EMI's case is lost: now Guy Hands must face the music

Within 48 hours of his crushing legal defeat in New York, where a jury threw out allegations that Citigroup tricked him into paying too much for EMI three years ago, Guy Hands was back in his six-bedroom house in Guernsey to ponder an uncertain future.

He had taken a massive gamble in seeking to sue Citigroup for fraud by claiming it duped his private equity firm, Terra Firma, into paying £4.2bn for the music company at the height of the credit boom in 2007.

Had Hands won the case and collected billions in damages, he could have put EMI on a sounder financial footing and held the whip hand when it came to renegotiating a debt restructuring package with Citigroup in the weeks ahead.

Instead, his case was ripped to shreds and his accusation that Citi's London banker David Wormsley had pretended that another bidder was in the frame to buy EMI was shown to be baseless.

It was a humiliating end to a three-week hearing held in the federal courthouse on Worth Street in Lower Manhattan that pitted the two former friends against each other in what the judge described as "a catfight between two rich companies".

"Hands doesn't like losing and I imagine he is taking this pretty badly," says one former associate. "I fear the trial showed he was more interested in recouping losses for a bad investment decision than trying to establish he was defrauded by a ruthless investment banker."

London-based financiers lined up to accuse Hands, a millionaire tax exile, of "buyer's remorse" following a year in which EMI haemorrhaged more than £600m. Despite having a roster of international stars such as Coldplay and Kylie Minogue, EMI has been hit by the defection of major acts such as Paul McCartney.

"For Hands, this was clearly a deal too far," says one financier. "He overpaid for EMI, pure and simple. Any bank doing business with him in the future will be careful to follow the letter of his instructions, to avoid the risk of litigation. There will be no more gentlemanly capitalism between Hands and his advisers, that much is certain."

But the fact that Hands lost his case could make him more reluctant to take legal action in the future. One lawyer at a leading London firm says: "This was always going to be a very difficult for Hands to win as the case turned on a series of phone calls during which no records were kept. Copycat cases are almost inconceivable after what happened last week – unless you have cast-iron proof."

Hands's friends say he believed Citigroup, a longtime and trusted adviser, had played fast and loose with the truth and that it was a sense of moral outrage that drove him to seek legal redress, rather than financial self-interest.

Clearly, the jury didn't agree with his analysis, and public relations experts contend that Hands has suffered serious reputational damage. But they also believe it's fanciful to assume that banks will stop doing business with him: "Money always speaks louder than words," as one executive puts it.

Despite Citigroup's courtroom victory, some observers contend that the bank has not emerged squeaky-clean either. One banker says: "Citigroup's role in the EMI auction looks to have been riddled with conflicts of interest. The bank was a long and trusted adviser of Terra Firma, but in 2007 it acted for EMI when the proper course of action would have been for it to have had nothing to do with the sale from the outset.

"And at the same time, Citi provided debt finance for Hands to do the EMI deal while acting in the interests of the vendor. If that isn't a conflict of interest, I don't know what is."

But now that Hands has lost the legal arguments, he must consider the options for EMI, where the court case has affected morale among staff and sparked fears that more major acts could defect to rivals.

Operationally, the company has been improving its position, recording a trading profit of £121m for the 12 months to March 2010 against a loss of over £250m two years earlier. Sales increased 5% to £1.65bn last year, and the company recently accounted for five of the six top-selling albums in the UK. It has also signed some big new acts such as Katy Perry and Tinie Tempah.

Yet EMI is saddled with debt of £3bn and must meet quarterly banking covenants that are measured on a ratio of EMI trading profit to net borrowings. After raising over £100m from Terra Firma's investors in the summer, EMI is confident it will meet its covenants in December, but will fail to do so in March. Then the big question will be whether Terra Firma's backers are prepared to stump up more cash to provide "an equity cure". Observers say Terra Firma needs to find £250m before 2014.

After Hands's unsuccessful court case in New York, analysts believe that his investors will simply refuse to furnish more cash. If that happens, Hands would have no choice but to allow Citigroup to seize control of EMI – a move that would almost certainly pave the way for a sale to a rival such as Warner Music, possibly in alliance with another private equity group.

But long before we get to March, Hands will sit down with Citigroup in an attempt to hammer out a capital restructuring deal. Before the court case, he wanted Citigroup to write off debt in return for Terra Firma injecting more equity, a manoeuvre that would have facilitated a debt revamp without Hands having to cede control.

But after the court case, Citigroup is in a position to drive a hard bargain. The bank is arguing for a debt-for-shares swap that would allow it take ownership of more than 50% of EMI's equity, giving it de facto control. Under that scenario, it would appear to be game over for Terra Firma, which would have to hand over the day-to-day running of EMI to US bankers.

Whatever happens, Hands's purchase of EMI will go down as one of the worst deals of the boom years and a major error of judgment by Hands himself.

"It could take years for him to re-establish his credibility. His reputation is in tatters," says a rival private equity investor.