Analysis : Will the Real Milken Please Stand Up? : Insider Trading Case Raises Questions on ‘Junk Bond’ King’s Legacy

There’s a question behind the Securities and Exchange Commission’s allegations of insider trading, market manipulation and fraud against Drexel Burnham Lambert and the head of its high-interest bond department, Michael Milken.

And the question is, which is the real Milken? For several years business circles have admired Milken, the 42-year-old financial wizard whose brilliance and drive almost single-handedly created a $100-billion market in high-yield, or “junk” bonds. He has been hailed by business publications and Harvard Business School professors as a new J. P. Morgan, after the turn-of-the-century financier who put together some of America’s biggest companies including the old U.S. Steel.

But the SEC’s accusations paint a different picture, of Milken as mastermind of hidden stock-buying schemes that recall not J. P. Morgan but Michael J. Meehan, the stock exchange operator who organized the infamous RCA pool in 1929. In that pool--similar to others that helped bring about the Great Crash--big investors colluded to drive up the price of RCA, to lure public investors into the stock and then to sell out at a fat profit, leaving the public suckers holding the sinking shares.

The securities laws of the 1930s outlawed such schemes and ordered full and timely disclosure of stock ownership as a way to keep the markets honest. It is lack of disclosure that the SEC is accusing Milken of today.

So is it Milken as Morgan or Milken as Meehan? Obviously, only a trial can answer the SEC’s allegations, which Milken denied as soon as they were made, saying: “I am confident that I and my colleagues will be fully vindicated.”

But as to why Milken has attracted so much admiration and condemnation, you need to understand what he did and how it affected the lives of many. A bright student at UC Berkeley and the University of Pennsylvania’s Wharton School of Business, Milken started out with a financial insight. After careful research, he discovered that the bonds of companies that had fallen on hard times were good investments because their high interest rates more than compensated for the risk of bankruptcy.

The idea may not sound extraordinary, but in finance as in football, execution is everything. Milken realized in the early 1970s that institutions which invest America’s retirement savings were looking for an investment that was more predictable than common stock yet higher yielding than corporate or government bonds. So he worked hard to sell the institutions junk bonds and created a new business for Drexel.

Then he got Drexel to issue bonds for new, untried companies--and sold those bonds, too, to large investors. Essentially what he did was bring finance to businesses that other people thought of as poor credit risks--new companies that had trouble borrowing from banks. Some companies Drexel backed, such as MCI and Texas Air, brought healthy change to U.S. business.

But Milken’s next step, the junk bond takeover, is where the issue becomes clouded. Drexel issued junk bonds to finance takeover raids on Phillips Petroleum, TWA, Union Carbide and others. And fear of Drexel’s financing power drove other companies to restructure, laying off employees and saddling themselves with debt. Drexel advertising claims that this made U.S. business more efficient, but business professionals know that the junk bond takeover is little more than a tax dodge.

Numbers tell the story. If a company financed by common stock earns $10 a share pretax, it pays 40% tax on those profits and is left with $6-per-share earnings. Its stock might then sell at $66 a share--11 times earnings--and it would frequently sell for less.

But raiders calculate differently because they know that interest on debt is tax deductible. Thus, those same $10 earnings can pay the interest on $71 worth of 14% junk bonds because a debt-financed company pays no income tax. So a raider could easily buy a company selling at $66 a share with Drexel-issued bonds, use the company’s earnings to pay interest, and have money left over. “The promoters, who have nothing to do with making or selling anything but paper, keep the difference,” notes author Martin Mayer in his book “Markets.”

Such takeovers are not illegal, however much they hurt the long-term interests of U.S. business. But the SEC says that Drexel, to make sure of big profits, cooked its deals illegally with Milken calling the shots for people like Ivan F. Boesky, who held stock secretly so that raiders could accumulate shares in a company and then jump it. (Boesky confessed to insider trading two years ago.)

Again, Milken, who reportedly earns $40 million a year and has amassed a $500-million fortune, says he did nothing illegal, and will now press his defense in a court of law as he has pressed it in the court of public opinion in the two years since Boesky’s confession. Breaking long habits of reclusiveness, Milken lately has involved himself with such issues as employee ownership and Latin debt, and has worked for local charities.

What is likely to be the ultimate judgment? Will Milken be remembered as a J. P. Morgan? Probably not. Morgan himself was a buccaneer, but he is remembered as a builder. Milken on the other hand is more likely to be associated with liquidating U.S. business, not creating it. And Americans seldom commemorate decline.