Taming the Bond Buccaneers at Salomon Brothers : How Warren Buffet and friends swept up after the Salomon scandal, possible saving the firm from federal regulators furious after a decade of skuldggery on Wall Street.
THE 12 EXHAUSTED SALOMON BROTHers officers sitting around the oval burled-walnut table in the 45th-floor boardroom of their New York World Trade Center headquarters confronted a reality that one week before would have seemed absurd: Their firm was in danger of collapsing.
On this Friday afternoon, Aug. 16, a week after news broke that Salomon’s chief trader of U.S. debt securities had cheated in an attempt to skirt federal regulations governing Treasury auctions, Washington officials were preparing to close the firm’s doors.
Smarting from public fury over an avalanche of financial scandals ranging from Wall Street’s insider-trading disgrace to the S & L bailout and the Bank of Credit and Commerce International fraud, Treasury Secretary Nicholas F. Brady, backed by Federal Reserve Board Chairman Alan Greenspan, was poised to yank Salomon’s privileged status as the biggest buyer and seller of U.S. debt. Such a censure had never before been imposed, and its ripple effects could destroy the firm.
“Salomon was like an airplane that had suddenly lost all its forward motion. Everything stopped,” recalls then co-head of investment banking Deryck C. Maughan. Chairman John H. Gutfreund and President Thomas W. Strauss had resigned earlier that day. Vice Chairman John W. Meriwether was under a cloud of suspicion that would lead to his resignation two days later. The stock had been suspended from trading, after losing a market value of $1.3 billion in one week. Jittery bankers were threatening to cut back loans. Investors were boycotting Salomon’s commercial paper. Prestigious customers, primarily public institutions such as the World Bank and the California Public Employees Retirement System, had suspended certain business dealings. The Justice Department’s antitrust division and the Securities and Exchange Commission had launched investigations.
Salomon’s management committee had learned only that morning that their biggest shareholder and most powerful board member, Warren E. Buffett, was arriving to take over as interim chairman and chief executive. Fresh off a private jet from his home in Omaha, Buffett was meeting some of the Salomon executives for the first time.
His down-home Midwestern manner helped ease some of the tension. Buffett, the 61-year-old chairman of holding company Berkshire Hathaway Inc., whose strategy of long-term investing has earned him a net worth of more than $4 billion, appeared unruffled to the officers, though he was under no illusions about Salomon’s situation. He made a few lighthearted comments about the “little problem we have to solve” and sent the group home for some rest.
The next morning, Buffett announced, “I think I should decide who will run the firm.” Says Maughan: “There was a massive intake of breath. All the oxygen left the room.”
With Gutfreund and his officers out or suspect, no natural succession suggested itself. Salomon executives feared that few inside the company would have sufficient credibility until all questions were answered. Buffett quickly determined his procedure. He would interview each executive for 10 minutes in an adjoining room; the contenders could devise their own batting order.
Their breathing restored, the executives arranged an impromptu parade in the order they sat. One by one, they marched off to answer Buffett’s key question: “Who do you think should run the firm?” Ten out of 12 named Deryck Maughan, the 44-year-old son of a British coal miner, who had toiled for 10 years as a United Kingdom Treasury official before he was recruited in London by Wall Street’s Goldman, Sachs in 1979.
Maughan moved to Salomon four years later and established a reputation as a crackerjack administrator by building Salomon’s Tokyo operation into a money-making showcase. Destined for bigger responsibilities, he had been transferred to New York in spring, 1990. Throughout the preceding tumultuous week, Maughan had been besieged by colleagues urging him to play a leading role in Salomon’s reorganization. His resigned response to Buffett: “I’m afraid it may have to be me.”
As new chief operating officer, Maughan would run the firm day by day, overseeing implementation of new systems of control and compliance with industry regulations. He would also minister to skittish customers and a stressed-out staff, with Buffett pitching in where he could. Finally, Maughan would orchestrate a lifesaving contingency plan to liquidate assets that would provide operating cash while investors shunned Salomon’s commercial paper, the firm’s own IOUs.
Buffett would concentrate on such constituencies as regulators, politicians and shareholders. He would also map the strategic course required to downsize and restructure Salomon. In the process, he would try to tame the buccaneer attitudes that Washington held responsible for the Salomon mess.
For while Salomon officials maintain that the firm has always had solid ethical values--and point out that none of its bankers were implicated in the insider-trading scandals of the late 1980s--regulators believe that Salomon’s atmosphere encouraged a troublesome aggressiveness that exalted winning above all.
Though Gutfreund talked about ethics, his conduct often sent a contrary message. Cigar clamped firmly in his teeth, the bantam chief executive officer had ordered his staff to arrive each morning “ready to bite the ass off a bear.” He ruled the fractious firm for 13 years, firing people at whim, eliminating entire businesses without warning and condescending to many with an attitude of sneering contempt.
Salomon’s raucous behavior was embarrassingly detailed a few years ago in “Liar’s Poker,” a book by former Salomon trader Michael Lewis. Lewis described Solomon’s trading floor as a jungle with savage, crude traders pigging out on gargantuan takeout orders as they stuck customers with lousy bonds in order to slough off unprofitable Salomon positions--a tactic called “jamming.” Traders who jammed were praised in potent adolescent imagery: They were anointed “Big Swinging Dicks.”
Wheeling-and-dealing traders make up only one part of the Salomon Inc. empire, which includes the dominant financial-services arm of Salomon Brothers as well as a smaller oil-refining unit, Phibro Energy. One of the biggest Wall Street firms, with 9,000 employees in offices girdling the globe, Salomon Inc. racked up estimated 1991 revenues of more than $9 billion. Best known for its worldwide securities trading, Salomon Brothers also manages institutional portfolios, advises corporations, brokers stocks, bonds and precious metals for individual investors, underwrites public offerings and issues mortgage-backed securities.
Salomon’s bond traders--who bet hundreds of millions of the firm’s capital every day, often earning paper-thin returns of a fraction of 1% on enormous volume--were the repository of a sacred trust bestowed by the august Federal Reserve System. To pay government bills, finance the budget deficit--about $269 billion in 1991--and refinance existing federal debt as it comes due, the U.S. government sells billions of dollars in Treasury bills, notes and bonds at frequent auctions, often to foreign institutions. Of the 38 financial concerns designated to buy securities at every auction and resell them, Salomon bought and sold the most. As a result, the firm was locked into a special relationship with the Fed and the Treasury.
Treasury sets the rules for auctions, and the Federal Reserve Bank of New York runs them. These agencies relied on Salomon’s financial strength and trading expertise to continually absorb a hefty portion of the $2.3 trillion in notes and bonds issued in the past decade; for Salomon, primary-dealership status was essential to engaging in more profitable businesses such as mortgage and corporate bonds. Even more critical, the endorsement of the U.S. government enabled Salomon to trade bonds issued by foreign governments.
Because of their long symbiotic relationship with the firm, Treasury and Fed officials were embarrassed as well as outraged when they discovered that 36-year-old Paul Mozer, Salomon’s chief government-securities trader, had, according to Salomon’s investigation, violated government rules in an effort to buy more bonds than the law allowed. Even worse, Gutfreund had learned about it and failed to report it.
Disclosure of Salomon’s offenses raised troubling questions for Congress as well as regulators. Had Mozer manipulated the market or colluded with other trading companies? Would his actions so taint the market that the already astronomical cost of financing U.S. debt would mount further? At a September hearing convened by the House subcommittee on telecommunications and finance, Rep. Matthew J. Rinaldo (R-N.J.) summarized those worries: “The SEC is attempting to determine whether there is widespread collusion occurring in connection with Treasury securities auctions. Confidence in our capital markets has been eroded, (which) ultimately will drive borrowing costs upward at the expense of the taxpayer.”
Investigations are continuing, but findings so far indicate that the crisis escalated far out of proportion to the money involved. Mozer’s inept little scam had netted the firm only a pittance, between $3.3 million and $4.6 million, and cost taxpayers nothing in interest. Contrasted with the billion-dollar looting of the stock market by convicted felons Ivan F. Boesky and Michael Milken, Mozer’s crime was small potatoes--but it was enough to bring his swaggering company to the brink of ruin.
THOUGH SALOMON STILL FACES DAUNTING HURDLES, EARLY CHAPters suggest that Buffett has succeeded in laying the groundwork for a solid recovery and, in the process, has written a new script for the management of corporate malfeasance. His strategy of full disclosure, cooperation with investigators, apologies to customers, regulators and politicians and a wholesale housecleaning of miscreants has earned widespread admiration.
Initially, Buffett’s strategy was implemented in a blitzkrieg of summary decisions. The day after Buffett elevated Maughan, the firm faced two major challenges. First, Secretary Brady acted on his threat to suspend Salomon’s right to participate in government-securities auctions. In a virtuoso save, Buffett jawboned Brady into granting a partial reprieve that allows the firm to buy and sell government bonds for itself but not broker them for clients.
That afternoon, Buffett--who had previously cooperated with media only selectively--submitted to an extraordinary three-hour press conference. His example signaled that no matter how painful the experience, Salomon recognized that the public had a right to ask questions and receive answers. This was a 180-degree turn from the company’s previous haughty disregard for public accountability. In ensuing weeks, Salomon issued a stream of press releases documenting additional violations and executive changes. Buffett refused further interviews, but Maughan and other top executives continued to meet frequently with the press.
Buffett was summoned to hearings before both houses of Congress, where he repeated his contrite message: Salomon had erred, the culprits would be expunged, and new management would do everything possible to assist the investigations and rebuild a firm committed to doing “first-class business in a first-class way.”
Unlike many businessmen, Buffett, whose father was a Nebraska congressman, is comfortable in Washington. Says Howard B. Homonoff, former counsel to the House subcommittee on telecommunications and finance: “Buffett respects Congress; he doesn’t think, like most Wall Streeters, that we have no right to ask questions. He has a respect for the process, and when he testified, it showed.”
Back in New York, Buffett asked for additional high-level resignations, and a memo ordered employees to report any “legal violation or moral failure” to Buffett personally. In the crucial chief legal position, Buffett installed a trusted colleague, Los Angeles attorney Robert E. Denham, formerly managing partner of Munger, Tolles & Olson. Under his direction, specialists from the accounting firm Coopers & Lybrand audited, then endorsed, new forms, procedures and computerized systems Salomon had devised to prevent future problems--or identify them rapidly. An in-house compliance representative now monitors each government-securities auction. Denham also coordinates with outside counsel defending Salomon in the 43 civil suits filed by aggrieved shareholders and Treasury-market participants.
At the same time, Salomon began to liquidate billions in assets to raise cash. Treasurer John G. Macfarlane III, putting into play a crisis strategy devised two years earlier to cope with an emergency, directed the sale of a mind-numbing $50 billion in securities over 40 days, shrinking Salomon’s $150 billion in assets by one-third.
To many shellshocked Salomon employees and the broader New York constituency of lawyers and public-relations experts who feed off investment banking, Salomon’s public mea culpa and reforms prompted considerable scorn. Said one attorney: “Buffett is so obviously pandering to the regulators.” They criticized personnel decisions, such as cutting off pay, medical benefits and reimbursement for legal fees to the ousted officers. “He is so rigid and doctrinaire, with no humanity or compassion,” charged another. Some disdainfully dubbed him “Jimmy Stewart” for his morally upright demeanor. A few cynical Salomon traders grumbled they would adhere to Buffett’s strict standards only until the crisis blew over.
Not all the executives recognized their peril. Admits Eric R. Rosenfeld, a former Harvard Business School professor who replaced Mozer as interim government-trading chief: “I didn’t realize until later what serious trouble we were in. I questioned some of Buffett’s line calls. When people look back, they’ll realize he saved us.”
The barrage of emergency actions stabilized Salomon by late October, when a certain calm descended. Buffett chose that moment to blast away at the cozy cronyism of the old Salomon. His vehicle was a stunning two-page letter to shareholders that ran in the New York Times, Washington Post, Wall Street Journal and Financial Times of London (cost: about $600,000).
The remarkable manifesto declared truths that would have been unutterable only a few weeks earlier: that Salomon had been poorly managed, that returns on equity were far below the average earned by American business, that some employees were vastly overpaid, that stockholders had received too small a return on their investment and that outside directors had been kept in the dark about management’s subsidizing of poorly performing areas with profits from strong sectors.
To impose rationality on this organizational chaos, Buffett announced an astonishing first step: He would reduce 1991 bonuses by $110 million, and he would peg bonuses to performance. Buffett also declared that top-paid people would henceforth receive much of their bonus in stock, not cash. Though these measures might cause an exodus, Buffett said he wasn’t worried. “In the end, we must have people to match our principles, not the reverse.”
There was also good news, Buffett wrote. Riding the wave of a buoyant year for Wall Street, thanks to strong securities markets--one of the few bright spots in a dreary economic firmament--Salomon produced surprisingly good earnings. The firm eked out $85 million in third-quarter profits after setting aside a $200-million special reserve to cover anticipated legal costs. Moreover, Buffett said, the firm’s investigation concluded that “a few Salomon employees behaved egregiously,” but the problem was not “pervasive.”
Buffett’s letter prompted a deluge of congratulatory calls and letters from shareholders, customers and corporate chiefs. Thomas Dunfee, ethics professor at the Wharton School of the University of Pennsylvania, attributes Buffett’s effectiveness to his quick and decisive action. “His steps signaled real concern, not just public relations,” says Dunfee. “Senior managers were fired, bonuses were taken back, structural changes were made. His message had an enormous impact.”
Says Samuel L. Hayes, professor of investment banking at Harvard Business School: “Buffett has set a new standard for managements’ response to fraud. The squeaky-clean operating procedures he set in place defused and disarmed the people who were going to throw the book at Salomon. His actions will be studied chapter and verse in future scandals.”
ON SALOMON’S IMMENSE TRADING FLOOR, WHERE COMPUTERS blink and electronic headlines relay minute-by-minute financial data and the news of the day, traders express little rage at Mozer. Rather, they feel sorry for him and confused by what he did. By and large, the vitriol is reserved for their former chairman. Had Gutfreund dispatched his duty as the firm’s top officer and informed Treasury of Mozer’s misdeed when he heard about it, they say, the entire episode could have been settled with minor consequences.
By most accounts, Mozer was a highly competitive--some would say nerdy--workaholic. Married to a Morgan Stanley trader, he cultivated few outside interests besides tennis and music and socialized mainly with fellow bankers. No one has unraveled why he embarked on a scheme that was sure to be discovered--or, more perplexing, one that gained him not a dime.
Some claim he felt insecure that he didn’t have a Ph.D. from a prestigious university--he graduated from Whitman College in Walla Walla, Wash., and earned an MBA at Northwestern University--and was competing with the likes of Rosenfeld, who did (from Massachusetts Institute of Technology). Others suggest Mozer grew besotted by Salomon’s importance and decided the firm was so critical to funding the nation’s deficit that he was above the rules.
The first inkling of the war between Salomon and the regulators came more than a year earlier, on June 21, 1990. At an auction for four-year notes, Mozer pulled a stunt the Fed and Treasury had never seen before: He bid a low price for more than 200% of the notes being auctioned. Then-deputy assistant secretary for federal finance Michael Basham and his superiors were outraged, but they soon figured out his strategy.
For a trader, the object at a Treasury auction is to bid as low as possible without losing out on a sale. Treasury allocates bonds first to the bidder willing to pay the most, then to the next-highest bidder and so on, until it gets to the lowest bids. Treasury parcels out securities to the lowest bidders in proportion to the size of their bid, which means the larger a low-priced bid, the greater the share. Mozer’s ploy: to bid for impossible percentages at low rates, thereby guaranteeing Salomon a large share of an auction at a favorable price. Since primary dealers immediately sell most of their inventory to private investors and institutions--hopefully at a tiny markup--they stand a better chance of a profit if they pay a rock-bottom price.
Although Treasury did not limit how much one firm could bid for, no one was allowed to buy more than 35% of an auction’s total. What Treasury feared from Mozer’s game was that his outsize award might prevent other legitimate bidders from receiving a fair share.
Basham told Mozer he would institute a new rule if the trader did not desist. At the next auction for Resolution Funding Corp. bonds on July 11, however, Mozer once again bid for more than 100%. Says Basham, who recently left the government to join Smith Barney, Harris Upham & Co.: “I can’t remember ever being involved in an act more arrogant. I took it as a given that if the United States Treasury asks you not to do something, you take that to heart.”
Seriously concerned about the market’s integrity, Basham promulgated a new rule: No dealer could henceforth bid for more than 35% of a security for its own account, although it could bid on additional amounts for customers. The regulation instantly became known as the “Mozer-Basham Rule.”
Rosenfeld recalls what happened next: “When Basham put the new rule in, Mozer was apoplectic.” The trader reportedly told friends, “I’m going to get that guy fired.” He further inflamed the regulators by alerting the New York Times, which ran a story quoting Mozer criticizing the Treasury.
Recognizing the futility of the brewing fight, Salomon dispatched Mozer to London for a long trip. Upon his return, the firm added foreign-currency trading to his duties, with the intent to ease him out of government securities. Says Rosenfeld: “Things calmed down. Paul told us he could live with the rule.”
Today it appears he lived with it by breaking it. Salomon’s investigation disclosed that Mozer violated as many as three different rules in five auctions from December, 1990, through May, 1991. His most flagrant actions were to place bids in the names of customers without their consent. He also enlarged legitimate bids without customers’ knowledge, placing the extra amount in Salomon’s account immediately after the auction. Both techniques allowed Mozer to win more than the 35% Salomon was allowed. Whether Mozer engaged in additional illegalities such as market manipulation or collusion with other institutional investors is under investigation.
By April, Mozer became aware the Treasury regulators were on his trail, about to discover a fraudulent bid submitted in a February auction in which Salomon won 57% of the five-year notes. To cover himself, Mozer confessed the violation to his boss, Meriwether, a charismatic executive widely admired within the firm.
According to a Salomon statement filed with the House Ways and Means Committee, when Meriwether asked Mozer if that was his only unauthorized customer bid, the trader lied and said yes. Meriwether said he told Mozer his action could cost him his job, then reported the problem to Strauss, who informed Donald Feuerstein, chief legal officer. Soon thereafter, Meriwether, Strauss and Feuerstein broke the news to Gutfreund.
But instead of reporting the violation, Gutfreund dithered. Asked by angry colleagues last August why he hadn’t acted, Gutfreund contended it was “a screw-up.” He claimed the officers intended to report the infraction and admitted they should have. “But,” he said with a vagueness many could not accept, “we just didn’t get it done.”
As baffling as it seems, Mozer continued to violate Treasury rules even after his confession to Meriwether. He submitted a partially unauthorized bid at a May 22 auction that resulted in Salomon’s winning more than 40% of the notes. Six other institutional investors--some of them clients for whom Salomon also bid at the May auction--won major allotments.
Salomon officials maintain they have uncovered no evidence of collusion between Salomon and those investors. All together, however, the group cornered nearly 94% of the auction, and a severe shortage of those two-year notes, a “squeeze” in traders’ jargon, ensued in the secondary market.
On May 29, Basham called the toughest cop on the beat, the Securities and Exchange Commission. The agency launched a secret investigation in the hope that Mozer would tip his hand if he didn’t know he was being watched. After a Treasury official traveled to New York to question Mozer, Gutfreund requested further discussions with Treasury officials in Washington on June 10 to defend his firm’s action in the May auction.
At the meeting, the officials did not ask Gutfreund directly if Mozer had violated rules; they didn’t want to jeopardize their covert investigation. A report on Salomon’s internal investigation filed with Ways and Means relates that Gutfreund told the regulators he was unaware of any impropriety in the May auction. No other auction was discussed. The officials concluded that if Gutfreund’s intention all along had been to inform them, the meeting would have provided the ideal time and place. Says a regulator who asked not to be identified: “If Salomon had discovered what Mozer was doing, fired him and come to us, maybe all this could have been worked out. Revelation of the cover-up raised everything to a much higher level of concern.”
There are signs that the SEC does not believe Gutfreund’s “screw-up” story. Richard C. Breeden, chairman of the agency, testified before the Senate Banking Committee in September that “the firm’s silence . . . raises serious questions about whether there was a climate within Salomon that tolerated or even encouraged wrongdoing. It is not,” he chided, “an adequate ethical standard for a financial firm simply to avoid indictment.”
Breeden has continued to berate the former Salomon managers in speeches, which suggests that he expects an SEC enforcement action. The commission is weighing the seldom-invoked civil charge of failure to supervise, a law that holds officers responsible for improper acts by subordinates. If convicted, the former officers could be fined and/or barred from the securities business.
Today, Mozer awaits the results of Justice and SEC investigations and works on his defense. Although he hasn’t been charged, he recently hired a criminal lawyer noted for cutting plea bargains.
FOUNDED IN 1910 BY THREE SONS OF AN ALSATIAN IMMIGRANT, Percy, Arthur and Herbert, Salomon Brothers excelled at buying bonds for the partnership’s account and reselling them to customers. In the ‘60s, Percy’s son William, called “Billy” even today at age 77, took over as managing partner. Business exploded during the next two decades as institutional investors--large corporations, insurance companies, pension funds and the like--poured the nation’s savings into stocks and bonds. Salomon was an upright if unexciting firm whose partners plowed much of their pay back into the enterprise. Many were generous philanthropists.
John Gutfreund, an English major at Oberlin College in Ohio, joined Salomon in 1953 as a trainee, and by 1978 Billy Salomon had handpicked him as the next managing partner. Gutfreund had edged out a formidable competitor, William Simon, who went on to serve as Treasury secretary under President Gerald R. Ford. During his climb to the top, Gutfreund was regarded as a bond-trading grind, a sober man with a quiet wife and three sons.
After his wife left him in the late ‘70s, however, Gutfreund married Susan Kaposta Penn, a former Pan Am flight attendant and divorcee 16 years his junior with extravagant social ambitions. The couple poured $20 million into a 5th Avenue duplex, then spent millions more on a second home in Paris. Gutfreund’s impetuous wife became the butt of cruel jokes in New York for her pretentious dinner parties and ridiculous prattle (“It’s so expensive to be rich!”). But friends maintained that Susan gave John what he wanted: glamour, excitement, beautiful possessions and a lusty sex life that Billy Salomon recalls Gutfreund describing at the office.
Longtime associates claim that Gutfreund’s personality changed after his marriage to Susan, that he grew more ruthless. They believe her incessant need for cash pressured Gutfreund and could have been a factor in his decision to merge the partnership with Phibro Inc. in 1982 (the resulting entity was initially called Phibro-Salomon Inc., but Gutfreund eventually ousted Phibro’s chief, cut back its operations and asserted dominance by renaming the company Salomon Inc.).
Soon thereafter, observers gossiped that the Gutfreunds’ social whirl was deflecting John’s attention from business. Whatever the truth, by 1987 Salomon was floundering, its stock price so low that it became a target of takeover specialist Ronald O. Perelman, chairman of Revlon Inc.
Gutfreund prevailed over Perelman only because Buffett came to his rescue with a $700-million purchase of preferred Salomon stock. Many insiders were angry about the deal--another secret Gutfreund negotiation. They worried that Buffett’s $63 million in annual dividends could shrink their bonuses. Furious shareholders filed 19 lawsuits, eventually settling for an undisclosed amount.
Buffett joined the Salomon board of directors and lionized Gutfreund in the Berkshire annual report as a man of integrity. However, many admirers questioned the deal, because Buffett had long denounced Wall Street for sleazy ethics. He once advised, “If you want to make money, hold your nose and go to Wall Street.”
With the help of Buffett’s investments, a surging worldwide securities market and an expansion of government debt, Salomon recovered and prospered. Today people scratch their heads in wonder that Gutfreund jettisoned his career to protect Mozer. In testimony, Maughan called Gutfreund’s actions “inexplicable and inexcusable.” Some suggest it was hubris, but others say Gutfreund may simply have been trying to hang onto his job.
Though it appeared that Gutfreund dominated the firm, in fact, over the previous year and a half his position had grown precarious. Salomon was poorly managed--a truth Buffett soon uncovered--and drifting. A group of disgruntled managing directors, including Mozer, coalesced around the popular Meriwether, whom they wanted in the top position. Says a senior executive: “Ninety-nine percent of us wanted new leadership.”
Gutfreund clung to power in part by pacifying rivalrous partners with inflated pay. His survival strategy led to a confrontation that threatened his undoing. In October, 1990, Gutfreund approached the compensation committee of the board with a plan to dole out $120 million more in bonuses than the previous year. Board and committee member Buffett hit the roof. Salomon Brothers profits had declined by $100 million.
Charging that the plan not only flouted the principle of pay for performance but also trampled shareholders’ rights, Buffett asked Gutfreund to revise the figure downward. In a rebuff to his powerful shareholder, Gutfreund returned in December with a request for an additional $7 million.
Buffett cast his first negative vote ever as a compensation-committee member, but he lost. News of Buffett’s vote hit Salomon like a rocket. Says William A. McIntosh, chief of bond sales: “It was public knowledge that Gutfreund had received a negative vote from his most powerful board member. John felt pressure from Warren to get compensation in line. Yet high pay in (one profitable bond operation) had raised everybody’s demands. John was in the middle, a sandwich.”
Salomon was rife with speculation that the only way Gutfreund could hang onto his job was to wring out bountiful earnings in 1991. Amazingly, he lucked out, briefly; Salomon racked up record profits of $451 million during the first six months. In the aftermath of the May bond “squeeze,” Gutfreund may have feared that a confession of Mozer’s violations would prove too costly in bad publicity and potential lawsuits and fines for him to survive. Gutfreund’s waffling sealed his fate.
The denouement played out over one emotionally wrenching week that began on Friday, Aug. 9. Aware that regulators were unraveling Mozer’s seams, Gutfreund had several weeks before finally ordered an investigation by outside counsel Wachtell, Lipton, Rosen & Katz. On that day, the results were disclosed in a company press release admitting two unauthorized Treasury auction bids that violated the 35% rule and reporting the suspension of four employees--Mozer, Managing Director Thomas Murphy (Mozer’s assistant), a trader and a clerk.
The unfortunate release caused widespread derision (“What a relief Salomon caught that clerk!”). It was well known that Gutfreund kept a desk on the trading floor and involved himself in government auctions. Few believed he could have been unaware of Mozer’s actions.
The following Monday, Salomon executives demanded explanations from Gutfreund and Strauss, but they hit a stone wall. Salomon managing directors say the two stuck with the story that their failure to report was managerial oversight rather than negligence. By Wednesday night, the firm’s management committee asked Gutfreund and Strauss to resign. They refused. Asked Strauss: “Who would run the firm?” A disgusted insider muttered to himself, “Anyone could run this firm better than you.”
The coup de grace was delivered Thursday night by E. Gerald Corrigan, chairman of the Federal Reserve Bank of New York. In a phone call to Gutfreund, Corrigan warned that unless Salomon produced dramatic changes immediately, regulators would take “drastic action.” Gutfreund knew the euphemism meant Treasury would suspend the firm’s designation as primary trader. The next day, Gutfreund informed his colleagues that he and Strauss would submit resignations to the board. He refused to explain or apologize. “Apologies are bullshit,” he snapped.
DERYCK MAUGHAN, SALOMON’S tall, soft-spoken chief operating officer, roams Salomon’s corridors and cavernous trading room, stopping to invite someone to lunch, ambling over to another to ask, “Are you on the team? Is anything bothering you?” He claims the main difference between him and Gutfreund is 20 years in age. Others think it’s a lot more than that: “Maughan was an inspired choice,” says author Michael Lewis.
As Phase 2 of the Great Salomon Salvage got under way in November, Maughan’s business review disclosed that three-quarters of Salomon’s profit was generated by five operations: U.S. bond arbitrage; bond trading in the United States, Europe and Asia, and Asian stock operations. Despite a sizzling U.S. stock market, Salomon’s domestic stock trading hadn’t made money for two years. Although Salomon’s investment-banking arm, which advises corporations, took in its highest revenues ever in ’91, it was not profitable. In restructuring the firm, Maughan eliminated nearly 150 jobs. Most of the cuts fell in real estate, stock trading, equity analysis and the investment bank.
Over the next two months, several dozen more executives resigned. Many departed after learning they would not play important roles in the reorganization. When Maughan chose nine officers to form an executive committee to run the firm, four of whom work in bonds, the selections telegraphed his intent to concentrate on Salomon’s most profitable business. This prompted a top stock trader and former investment-banking chief to leave.
Bonuses were announced in December; 70% of the managing directors took cuts from the previous year. Some highly paid executives suffered a 50% cut, and many walked out. Maughan says this has been the toughest part of his assignment so far. “The business is being refocused, and it’s extremely painful. The worst is telling people I like and respect that they have to go.”
Each round of firings or resignations rekindles rumors on Wall Street that valuable talent will flee Salomon this month, when the firm pays out $130 million to about 100 managing directors from a deferred-compensation pool established at the time of the Phibro purchase. Those rumors are one reason Maughan tries to boost morale among remaining members of the team. More nerve-racking were Salomon’s dreary fourth-quarter results. Many Wall Street securities firms enjoyed record profits for the period because of strong underwriting volume, but Salomon didn’t join the party. Salomon Inc. announced that it would lose about $30 million due to problems in the Phibro subsidiary and that Salomon Brothers would earn only a “modest” profit: Analysts estimated the amount would be less than $40 million before taxes. Because the first six months were so strong, however, Salomon Inc. had an excellent year, earning about $500 million, compared with $303 million in 1990.
There was also heartening news. Two important clients, the World Bank and the California state pension fund, returned to the fold. Still, executives brood over what lies ahead. No one at Salomon will relax until the Justice Department and SEC investigations are concluded. The greatest fear is that Justice may file criminal charges. The SEC is expected to produce a report by the end of this month; Justice action is not anticipated before summer.
“We’d like the government to see that a criminal indictment is not appropriate,” argues General Counsel Denham. Increasingly, legal experts agree. Says Columbia University law professor Louis Lowenstein: “I’d be very surprised if a criminal suit were brought.”
Looking toward the aftermath of the Salomon case, the Treasury, Federal Reserve and the SEC have proposed opening up the auction market to include additional firms beyond the 38 primary dealers who dominated in the past. They also pledge to intervene in squeezes by flooding the market with additional securities and to inaugurate electronic surveillance to more effectively monitor auctions.
One lesson provided by this curious case is the depth of public outrage with greed and arrogance in the financial community. What disgusted people was the attitude that Salomon could pick and choose which rules to abide by--rules promulgated by no less a power than the U.S. government.
Given the level of distrust, investment bankers would be well advised to tighten supervision of young hotshots who believe they are worth the millions they are paid every year. Harvard’s Hayes points out that men and women with the authority to commit vast sums of their firms’ money possess the concomitant power to destroy their firms’ reputations. “You don’t learn how important public confidence is until it is shattered,” reflects Salomon bond chief McIntosh.
Assuming no criminal indictment is brought, what will the new Salomon look like? Observers from academia, the government and the financial community offer a surprising consensus: The new Salomon will increasingly resemble the partnership of old. The compensation plan to reward officers with ownership is one step. Returning to the firm’s roots with an emphasis on bonds is another. Predicts Prof. Hayes: “They will remold the basic animal, taking the best of what they have. There’s so much depth in that firm, so many good people. The culture that has nurtured the firm got out of hand, but it can be harnessed and made responsible.”
Deryck Maughan obviously shares that vision. “In the new is rediscovery of the old, of reassuring traditional values,” he says. “We all want to prove ourselves.” Welcome to the ‘90s.