Drexel’s Reputation Rides Along With Milken’s : With Lawsuit Comes Concern Inside Firm That Its ‘Guru’ Will Have to Step Down

In late 1987, with speculation about federal investigations of Drexel Burnham Lambert on one of its periodic upswings, a prominent Drexel executive remarked on the ties binding the investment firm and Michael Milken, its famous “junk bond” impresario, both of whom were named Wednesday as defendants in a federal insider trading lawsuit.

“If Michael were to walk out of this building and get run over by a truck, the firm could survive,” the executive said. “But if it turns out he was at the center of some serious wrongdoing, I don’t know what would happen.”

The remark was an acknowledgment that, even more than its fortune, Drexel’s very reputation was linked inextricably with Milken’s. The 42-year-old financier was simultaneously founder, chief theorist, sales manager and dominant trader of the modern market for junk bonds.

Drexel, Milken, three other Drexel employees, Miami Beach financier Victor Posner and his son Steven, and Pennsylvania Engineering Corp. were all named in the long-awaited civil suit filed in U.S. District Court in New York by the Securities and Exchange Commission.

The SEC complaint and possible criminal charges later could severely damage the company, according to its own officials and others in the industry.

Although Drexel so far has had a good year financially, the lengthy investigation has taken a toll. Drexel has lost the business of some blue chip companies that it had fought so hard to win in the early 1980s. The firm has been forced to share its underwriting of junk bond issues with co-managers--other investment banks--to reassure nervous customers. Because of increased competition, Drexel now handles less than 50% of the junk bond business, down from more than 90% in the late 1970s.

Drexel’s competitors haven’t been above exploiting the investigation for their own advantage, telephoning Drexel’s customers early in the inquiry to make sure they were aware of the serious charges Drexel might face.

But now, beyond the prospect of having to pay a monumental fine, Drexel’s biggest worry is that Milken will have to leave the firm. Drexel for months has been hastily grooming other officials, notably Peter Ackerman, an executive in Milken’s junk bond group, to take over from him. But one senior Drexel executive acknowledges that Milken for years has been the main force binding together Drexel’s band of clients.

“He’s the guru,” the official said, adding, “People don’t think of Drexel, they think of Mike.”

Such a dominant force in American finance that he has been called a latter-day J. P. Morgan, Milken is a notorious workaholic who survives on little sleep. He was at his desk in Beverly Hills by 4:30 a.m. each day and expected the same from his employees. At the height of his power, he was able to raise billions of dollars in a matter of days to back clients’ hostile corporate raids and leveraged buyouts. His annual extravaganzas at the Beverly Hills Hotel, referred to as the “predators’ ball” in a recent book about Drexel, attracted the biggest names in corporate raiding as well as many other luminaries in corporate America.

The interdependence of Drexel Burnham Lambert and Michael Milken is rooted as far back as 1969, when Milken, a Los Angeles native, began working part time at the Philadelphia investment firm of Drexel Harriman, a precursor of Drexel Burnham Lambert, while attending the University of Pennsylvania’s Wharton School of Business.

High Risk

For the next 18 years, Milken was one of the company’s stars. Even before joining Drexel full time, he was named research manager of the firm’s fixed-income, or bond, department in 1970; about a year later, he moved into the area he would make famous--high-yield bonds.

To the rest of the financial world, high-yield bonds are better known as “junk bonds.” They are high-risk debt securities, rated below investment grade because the company issuing them might default. The bonds therefore are high-yielding, paying unusually high interest to attract buyers. Pension funds and other big institutional investors traditionally shunned them as too risky. Milken, however, was a man of vision. Where others saw junk, Milken saw a fabulous opportunity.

Basing his pitch on studies done by academic economists and others, Milken told clients that if one held enough different junk bonds, the high interest paid by the whole portfolio more than made up for the possibility that some would fail completely. Sufficiently diversified, such a portfolio would actually outperform a portfolio of top AAA-rated corporate bonds.

With this pitch, Milken essentially created a whole new securities market based on junk bonds. Drexel became the junk bond market, and Milken was the nexus. As his base of customers grew in the 1970s, Milken’s problem was to find a big enough supply of junk bonds to match the demand he had created through his successful salesmanship.

Until then, he had been dealing mainly in already existing junk bonds, primarily “fallen angels,” or formerly high-quality bonds that were selling at deep discounts because the companies that issued them had fallen on hard times.

Milken’s solution to the supply problem revolutionized the way medium-size American companies raise money. He began aiding hundreds of small and medium-size firms to raise capital by issuing new junk bonds. Previously, smaller companies that wanted to grow had to rely on loans from banks and insurance companies. These loans often had many restrictive covenants attached. With money raised from Milken’s enthusiastic new buyers of junk bonds, companies would be more or less free to do what they wanted with the capital.

Milken communicated his intellectual self-confidence and faith in entrepreneurial free enterprise through his glaring, deep-set eyes. His idea enthralled investment managers. Why buy 8.5% bonds issued by a blue chip company that might be on the way out? he might ask. Instead, you can buy 14% bonds of relative newcomers such as Summit Health or Triton Group, on the way up.

Exorbitant Fees

Milken’s junk bond group became such a source of profit for Drexel that the firm gave him an unusual degree of independence. When Milken announced in 1978 that he wanted to leave Drexel’s headquarters in the Wall Street area and move the group to Los Angeles, Drexel’s top management had little choice but to accede. The independence of Milken’s group and the financial benefits that Milken showered on his select group of salesmen and traders sometimes caused jealousy in other Drexel departments.

In the late 1970s and early ‘80s, Drexel completely controlled the junk bond market. Because it was essentially the only firm in the business, Drexel could charge exorbitant fees. The profitability of this mushrooming business left Wall Street’s biggest, well-established investment banks scrambling to catch up with the upstart Drexel.

But with Milken and Drexel so well entrenched, the other firms at first had trouble getting a foothold. Drexel, meanwhile, was seeking to expand its other investment banking services so that it could compete head-to-head with the biggest full-service investment banks. In the early 1980s, Drexel engineered another coup that allowed it to break into the gold mine of mergers and acquisitions.

By the late 1970s, the wave of mergers and hostile takeover attempts that changed the corporate landscape was well under way. The innovation worked out by Milken and Drexel Chief Executive Frederick Joseph was to transform the enormous junk bond market they had created into a source of cash for corporate raiders. Milken set up a method for floating huge issues of junk bonds quickly to raise cash for surprise corporate raids.

Some of these raiders were businessmen whose early ventures Drexel had financed with junk bonds. Now they would use Drexel financing cash in bids to gobble up companies much larger than their own. Among Drexel’s more prominent raider-clients were T. Boone Pickens Jr., Carl C. Icahn, Ronald O. Perelman and Victor Posner.

Such large pools of cash could be raised from Milken’s coterie of loyal junk bond buyers, some of whom had developed prosperous businesses founded mainly on junk bond investments. One was Fred Carr, chairman of First Executive Corp., a Los Angeles life insurance company that invested in junk bonds so that it could give insurance customers a better return on their money than conventional slow-growing policies. First Executive had become one of Milken’s best customers.

Virtues of Junk

Similarly Thomas Spiegel, the president of a family owned Beverly Hills thrift named Columbia Savings & Loan Assn., boosted the firm’s earnings by investing heavily in Milken’s junk bonds.

Carr and Spiegel could often be heard proclaiming the virtues of junk, lifting even their vocabulary from Milken. When it came time to finance hostile raids, these clients were ready with instant cash. Even if the attempted takeover fell through, these investors would still be rewarded with handsome commitment fees.

Many in the financial community were convinced that Drexel’s downfall would be economic, not legal. The companies for which Drexel raised money by issuing junk bonds were becoming too leveraged with high-priced debt. Milken often persuaded companies to issue bonds for amounts well above their needs. Come the inevitable recession, and the burden of junk bond interest would drag them down like cement.

“People in finance have always said that debt ratios of 30% or 35% were prudent, because nobody knows what the future brings,” remarked Nicholas F. Brady, then the chairman of the investment firm Dillon, Read & Co. in 1985. (Brady was later head of the presidential commission investigating last October’s stock market crash, and he was recently nominated to be secretary of the Treasury.) “Now we’re talking about some companies that are leveraged 100% or 85% or 90%. This is hit-and-run driving on the financial highways.”

To be sure, there were some defaults. A notable one was an issue by Flight Transportation Co. that collapsed after the corporation was sued for fraud by the Securities and Exchange Commission. But Drexel and the junk bond market that it created have been remarkably resilient so far. Defying predictions by experts, it has bounced back, first after word of the Drexel investigation was leaked in early 1987 and then following the stock market crash.

One reason for Drexel’s strength in the face of adversity has been its reputation for supporting its own clients. Milken maintained a market by promising to buy back bonds if purchasers suddenly needed to unload them. He also often engaged in elaborate trading strategies to prop up the price of a Drexel-underwritten bond, thus winning the confidence and loyalty of his customers.

Eager to Back Raiders

“In my entire career on Wall Street, I have never backed out of a transaction once I’ve agreed to stand up to it, no matter how onerous it turned out to be,” Milken told a questioner during a legal deposition in 1986. “One has his reputation to consider.”

But Drexel’s eagerness to back corporate raiders, the firm’s seeming arrogance as a Wall Street parvenu and Milken’s dominance of the junk bond market inevitably led to criticism. Within a month after Ivan F. Boesky’s fall, Joseph acknowledged that while raising money for at least three major takeover bids, the firm had distributed thinly disguised information about the deals throughout its customer network. At least once, in 1985, the stock involved became subject to apparent insider trading.

There also were increasing allegations that the firm strong-armed corporate managements to acquire underwriting and merger business. After Boesky settled civil insider trading charges in November, 1986, the allegations redoubled. Staley Continental, a Chicago food processing company, sued Drexel, charging that an executive threatened the company with a hostile leveraged buyout that would oust its management unless Staley hired Drexel as its investment bank. Drexel denied the Staley charges, and last month Staley dropped its lawsuit as part of a deal in which Drexel agreed to buy Staley’s commodity trading unit for an undisclosed price.

There were also intramural irregularities that disturbed some Drexel executives. One was Milken’s penchant for going into business with the firm’s own clients, creating a web of personal relationships that tied some of these clients closer to himself than to the firm. This continually raised questions about whether a given deal was more to Milken’s benefit than Drexel or its other clients.

Milken held a large interest in at least one First Executive reinsurance subsidiary, for instance; he and Carr were both investors in an independent firm specializing in arbitrage, a form of securities speculation.

He was a partner with Saul Steinberg, another big Drexel customer, in Reliance Capital, a financing partnership under Steinberg’s Reliance Group, and also acknowledged holding a financial interest in Columbia Savings & Loan Assn. Milken, his brother Lowell and some other investors owned the Wilshire Boulevard building in which Drexel kept its Beverly Hills headquarters, making the firm at once his employer and his tenant.

Milken’s penchant for setting up independent employee partnerships also has attracted scrutiny. According to records obtained by a congressional committee, the purchase and sale of junk bond issues sometimes seemed to be manipulated to benefit these partnerships at the expense of Drexel’s clients. The records also show that Drexel demanded that companies issuing junk bonds also issue warrants to buy the company’s stock at a specified price, as an additional incentive for investors to buy the bonds. But the records suggest that Drexel sometimes kept the warrants for itself or the employee partnerships. Drexel denies that it has done anything wrong.

Involved With Boesky

In retrospect, Drexel’s most serious mistake may have been to get involved with Ivan Boesky. In 1986, Milken agreed to finance a limited partnership for Boesky, then Wall Street’s premier takeover speculator. Drexel had hired an independent investigator and had learned that Boesky was the subject of a Securities and Exchange Commission investigation, but the firm decided to proceed anyway.

Things began to unravel in May, 1986, when a Drexel investment banker named Dennis B. Levine was charged with having made $12.6 million through insider trading in stocks of more than 50 companies. Most were corporations whose mergers, restructurings or acquisitions came before Levine or his colleagues at three investment banks during his five-year career.

Levine later told the SEC that Boesky had also agreed to pay him for secret intelligence.

The Levine case tarnished Drexel’s reputation. When Boesky later paid a $100-million penalty and pleaded guilty to a felony charge, it was an even more devastating blow. It raised the specter that someone as highly placed as Milken might be engaged in widespread wrongdoing.

As the SEC and criminal investigations of Drexel dragged on, the firm took solace from what several Drexel officials say has been exceptional loyalty from its customers. In the first half of this year, the firm earned $161 million in fees from underwriting bond issues, more than any other Wall Street firm.

One Drexel official said: “Company loyalty has been astounding to us.” He added that client sympathy ran with Drexel, not with prosecutors. “In large measure, they have been extraordinarily anti-SEC,” he said.

Drexel also has fought to improve its public image. Milken and Drexel have tried to play a visible role in devising ways for some U.S. banks to solve their Third World loan problems. And Drexel has undertaken a massive advertising campaign, seeking to portray the firm as performing in the public interest by making possible new housing, playgrounds and the cleanup of toxic waste with funds raised from junk bonds.

Diminished Importance

While the SEC suit may end up damaging Drexel’s business, few junk bond experts expect it to have much affect on the junk bond market as a whole. In recent years, First Boston, Morgan Stanley, Merrill Lynch, Bear Stearns and other big investment brokers have all aggressively sought and won a piece of the junk bond business, diminishing Drexel’s importance.

One longtime Drexel client said: “It’s been my contention from early on that (once a suit was filed) the only problem we’d have is getting an airplane reservation.” He said, “Every investment banker would be flying out to visit every Drexel client.”

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