to think of itself as the friendly giant when things are going well in the mountain-rubbing business; but the unconscious, defenseless victim when things go badly.
Last week at one end of the world, JPM claims to have known everything and been responsible for every successful turn in the financial fortunes of its client, a mining company, arguing it deserves to earn multiple multi-million dollar fees for doing so. At the other end of the world, the bank claims to have known nothing at all about the multi-billion dollar criminal fraud perpetrated by its client, who enriched himself by moving his unlawful proceeds in and out of JPM accounts.
On Friday, lawyers for JPM wound up their argument in the New South Wales court of appeals in Sydney, Australia. This is a case which is challenging the mining industry consensus on what investment bankers really earn, and deserve to be paid, when metal prices skyrocket, and mining company takeovers command premium prices. JPM lost at the first court level in March of this year, when state Supreme Court judge David Hammerschlag (“Hammer Blow”) ruled that JPM hadn’t earned its fee claim of A$50.18 million (dollars are Australian unless noted). Hammerschlag dismissed JPM’s demand for the money from its mining company client, Consolidated Minerals owned by Gennady Bogolyubov, calling it “capricious, unreasonable and unjust”.
Hammerschlag also calculated that JPM was entitled to a total fee of $19,250,680.08, comprising a combination of “base defence response” and “incentive” fees, engagement bonus, monthly retainers for services, and costs. Such liability was offset by the $20 million payment by cheque on 12 February 2008 which Consolidated Minerals sent JPM on February 6 of 2008, and which JPM banked immediately.
According to JPM, the trial judge made counting and reasoning mistakes, and that JPM should be “rewarded for obtaining ‘additional value’ for the shareholders by reference to the additional value actually achieved.”
Last week in New York, details of a lawsuit against JPM were unveiled by Irving Picard, the US-court appointed trustee for the investment businesses of convicted fraudster, Bernard Madoff. Picard’s lawsuit charges JPM with being the primary banker for Madoff, arguing that “JPMorgan was wilfully blind to the fraud, even after learning about numerous red flags surrounding Madoff. While many financial institutions enabled Madoff’s fraud, JPMorgan was at the very centre of that fraud and thoroughly complicit in it.” The trustee is suing for US$6.4 billion. JPM replies: “As a provider of regular commercial-banking services,” the bank claims it is in no way liable for what it didn’t know of how the money was earned.
The New York case documents are still sealed, and won’t be argued by lawyers in front of a judge for several months. The Sydney appeal has already been argued through 83 pages of court filings, and two days of hearings on December 2 and 3. The three-judge Sydney panel will issue their ruling in February or March.
Their decision, plus Hammerschlag’s, have global significance, because they will determine what services investment banks like JPM actually provide clients engaged in mergers, acquisitions, friendly and hostile takeovers – and what ought to be the relationship between what the banks demand for reward and what the outcome is for their clients. For the first time in a court anywhere in the mining world, Bogolyubov’s company is arguing the giant investment bank didn’t earn what it claims, because most of the premium in takeover price resulted from other factors — the global boom in manganese and steel prices, and a bidding competition which JPM did nothing to introduce or encourage.
Less money is involved in the Sydney case than in the New York one, although all the big money in global transaction advisory fees which investment banks charge hangs on the Sydney court ruling. The original claim by JPM against Consolidated Minerals was for a fee payment of $86,978,264.18. This was subsequently reduced in court to a claim of $50,818,436.18. Because Consolidated Minerals has already paid $20 million of the JPM bill, the balance still in demand before the court is roughly $31 million, with extra interest and possible court costs. However, at one point in the latest proceedings, JPM argued afresh that its fee claim could go as high as $66.4 million. Consolidated Minerals has charged JPM with “double counting”, “double dipping””, with fee claims that are “commercially absurd”.
Both JPM and Consolidated Minerals agree that between October 2006 and January 2008, the market capitalisation of the mining company jumped by $805 million – from a starting point of $495 million to a closing point of $1.3 billion. But the dispute between them which the court must settle is when exactly the bidding process started, and when JPM started earning the fees it is claiming. At stake was one of the largest manganese mining operations in the world with almost 18 million tonnes of estimated reserves and resources of manganese, a hardening alloy required by steelmakers. As steel prices shot up from 2006, principally driven by China, so did manganese prices:
In the middle of 2006, Consolidated Minerals, thinking it might become a takeover target, negotiated an agreement for JPM to act as an adviser in relation to “any actual takeover, merger, or other business combination offers” which might materialise. Many offers did. But Consolidated Minerals has told the court JPM “promised to do very little…[Its promised] services are essentially matters of analysis and advice. Notably, the Bank did not promise to try to organise an auction for the company or even to solicit any offers.”
As several bidders emerged to make counter-bids against each other, and the share price of Consolidated Minerals rose, Hammerschlag has ruled that “[at] least part of the reason for the significant increase in the amount offered was an increase in the price of manganese…”
Consolidated Minerals argues in support of the Hammerschlag decision that JPM had a duty to “assist the Company to achieve the highest Offer price, irrespective of who was bidding or when they bid.” The fee JPM has called its Base Defence Response Fee has been calculated as 0.75% of this added transaction value, or 1% if the deal was completed. On top, JPM is demanding a 3% Incentive Fee; based on the formula of any increase in the Offer price up to 25% above the initial Offer, and 5% of any increase in the Offer price of more than 25% above the initial Offer.
That, Consolidated Minerals testified to the appeals court, ” is properly understood as a bonus where J.P. Morgan did something above and beyond, namely, assisting Consolidated Minerals to get a particular bidder to offer a higher sum than it was willing to pay in relation to its opening proposal. In the context of a bidding war, it was a reward for keeping a particular bidder – the one who ultimately wins – in the process.”
The bigger issue that has now surfaced is whether JPM had a duty according to its service agreement with its client, and cannot later claim to earn an additional incentive fee for doing what it was already duty-bound to do.
The winner of the bidding match for Consolidated Minerals was the Ukrainian Bogolyubov, who is developing manganese production mines and refineries across the world from Australia to Ghana and Ukraine. But Bogolyubov started buying shares of Consolidated Minerals well before the bidding contest started and he joined it. JPM insists that the $14 million Bogolyubov spent on this 14.29% pre-bid stake ought to be counted as part of the transaction value on which its fees should be based. Hammerschlag threw that out as an unearned.
JPM argued last week the judge had made a mistake, because the final value of the transaction included the value push Boglyubov had originally given, whether or not he intended at the time to enter a bidding war. Consolidated Minerals told the appeals court that since there was no evidence of a link between the first share purchase by Bogolyubov and his final and successful takeover bid, “the connection was missing” between what happened, what JPM did, and what it claimed it had earned.
Consolidated Minerals has also accused JPM of inflating its fee calculation by adding to the transaction value at the end of the takeover process $44 million in net debt which Consolidated Minerals was holding. Judge Hammerschlarg rejected that part of JPM’s fee claim, saying it had confused the fundamental distinction between the company (which was responsible for its debts), and its shareholders (who were not). Consolidated Minerals argues in its appeal brief that the share price of a company always reflects its debt position, as well as its income and other assets. So for JPM to count its fee from the rise in the share price, and also from the debt, “would be double counting”, records the brief. Counting assets and liabilities on top of the share price, in order to boost the bank’s fee “would make a nonsense of the commercial purpose of the definition of Transaction Value.”
As for JPM’s claim to get paid multiple fees for the multiple bids in the bidding contest, Hammerschlag called that capricious and unreasonable. That conclusion “must be right,” Consolidated Minerals told the court, “otherwise it would be entitled to as many …fees as there were unsuccessful bidders, even though the ‘defence’ failed because the company was taken over. It would not matter how unrealistic those bidders’ failed offers had been: J.P. Morgan would get ‘a fee equal to 1.0% of the proposed Transaction Value’ for each of them. There can be no commercial justification for such an outcome… It would be commercially absurd for the Bank to double dip, picking both an Incentive Fee covering that period, and also several Base Defence Response Fees triggered by [Consolidated Minerals] board recommendations to reject the very offers which made the Incentive Fee possible.”
Before Hammerschlag’s ruling, JP Morgan’s Sydney Managing Director Jon Gidney was asked to clarify why his bank believes it is proper to claim duplicate or triplicate fees for the the services rendered in the Consolidated Minerals case; and to explain how he justifies fees for services that appear to have ended in failure, and for Bogolyubov’s success which was guided by a rival bank at a significantly lower charge. Gidney declined to respond, adding: “I don’t think there is any purpose in having this discussion.” All JP Morgan’s Sydney spokesman Andrew Donohoe would say after Hammerschlag’s ruling was that “we believe there are strong grounds for appeal.”
Gidney was questioned in court during the initial trial before Hammerschlag. The transcript of what he said appears in the submissions to the appeals court this past July. Gidney admitted being worried that JPM’s fee demand might not be paid by Consolidated Minerals. He was then asked if his concern was “whether or not JP Morgan had really earned the fee as opposed to there being a spike in the manganese price which had driven the share price up?” Gidney replied: “Yes.” “And you were worried, were you not, that JP Morgan might never get paid unless it sued?” “Yes.”
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