THE DREXEL AGREEMENT TO SETTLE : The Company : Drexel Faces a Troubled Future, but ‘Junk Bonds’ Seem Likely to Endure
Drexel Burnham Lambert’s $650-million fine and guilty plea to six felony counts of securities violations could have a major long-term impact on the firm’s future, industry observers said Wednesday.
The developments could, they said, lead to further erosion of Drexel’s vast share of the market for high-yield “junk bonds,” dissension and defections among key employees, trouble in attracting new clients and shareholder and employee lawsuits. Drexel also may be required to scale back parts of its operations, including the lucrative junk bond and merger business.
Such problems, one analyst suggested, could result in woes similar to those that racked E. F. Hutton Group, the once high-flying securities firm that was forced to seek a merger partner in 1987, two years after pleading guilty to federal check-kiting charges.
However, the settlement will have little or no effect on the fast-growing market for junk bonds that Drexel pioneered, industry experts said. That is partly because other investment firms have emerged as major players in the market for junk bonds, high-yield securities typically used to finance takeovers or to raise money for companies considered poor credit risks.
The hefty fine--believed to be the largest ever paid by a U.S. corporation to settle criminal charges--should not significantly erode Drexel’s financial strength, analysts said. Thanks to the firm’s strong profits and high financial reserves, it has more than adequate resources to pay the fine and still meet regulatory capital requirements, analysts and company officials said.
“From a financial point of view, this settlement isn’t going to put Drexel out of business,” said Perrin Long, brokerage industry analyst at Lipper Analytical Services. “The real concern is dissension in senior management. . . . Is this going to split the firm, and will people leave?”
Drexel’s capital--even after payment of the fine--will total about $2.25 billion, about $1 billion above regulatory requirements, Drexel spokesman Steve Anreder said Wednesday. Analysts estimate that the firm had set aside about $400 million over the past two years to cover any possible fines from the federal criminal investigation and a parallel Securities and Exchange Commission probe that resulted in civil charges filed earlier this year.
The $650-million fine also includes amounts to be set aside to cover expected claims from investors and others contending they lost money because of Drexel’s actions.
“We expect to remain in one of the strongest financial positions of any firm in the industry,” spokesman Anreder said. “We don’t expect (the fines and guilty plea) to have any impact.”
Drexel’s strong financial position stems in large part from its huge profits, particularly from lucrative mergers and acquisitions business and its bread-and-butter junk bond operations headed by Michael Milken and based in Beverly Hills.
Fees for underwriting junk bonds are at least three or four times those on investment-grade issues, according to John Speiss of IDD Information Services. Drexel underwrites most of its issues by itself and therefore keeps all its commissions, while rivals syndicate most of their deals with other firms.
According to a Securities and Exchange Commission filing earlier this year, Drexel earned $110.7 million in the first six months of this year, almost as much as the $130.2 million it earned for all of 1987. The 1987 results are believed to have been diluted by reserves set aside to pay for anticipated fines.
The firm also got a major boost in the past month when it won a lead role in financing the $25-billion leveraged buyout of RJR Nabisco by Kohlberg Kravis Roberts. Drexel’s role in that huge deal, including providing $3.5 billion in junk bond financing and $3.5 billion in short-term loans, could net it more than $200 million in fees. Sources close to the deal said it is unlikely that Drexel will lose its role in those deals as a result of its guilty plea.
But clearly in recent months, the cloud hanging over the firm from the federal investigations has taken its toll.
Drexel Chief Executive Frederick H. Joseph sent a memo to employees last month estimating that the firm lost $1.5 billion in revenue--and incurred $175 million in legal fees--since the federal criminal probe began.
Also, Drexel’s share of the $160-billion junk bond market has slipped sharply in recent months, at least for that portion involving underwritings sold through public offerings.
According to IDD Information Services, Drexel’s share of new public junk bond offerings between Oct. 1 and Dec. 20 totaled 23.3%, compared to 41.8% for the entire year to date. Drexel could be in danger of losing its lead in the public offerings area to Morgan Stanley and First Boston, with 21.3% and 18.4% shares, respectively, in the October-December period.
Drexel contends, however, that it remains dominant in the so-called private placement market, where new junk bond issues are sold directly to insurance companies, pension funds and other institutional clients here and overseas.
Wednesday’s fine and guilty pleas may not result in significant defections of existing clients, who remain intensely loyal to Drexel despite its legal troubles, analyst Long said. They are likely to stay even if junk bond guru Milken leaves Drexel, he said.
Indeed, Reliance Group Holdings, a New York firm controlled by long-time Drexel client Saul P. Steinberg, said late Wednesday that it planned to proceed with a proposed $150-million offering to be underwritten by Drexel. And other longtime clients, such as Texas oilman T. Boone Pickens Jr. and Shamrock Holdings Chief Executive Stanley Gold, also reaffirmed their loyalty to Drexel.
But the guilty pleas could make new or prospective clients more hesitant to go with Drexel, Long said. “Any organization that has a fiduciary responsibility has to take another look at its relationship with Drexel,” he said.
And some clients, particularly public pension funds, may be barred by state regulations from doing business with convicted or admitted felons. Indeed, E. F. Hutton lost several big pension fund clients following its guilty pleas, Long notes.
Drexel also may be required to restrict parts of its business--possibly including junk bonds and mergers and acquisitions--as part of a settlement of the SEC’s civil charges. Such a settlement with the SEC is a key condition of Drexel’s settlement of federal criminal charges with the Justice Department.
Drexel also may find itself racked by internal dissension and defections stemming from its decision to plead guilty rather than fight in the courts, and any appearance that it is abandoning Milken, who has many loyal followers. At least two key Drexel executives threatened earlier this month to resign if the settlement terms damaged Milken.
Similar dissension, along with a slew of litigation, contributed to the downfall of Hutton, which was forced into the arms of Shearson Lehman Bros. in 1987.
“Once a company starts falling apart, it snowballs,” said one investor with close ties to Milken. “I think they’re running a hell of a risk if they’re trying to dump Milken.”
As for the junk bond market itself, industry experts said the impact of Drexel’s actions were likely to be minimal, partly because the market was already anticipating a settlement and because investors are more concerned with the financial viability of bond issuers. Indeed, after the SEC’s filing of civil charges this past fall, junk bonds fell in price only slightly, and rebounded soon thereafter.
(Junk bond prices were little changed in late trading Wednesday, but news of Drexel’s settlement came too late in the day for much reaction.)
Also, Drexel’s role is not as dominant as before, and rivals such as Morgan Stanley, First Boston and Merrill Lynch stand ready to pick up any market voids caused by woes at Drexel, analysts said.
“The number of competitors has grown rapidly in the last few years,” said James H. Reinhardt, senior associate at Wilshire Associates, a Santa Monica consulting firm. “There’s just so many people (in junk bonds) now, the impact will be smaller than three or four years ago.”
Main story, Page 1, Part I DREXEL’S ‘JUNK BOND’ MARKET SHARE SINKS
Lead managers of public high-yield bond offerings in 1988. Private offerings not included. Dollar figures in billions.
Oct. 1 to Dec. 20
Firm Pct. Share Value Drexel Burnham 23.3 $1.9 Morgan Stanley 21.3 1.7 First Boston 18.4 1 5 Merrill Lynch 16.1 1.3 Goldman Sachs 5.1 0.42
Jan. 1 to Dec. 20
Firm Pct. Share Value Drexel Burnham 41.8 $11.4 First Boston 14.3 3.9 Morgan Stanley 11.5 3.1 Merrill Lynch 7.7 2.0 Salomon Bros. 6.4 1.7
Source: IDD Information Services