Active in ‘Junk’ Market : Milken Foundation’s Ties to Bond Deals Questioned
In April, 1986, the “junk bond” wizards at Drexel Burnham Lambert’s office in Beverly Hills arranged the financing for one of the biggest corporate buyouts ever--the $6.2-billion purchase of Beatrice Cos. by takeover artists Kohlberg Kravis Roberts & Co.
One of the small investors in the high-yielding junk bonds that financed the deal was the Capital Fund Foundation, a little-known charitable organization in Encino that was established and funded by Drexel’s junk-bond king, Michael Milken.
The $33.4-million purchase itself wasn’t odd, at least not for Capital Fund. While most private endowments invest conservatively--in blue-chip stocks, investment-grade corporate bonds, Treasury notes and the like--Milken’s growing foundation played heavily in the high-risk junk securities marketed by Drexel.
What was unusual, though, was what Capital Fund did with $1.45 million of the bonds a couple of weeks later.
The foundation sold the securities to Lahus V Inc., a company owned by Milken and his brother, Lowell, also a Drexel employee, according to records obtained from Drexel by congressional investigators. All of Lahus’ directors also were directors of the foundation; its offices were in the same building as Drexel’s.
The coziness of the deal disturbs the investigators. They say it may have violated federal tax laws that prohibit transactions between a foundation and a company owned by the foundation’s major contributors.
They also question whether the sale benefited the Milkens more than it did the foundation, because the bonds’ value was rising steadily when Capital Fund sold them to Lahus.
“You’ve got to wonder when the same people are on both sides of the deal,” said Rep. John D. Dingell (D-Mich.), chairman of the investigative subcommittee of the House Committee on Energy and Commerce, which is weighing whether to ask the Internal Revenue Service to probe the foundation’s activities.
The transaction was not the only time Milken’s tax-exempt foundation, defying the conventions of the nonprofit world, found itself deeply involved in the $150-billion junk-bond arena pioneered by Milken and Drexel.
Rather, investigators say Capital Fund has been involved in a number of troublesome securities transactions in recent years--dealings that raise questions about whether it has always placed its charitable purposes before the business interests of Milken or Drexel and its clients.
At the least, an examination of the $170.5-million foundation’s activities suggests that Capital Fund was an integral part of Milken’s complex financial empire--a repository of funds that from time to time made strategic investments that helped Drexel’s clients achieve their objectives in the junk-bond market.
Investigators go even further, saying the foundation may have helped Drexel manage the junk-bond market to its advantage, aided Drexel’s allegedly illegal dealings with imprisoned stock speculator Ivan F. Boesky and violated federal tax laws governing tax-exempt organizations.
A spokesman for Milken and the Capital Fund Foundation, asked for comment about the foundation’s conduct, rejected any suggestion of impropriety.
“The accusations against the foundation and those individuals who support its good work are utterly inappropriate and false,” said spokesman Kenneth Lerer. “This unfounded attack does a great injustice to the foundation and the hundreds of projects and thousands of people it serves. The foundation, as it has done in the past, will continue to devote all of its energies to improvements in education, health care and medical research, human welfare and community services.”
Drexel declined any comment.
The foundation, along with two others Milken has established over the last six years with personal contributions of nearly $263 million, in turn has donated more than $17 million to help more than 200 organizations, including groups involved in education, health research, the arts and social services.
Together, Milken’s foundations rank as the 10th largest in California and among the 50 largest in the United States. Milken and his assistants point to his foundations as evidence of his deep commitment to philanthropy and, although known for working long hours, he often makes personal appearances to promote his charitable causes.
SEC Complaint
Yet the Securities and Exchange Commission complaint that strikes at the very bedrock of Milken’s wealth and success in the securities markets says that Capital Fund played a role in Drexel’s allegedly illegal schemes with Boesky.
The complaint, filed in September, overall charges Milken, Drexel and others with securities fraud and illegal insider trading, among other things, but does not level any charges against the Capital Fund Foundation. Milken and Drexel have denied any wrongdoing.
The civil complaint stemmed from a massive federal investigation of illegal insider trading on Wall Street, a scandal that exploded into prominence in November, 1986, with Boesky’s settlement of charges that he had profited from non-public corporate information.
Boesky, who gained wealth and prominence buying the stock of companies besieged by hostile suitors, now is in prison for his crimes and is cooperating with ongoing civil and criminal investigations of Milken and Drexel. The Justice Department has indicated it will seek related criminal charges against Drexel and Milken, but there have been no signs that Milken’s foundations also might be charged.
In the SEC’s civil complaint, the agency alleged that Capital Fund was used to help cover up capital deficiencies at Boesky’s brokerage, Seemala. The alleged scheme occurred in early 1985, at a time when Seemala was investing heavily in Phillips Petroleum stock during Carl C. Icahn’s aborted attempt to buy the oil giant.
Brokerage firms such as Seemala are required to maintain minimum levels of capital as a safeguard to their clients. But the SEC alleged that Seemala kept investing in takeover situations, even though its capital position was $50-million below the minimum.
Boesky, at the time, was juggling more balls than he could handle. Seemala had posted massive losses on bad investments, the complaint says. Efforts by Drexel, his investment banker, to solidify Boesky’s finances with a $700-million reorganization of his businesses were stalled.
To hide the capital shortfalls, the SEC alleges, Drexel bought $73.8 million of Phillips stock from Boesky on March 11, 1985, then sold the same amount that day to five partnerships owned in part by Milken and to the Capital Fund, which purchased $4.8 million of the stock, the SEC said.
Through a series of such “non-bona fide transactions,” the SEC charged, Drexel and Milken aided and abetted Boesky’s evasion of the SEC’s capital-reserve requirements.
SEC officials have declined to talk about their view of the foundation’s conduct. But Dingell, whose subcommittee has reviewed the SEC complaint, said the Boesky transaction suggested Milken’s foundation had been operated for other than charitable purposes.
“Charities’ profits are not taxed because charities are supposed to help the poor--not the likes of Ivan Boesky,” he said.
Used Improperly
The subcommittee’s review of transactions by the foundation and other “insider” accounts of Drexel employees led Dingell to conclude that the accounts sometimes were used to manage the junk-bond market to Drexel’s advantage.
The accounts would make purchases that allowed Drexel to claim a bond issue was sold out, investigators say. Then, the accounts would sell into the resulting hot market for higher prices--often significantly higher than what Drexel would pay to buy the bonds from others, including popular high-yield mutual funds.
“Apparently, Drexel secretly took the good stuff for itself,” Dingell said. “People with IRAs or mutual funds lost out because Drexel cut to the head of the line.”
Previously, Drexel has defended its conduct in trading junk bonds for both the accounts and other clients.
The foundation’s publicly available tax returns show at least a dozen occasions in 1985 and 1986 when Capital Fund bought junk bonds newly issued by Drexel, then turned around to sell them for gains of 1.7% to 5.2% within 2 1/2 weeks.
In March, 1986, for instance, it bought $7.19 million in bonds issued by Banner Industries, an aircraft parts manufacturer controlled by Jeffrey Steiner, a takeover artist who often turned to Drexel for financing. In a pair of sales just over two weeks later, the foundation sold all but $960,000 of the securities for a gain of more than $315,000--an increase of 5.1%.
About the same time, Capital Fund bought $13.4 million in bonds newly issued by Bally’s Grand, a New Jersey casino operator. In trades over the next 17 days, it sold $8.5 million of the securities for a gain of more than $325,000--an increase of 3.8% by early May.
Far From Mainstream
With its heavy investments in the securities of Drexel clients and its interlocking directorates with other Milken entities, Capital Fund Foundation operates far from the mainstream of private endowments, experts say.
-- To manage their assets, most foundations hire outside investment firms with no ties to the foundations’ big contributors, said Jack Shakely, president of California Community Foundation, a Los Angeles umbrella group that provides administrative services for hundreds of small foundations with assets of $5 million or less.
For instance, the Conrad N. Hilton Foundation--a $217-million endowment established by the late hotel magnate--contracts with five independent money managers, selected with the assistance of a foundation consultant, to invest its funds, according to Patrick J. Modugno, vice president for administration of the Los Angeles-based group.
By contrast, Capital Fund’s money manager, Century Institutional Advisors, is headed by two lawyers with close ties to Milken--Richard V. Sandler, Milken’s personal lawyer, and Craig M. Cogut, one of Sandler’s law partners and the former president of a company that provided support services to Milken’s high-yield bond group at Drexel.
Century, which collected more than $468,000 in fees from Capital Fund in 1986 and 1987, has offices in the same building on Rodeo Drive in Beverly Hills that houses Milken’s operations. In filings with the SEC, Century has acknowledged that most of its securities trades are executed by Drexel and stated that Cogut and Sandler “have various business relationships with Drexel Burnham Lambert Inc.”
-- It also is typical, according to Shakely, for independent, outside directors to sit on the boards of private foundations--in part to bring expertise in the foundation’s areas of charitable interest, in part to dispel any perception that a board lacks objectivity.
The board of the Louisville, Ky.-based James Graham Brown Foundation--whose assets of $168 million nearly match Capital Fund’s--includes both former associates of Brown, a late Louisville businessman, and other community leaders such as the chief executive of Louisville Gas and Electric Co. and a former president of the area’s phone company, according to Graham B. Loper, the foundation’s vice president.
Capital Fund’s board, on the other hand, consists wholly of individuals with ties to Milken and the foundation: Milken; his wife, Lori; Lowell Milken and his wife, Sandra; Sandler’s wife, Ellen, who replaced her husband on the board last year; Edward G. Victor, another of Sandler’s law partners; Ralph Finerman, whom the foundation in past years paid for accounting services, and Julius Lesner, the foundation’s paid executive director.
-- Most foundations, wanting to protect their endowments’ principal so that their donations can continue uninterrupted for decades, invest conservatively in blue-chip stocks, investment-grade corporate bonds, Treasury notes and the like, Shakely said. Neither the Hilton nor Brown foundations invests in junk bonds, for example.
“Foundations must be cautious about (earning) a steady income flow so that they’re able to make grants,” Shakely said.
Bought Mostly Junk Bonds
But the securities bought by Capital Fund largely have been junk bonds, which pay a relatively high interest rate because they present more risk to the investor. The foundation made multimillion-dollar purchases of junk bonds floated by such takeover specialists--and Drexel clients--as Kohlberg Kravis Roberts and Revlon Group Chairman Ronald O. Perelman.
Junk bonds are used to finance a variety of corporate activities, occasionally takeovers, and the acquiring party is often left with a huge amount of debt. If the acquired company generates enough cash flow, or can sell some assets, the bonds are repaid without problem and junk-bond investors profit handsomely.
But critics warn that when the next recession hits the U.S. economy, heavily indebted companies may be unable to pay back their debts, leaving junk-bond holders in the lurch.
Still, there’s no law against Capital Fund investing in junk bonds, and Milken’s own near-billionaire status and Drexel’s success underscore how many financial institutions have profited from investments in junk bonds.
Indeed, Capital Fund at times has enjoyed substantial returns from its junk-bond purchases. A $17-million investment in Metromedia bonds--securities so poorly regarded that Talton J. Embry, a New York money manager who directs a large junk-bond portfolio, remembers that Drexel “begged” him to buy them in 1985--returned a $2-million gain 10 months later.
But investigators say that the foundation’s investments at times have seemed designed, in part, to advance Milken’s and Drexel’s financial interests.
The foundation’s bond sale to Lahus V is an example, they say.
The bonds were originally issued by BCI Holdings, a company organized by Kohlberg Kravis Roberts to acquire Beatrice. Lahus V, in addition to being wholly owned by Michael and Lowell Milken, had three directors who also were members of the foundation’s board: Lowell Milken, Sandler and Victor.
Tax Law Problems
The sale might have run afoul of federal tax law, which prohibits transactions between a foundation and a company more than 35% owned by the foundation’s major contributors, investigators for Dingell’s subcommittee say. Such “self-dealing” can subject a firm or individual doing business with a foundation to a tax of 5% annually on the transaction, until the tax is paid--and ultimately to a 200% tax if the IRS sees fit, according to Keith M. Loebig, an IRS expert in Los Angeles on tax-exempt organizations.
Moreover, the foundation sold the BCI bonds during a period when their value was rising steadily, the subcommittee found. Subcommittee investigators said it is questionable whether the sale was in the foundation’s best interest or whether it instead benefited Lahus V and the Milkens.
And the Capital Fund Foundation, in its 1986 federal tax return, failed to disclose the Lahus V trade as required by the tax code, the investigators contend.
