VIEWPOINTS : Innocent--Until Proved Otherwise : Jury Is Still Out on Drexel Burnham Lambert
Asked about Drexel Burnham Lambert, an ambidextrous investment bank that makes waves in New York and money in Beverly Hills, most people on Wall Street would mutter darkly that the jury is still out on that one. This is as much a comment on our times as a comment on Drexel. As yet, after all, there is no jury and, indeed, no published charges.
When insider trader Ivan Boesky bit the dust, he spat out allegations about Drexel, which was frequently his partner, with some millions of dollars flowing back and forth for purposes never entirely explained. And Connie Bruck’s widely publicized new book, “The Predator’s Ball,” accuses Drexel of bullying both clients and their prey for its own profit and of hiring whores to entertain customers.
But it is not yet proved that what Drexel did to help Boesky put together his raids went beyond the gray area where lots of firms live in these deregulated times, and Bruck in fact admires as well as criticizes. Just about all the eminent names in the financial services business play hardball with companies that they think they can push around--as well as redistribute some of their fee income to the purchase of exotic amusements after the hockey games.
As pioneers of junk bond financing techniques that involve the payment of high interest rates by companies and people who strike conventional lenders as poor credit risks, Drexel has obviously been seen with business partners of racy reputation. But one also can argue--Drexel does--that it was the robber barons who made America great.
Most commentators worry that too much borrowing and too high a fixed burden of interest payments will make American industry fragile. Dividends, after all, can be skipped, but failure to pay that 15% on the junk bonds puts the company in the tank. This argument is met at Drexel with the assertion that, for the entrepreneur, equity capital is the most expensive, because it means he has to split the future of his company with investors.
Drexel’s chief executive, Fred Joseph, claims that American industry is under -leveraged, that companies fail to grow because they worry too much about losing their double-A bond rating. “Entrenched managements,” he says, “don’t do a good analysis of how much risk they can afford to run. The default rate in this country has been too low.”
Most of Drexel’s bonds are substitutes for the term loans banks have been too timid to make. Some fraction of them (the firm says less than 10%) has been issued in support of takeovers, mergers and acquisitions and leveraged buyouts that create hollowed-out corporations with little equity and lots of debt.
Still, in a time span that includes the sharp 1981-82 recession, nearly all of Drexel’s borrowers have survived, and many have flourished. They bent--there were a number of what might be called functional bankruptcies, in which bondholders wound up with equity to replace defaulted debt, a situation Drexel contends is part of the security behind a junk bond--but only a handful actually broke.
Long Customer List
Joseph defends the firm’s takeover and leveraged buyout activity as capitalism at its best: Shareholders get a price above the recent market level for their stock, and the management that was responsible for the inadequate stock price is replaced (in a takeover) or stimulated to do better because now it is the managers’ own money (in an LBO). Being a truly great salesman, he can make these two rather contradictory claims in one long sentence and one long breath.
In fact, however, the issuance of junk bonds is not an example of free enterprise rampant. It is a federally subsidized activity, like dairy farming. The name of the game is that earnings available to stockholders are taxable income to a corporation, while earnings that go to pay interest on debt are not taxed. Moreover, through the miracles of “purchase accounting,” acquiring companies can write up the book value of their new possession and take depreciation allowances that further reduce taxable profits. (This loophole was made less capacious in the 1986 tax law, but it’s still there.)
The customer list for junk bonds is something Drexel, like any sales operation, doesn’t discuss, but clearly it is large and rich and full of big institutions that wouldn’t wish to admit they buy such cheap goods. Banks with non-performing real estate and Latin American loans, savings and loans that bet the wrong horses, pension funds where the managers are measured for performance every 15 days--all need high yields to compensate for the assets that don’t yield at all.
Drexel argues that most of these lenders are better off with junk bonds than they would be choosing their own borrowers, and Securities and Exchange Commission member Joseph A. Grundfest (among others) agrees: “What’s a commercial loan?” he says. “It’s an illiquid junk bond. For the S&Ls;, the alternative is running around with some fly-by-night (real estate) appraiser, and two years later you can’t find the documents.”
And the firm argues effectively that the junk bond instrument is inherently better for the lender than a bank loan--a junk buyer, unlike a bank, can gain call protection (a premium for early repayment) and even a piece of the profits down the pike, to compensate for added risks.
Unprofessional customers, however, can offer unusual opportunities. At recent hearings before U.S. Rep. John D. Dingell (D-Mich.), Drexel had to admit that some of its salesmen, knowing what prices the buyers were willing to pay, bought bonds cheaply for their own account at big profits. The Drexel lawyers had an unnerving reply: The law that prohibits this sort of profiteering by the employees of underwriters should be read to apply only to stocks, not bonds. The law, they were saying, did not have a purpose. Just words.
Worrisome Possibility
Statistically, Drexel can show that the resale prices of junk bonds are more stable than those of higher-quality instruments, because changes in the interest-rate climate affect them less, and because the firm smoothes the aftermarket for the bonds it underwrites, even at some cost to itself. “Sometimes,” says Joseph, “you have to stroke the horses.”
Drexel argues passionately that “restructured” companies invest more, employ more and eventually spin off new and improved equity, but the stronger case, I think, is that leveraged buyout and takeover activity is bad for the country over time. There is more to capitalist enterprise than the maximization of short-term profit for investment bankers, corporate managers and tax-exempt pension funds.
We do not want a corporate structure that, by substituting debt for equity, concentrates profit in the hands of a few holders of a shrinking equity base while spreading risks around a growing community of debt holders, however well compensated or well protected they may be. We were supposed to be building a “people’s capitalism” around here.
The discomfort with concentrated ownership may give the SEC and the U.S. Attorney’s office in New York adequate license to grab Drexel for offenses that are overlooked when others commit them. It is harder to claim that the undesirability of Drexel Burnham’s activities justifies trying its case in the newspapers. The most recent flap began with a story that the SEC commissioners had voted privately to take civil action against the firm if the U.S. Attorney can’t make a case for criminal prosecution, and surely the public has no right to know that.
Drexel has not financed a hostile takeover in two years, and its ambition level has risen a lot--teams now work toward recapitalizing our damaged banks and S&Ls; and restructuring Third World debt. History essentially accuses Drexel of violating the intent of securities and antitrust laws the present Administration did not have the intent to enforce. Under those circumstances, those who do wish to see the law enforced can say sunshine is the only disinfectant. Get it in the open, and let the public judge. So the jury is still out.
