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Putting Principle Before Profit

Here is a headline you don’t often hear: Investment Bank Turns Down Profit In Favor Of Ethics.

In the past few years, the public has learned quite a bit about Wall Street’s inner workings, and it certainly hasn’t been encouraging. Credit ratings agencies are under fire for rating trash as strong securities (see my favorite article on point), and banks are drawing negative attention for using their bailout funds questionably. But in such a fraught professional landscape, it is heartening to see a firm unwilling to sell its integrity for a profit.

In 2007, Houlihan Lokey, a California investment bank, refused to provide a solvency opinion to Tribune Company due to concerns about the proposed transaction’s high debt levels. Now it has made the news as part of Tribune’s bankruptcy.

A solvency opinion is an evaluation of a proposed leveraged transaction — that is, a business deal where the buyer finances a large part of the purchase price through borrowing. By obtaining a solvency opinion, lenders and the company’s board of directors can likewise be confident that the company should remain able to meet its debt obligations once the deal goes through.

Should the company file for bankruptcy, solvency opinions also protect lenders from lawsuits. Sound ones do, at least.

In Sam Zell’s case, his attempt to buy Tribune could not proceed without such an opinion. Houlihan Lokey had been trying to woo Zell as a client for some time, according to an unnamed source familiar with the deal. But the desire for Zell’s business did not stop Houlihan from rejecting Tribune’s overtures, as Houlihan believed the deal would saddle Tribune with too much debt to remain sound.

Zell called the firm when they declined to provide an opinion. According to the executive who took the call, “Sam was upset that [Houlihan Lokey] was holding up his deal and asked [the Houlihan Lokey executive] for an explanation.” For Zell, evidently, all that mattered was the deal moving forward. But Houlihan held its ground.

Keeping its integrity turned out not only to be an ethical move for Houlihan, but also a prudent one. Valuation Research Corporation, the company Tribune eventually used for its solvency opinion, is currently enmeshed in the bankruptcy examiner’s investigation of Zell’s buyout. In the light of U.S. Bankruptcy Judge Kevin Carey’s decision to release the entirety of examiner Kenneth Klee’s report, despite objections from creditors, it is obvious that VRC’s solvency opinion was sloppy at best.

Klee writes, “Perhaps foreshadowing the fact that VRC ultimately charged the highest fee it had ever charged for a solvency opinion, $1.5 million, VRC’s discussions on the first day it was approached by Tribune included an analysis of the fee necessary to compensate VRC for the risk involved in providing a solvency opinion for a transaction with the leverage anticipated in the Tribune transaction.” VRC, it seems, saw the instability of the deal as well. In Klee’s opinion, VRC didn’t question the financial projections management handed them with any degree of rigor, thus defeating the purpose of a solvency opinion but allowing the deal to proceed.

If nothing else, the Tribune deal illustrates the flaw in our current theoretically objective ratings system, where a company can shop around for “independent” opinions until it finds the one that suits it. For every Houlihan, there will be a VRC, and the latter will be the company that makes the bigger headline.

Sometimes, though, less news is good news. Everyone in the business world has been in Houlihan’s position at one time or another. Of course we all seek more clients and greater revenue — but not at any price. Houlihan Lokey, though a relatively quiet side note to a larger and messier story, did a simple thing. It made the ethical choice.

And that is certainly newsworthy.

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One Response to "Putting Principle Before Profit"

  • jeff werbalowsky
    August 10, 2010 - 4:26 pm

    The hardest thing in the service business is saying no to clients who you want to serve. There are no prizes for turning down a deal, and it is a very unusual circumstance in which the right decision to turn down a deal ever even comes to light. Maybe your article should serve as an inspiration for a business school course, as saying no is anathema to most service organizations including ours (and is often the profit minimizing course). Turning down a deal is the ultimate triumph of delayed versus instant gratification, completely antithetical to the standard financial services model, but critical to long term survival and professionalism.