Guilty Plea May Scare Drexel’s Public Clients : Problems Could Have a ‘Chilling Effect’ on Firm’s Municipal Bond Business
Fallout from Drexel Burnham Lambert’s agreement to plead guilty to six counts of breaking federal securities laws will likely hamper the beleaguered Wall Street firm’s effort to diversify into the municipal bond market.
Legal and investment experts note that state and local agencies in California are not prohibited from doing business with a firm that admits to having committed felonies. But, they added, public money managers are likely to be cautious in any future dealings with such a firm.
“There is no outright legal prohibition, but it’s something that we look at to see if (the fraud) is in areas in which they are doing business with us, or if this is a part of their operation,” explained Basil J. Schwan, assistant chief executive of the Public Employees Retirement System, a $46-billion pension fund for more than 700,000 public employees in California.
“It’s like the E. F. Hutton case of a few years ago,” Schwan recalled. “There was quite a chilling effect on their business.”
Hutton, one of the nation’s largest securities dealers, which has since merged to form Shearson Lehman Hutton, pleaded guilty in 1985 to 2,000 counts of mail and wire fraud by writing checks against funds that had not yet reached company bank accounts.
Requirements of ‘Good Character’
The “chilling effect,” if it materializes in Drexel’s case, would be created by the voluntary withdrawal of business by public clients, said Ephraim Margolin, a San Francisco attorney, law professor and president of the 20,000-member National Assn. of Criminal Defense Lawyers.
“Practically every agency involved in licensing will have requirements of ‘good character’ that are couched in weasel words,” Margolin explained. Fear of failing to live up to such vague standards or to acting “prudently” in managing the money of others creates a form of “paranoia,” he said. Indeed, he added, such an effect may even be encouraged by government prosecutors who view it as a public service in helping deter future misdeeds by others.
“But in reality, it deters a lot of people who are not doing anything wrong,” Margolin said.
In recent years, Drexel has provided investment banking services to a widening range of public agencies in 46 states. These include Los Angeles’ city and county governments, a number of municipalities, housing authorities and special districts, as well as the state of California.
Last year, the company handled the sale of more than $13 billion in new municipal securities, $8.8 billion of which were exempt from federal taxes, even after 1986 changes in the Internal Revenue Code sharply narrowed the range of tax-exempt issues. And through September, 1988, the company had already placed $12.4 billion in tax-exempt bonds, helping the firm build a reputation not so dependent on the high-yield “junk bonds” it pioneered.
But even though the law does not restrain its future business with public agencies, Drexel will likely have to re-establish credibility among public money managers. “Its a judgmental question on our part,” explained Kenneth R. Cramer, California’s assistant state treasurer.
Even before the agreement was announced last week, the state had “shortened the type of business” it does with Drexel pending the outcome of the government’s investigation, Cramer said. He added, however, that “we would have been far more concerned had they not pleaded and the government filed racketeering charges against them.”
Financial Judgement
In investing temporarily idle state funds, the treasurer’s office has used Drexel primarily as a source of very short-term investments, most of them redeemable within 10 days, he said. Thus, Cramer’s chief concern is whether Drexel’s capital base might be impaired because of the $650 million in penalties that it agreed to pay.
“We decided that they had reserved a sufficient amount of money knowing that they might get a large fine,” Cramer said. “Their financial position remains quite good.”
Los Angeles County’s position is generally similar. “We’re not going to say we’ll never do business with Drexel Burnham Lambert,” said John Edmisten, a financial analyst for the county treasurer. “It’s a wait-and-see attitude until we can see the extent of the fraudulent material.”
Bakersfield’s finance director, Greg Klimko, said the city has employed Drexel in a limited way to manage an industrial development bond issue, but has not used it since 1987. “We’re a pretty conservative community here,” Klimko said, “and we have a tendency to stay away from firms that have a, well, less-than-prudent reputation.”
Question of Prudence
The Public Employees Retirement System, the state’s biggest pension fund, also does business with Drexel, said Walton R. Williams, who directs its bond investments. “As far as our continued ability or willingness to do business with them,” Williams said, “that comes down, basically, to a question of prudency. Under our charter we must be prudent in doing business with anyone.”
But, he added, from what is known at this point, “we would probably continue to do business with them.” After all, he said, Drexel’s financial situation appears to remain solid.
“So that kind of prudence wouldn’t be violated,” he said. “The rest is a question of ethics. We’d have to think about that.”
