Drexel Settles Charges, Faces Stiff Supervision : Milken to Be Fired but ‘Junk Bond’ Department Will Stay in Beverly Hills in Accord With SEC

Drexel Burnham Lambert Inc. agreed Thursday to settle Securities and Exchange Commission civil charges against the investment firm under terms that will require sweeping supervision of its activities but will allow its hugely profitable “junk bond” department to remain in Beverly Hills.

The agreement opened the way for the appointment of a new chairman for Drexel’s parent company, John S. R. Shad, who is a former SEC chairman, and two new outside directors. Shad will replace Robert E. Linton, who will continue as a director of the firm.

Impact on Clients

As expected, the settlement also requires the firm to fire its former junk bond chief, Michael Milken, and avoid any new direct or indirect business dealings with him. Sources said this leaves open the possibility that Drexel will be prevented from doing business with longtime clients who may retain Milken as an adviser.

Drexel will now be subject to some of the most intensive monitoring by SEC-approved officials ever imposed against a major Wall Street firm, making the SEC, in effect, Drexel’s probation officer. Failure to abide by the agreement could cost the firm its brokerage license.

The accord is designed to take away much of the independence that the firm’s New York headquarters allowed the Beverly Hills operation. Among other requirements, newly appointed compliance officers and a new Drexel general counsel will have the authority to veto deals that are considered legally questionable. A member of the firm’s executive committee, approved by the SEC, will be based in Beverly Hills to monitor the office.

The three new outside directors will head a special oversight committee of Drexel’s board. Expensive new computer facilities will be installed to monitor trading for signs of improprieties. An outside ombudsman was named to investigate employee complaints of possible wrongdoing. And a Philadelphia-based law firm approved by the SEC was hired as an independent consultant, to report on Drexel’s policies and procedures.

The firm and its employees also are required to cooperate in the government’s continuing investigation.

In addition, the firm’s convertible bond unit, which employs about 20 people, will be moved back to New York, as will the small amount of ordinary stock trading previously carried out by the junk bond unit.

The settlement will end Drexel’s involvement in what the SEC has characterized as the broadest securities fraud case it has ever brought. The SEC filed suit in September against the firm, Milken and several other individuals, including his brother, Lowell Milken, accusing them of defrauding Drexel clients, insider trading, stock market manipulation, falsifying records and illegally hiding the ownership of securities.

The settlement doesn’t affect the charges against Milken, two other Drexel employees or Victor and Steven Posner, clients of Drexel who also were named in the suit.

Gary Lynch, the SEC’s director of enforcement, said the settlement “assures that the problems that occurred at Drexel--and make no mistake about it, they were serious--will not be repeated.”

A Drexel lawyer involved in negotiating the settlement, who asked not to be identified by name, acknowledged that the firm’s operations will be under close, day-to-day scrutiny. But he said: “We don’t think that this means in any shape or form that the SEC is going to run Drexel Burnham.”

Cost Put at $2 Billion

The lawyers said the entire federal investigation has cost Drexel about $2 billion in legal expenses and lost revenue. But he said he didn’t expect the terms of the settlement to have much financial impact on Drexel’s future business.

In a written statement, the firm said the SEC agreement “positions Drexel Burnham Lambert to move forward and fully devote our energies to our clients’ needs.” Drexel said it currently has more than $2 billion in capital and enjoys continued strong support from clients.

Once the settlement goes into effect, it should clear the way for Drexel to carry out its announced plan to plead guilty to six federal criminal charges in New York and to pay $650 million in penalties, which includes $15 million specifically designated as a civil penalty under the Insider Trading Sanctions Act. But important legal hurdles remain.

The settlement cannot go into effect until it is approved by the federal judge handling the case. But the Milkens have asked the U.S. Supreme Court to remove the judge from the case because they claim he is prejudiced against them. A ruling could take months, but Drexel and the SEC are expected to ask a federal appeals court to allow the settlement to proceed anyway. It wasn’t clear Thursday whether lawyers for the Milkens would oppose the move and whether the appeals court would grant the request.

The Milkens also are challenging Drexel’s plea agreement on the criminal charges, which requires the firm to withhold most of their compensation for 1988. The amount is believed to total $200 million or more.

Under Milken, Drexel created the $180-billion market for high-yield, high-risk “junk” bonds, which transformed the firm into one of the most powerful on Wall Street. The bonds were used to finance corporate raids and leveraged buyouts, and they also revolutionized the way small and medium-size companies raise capital. But virtually all of Drexel’s legal problems stem from the activities of Milken and his department.

Michael and Lowell Milken have denied any wrongdoing and are vigorously fighting both the

SEC suit and criminal racketeering and securities fraud charges pending against them.

The settlement doesn’t impose any punitive action on Frederick H. Joseph, Drexel’s chief executive, who has been criticized by some commentators for not adequately supervising the junk bond department’s activities. The SEC’s Lynch refused to comment on Joseph but noted that he wasn’t named as a defendant in the SEC lawsuit.

Withholding Comment

A spokesman for Michael Milken said lawyers for the Milkens hadn’t yet had a chance to review Drexel’s settlement with the SEC and therefore wouldn’t comment immediately.

The SEC settlement requires the firm to fire Milken, who currently is on a leave of absence, and requires leaves of absence for any other employees who may be sued by the SEC for securities violations.

The Drexel lawyer said, however, that the provisions covering Milken would be lifted if he is eventually cleared on both the SEC and criminal charges.

Although not specifically mentioned in the settlement, Milken automatically will have to sell back to the firm his stake in Drexel as soon as his employment there officially ends, officials at the firm have said. Milken holds about 6% of Drexel’s stock and is the firm’s largest individual shareholder.

The settlement apparently won’t have much effect on a network of private partnerships that Milken set up with other Drexel employees and, in some cases, with the firm itself. Many Drexel employees reportedly earned millions from the partnerships. But the partnerships were criticized in hearings before a congressional committee, in part, because the partnerships allegedly were permitted to buy junk bonds at favorable rates, benefiting the Drexel employees but allegedly putting the firm’s customers at a disadvantage.

Greater Disclosure

While prohibiting new partnerships, the agreement will allow the current ones to continue, the Drexel lawyer said, although many of them eventually will expire. But the accord will require much greater disclosure to ensure that suspected abuses don’t recur.

If Drexel hadn’t settled with the SEC, it risked being indicted on criminal racketeering charges, and the SEC could have ordered the firm to close down.

In addition to Shad, the new directors include Roderick Hills, chairman of Manchester Group Ltd. and also a former SEC chairman, and Ralph Saul, who is a former president of the American Stock Exchange, a former SEC official and former chairman of Cigna Corp. Saul currently is chairman of Peers & Co.

The firm’s newly appointed ombudsman is William Huges Mulligan, a former federal appeals court judge who currently is a partner in the New York law firm of Skadden, Arps, Slate, Meagher & Flom.

Among other measures mandated by the settlement, Drexel will have to reorganize the junk bond department to minimize the risk that sensitive information about pending corporate raids or leveraged buyouts wouldn’t be leaked to the firm’s traders.

In addition, the firm is required to distribute a notice to employees warning them that they may be subject to disciplinary action if they refuse to cooperate in the government’s continuing investigation. A Drexel lawyer said the provision may apply to employees who refuse to testify after invoking their Fifth Amendment rights against self-incrimination.

The Drexel lawyer said the SEC had dropped a demand to move the junk bond department back to New York after Drexel argued that key employees might quit and that having the department on the West Coast allowed for longer working hours because of stock exchange trading hours and the difference between East and West Coast time.

Scot J. Paltrow reported from New York and Tom Redburn from Washington.

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