BUSINESS WATCH

The junk bond plague moves north

The moral of one saga seems to be that you can weave almost any web of corruption with little fear—if you do it on the stock market

Peter C. Newman January 16 1989
BUSINESS WATCH

The junk bond plague moves north

The moral of one saga seems to be that you can weave almost any web of corruption with little fear—if you do it on the stock market

Peter C. Newman January 16 1989

The junk bond plague moves north

BUSINESS WATCH

The moral of one saga seems to be that you can weave almost any web of corruption with little fear—if you do it on the stock market

PETER C. NEWMAN

In less than eight weeks, convicted swindler Ivan Boesky will be eligible for parole, having dramatically reduced his potential sentence by paying a $120-million fine and by eagerly ratting on his colleagues. His wife, Seema, who has been awaiting his release from prison at their magnificent Georgian mansion near New Castle, N.Y., is planning a happy homecoming gift for her Ivan—a new master bedroom suite capped by a vaulting Jeffersonian dome, with his-and-hers 680-square-foot dressing and bath complexes. Happy Ivan will reclaim his pink Rolls-Royce, settle back behind his famous 160-direct-line switchboard and resume the lifestyle to which his swindling ways had made him accustomed. The moral of this sleazy saga seems to be that you can weave almost any web of corruption and commit nearly any felony with little fear of serious punishment—providing you do it on the stock market.

The most recent example is the New York City brokerage house Drexel Burnham Lambert Inc., which late last month pleaded guilty to six felony counts, five of them involving fraudulent transactions with Boesky. The U.S. Securities and Exchange Commission (SEC) fined the company $780 million. Drexel chairman Frederick Joseph, who had been Boesky’s personal investment banker, agreed to go along with the indictment because it was far less severe than a sizzling list of charges that the SEC’s staff had drawn up. The charges outlined a pervasive pattern of illicit practices by the junk bond dealer, including elaborate schemes to gouge Drexel’s own customers.

Because Drexel had become so dominant on Wall Street, controlling nearly half of the junk bond market, few Wall Streeters have dared to criticize its practices. Only the odd legislator and financial writer has put the situation into its proper perspective. “We know now,” said Massachusetts congressman Edward Markey, who heads a House subcommittee on finance, “that the single most successful firm on Wall Street during the 1980s built its fortune large-

ly on a foundation of criminality.” Connie Bruck, the lawyer-author whose massive investigative history of Drexel was published last fall, described the firm as “the brass-knuckles, threatening, market-manipulating Cosa Nostra of the securities world”—and went on to amply document her thesis.

Drexel’s punishment for its thuggery is nothing more than the $780 million, $420 million of it due to be paid back to some of the individuals and corporations it defrauded. Apart from the many individual claims, 13 groups have already launched class actions against Drexel. There is even one suit being brought against the firm by its own employees, who were encouraged to buy its stock and who now find their investment worth a lot less than they were led to expect because of senior management’s deliberate flouting of the law.

It was Drexel, of course, which flourished with the blossoming of junk bonds—the highyield pieces of corporate paper used to raise funds which are added on top of all other debts, so that they carry the highest risk exposure. First used to raise money for venture companies not ready to qualify for more senior forms of financing, the high-yield bonds—usually four per cent over prime—at first served a legiti-

mate, if risky, purpose. But starting in 1984, Michael Milken, then in charge of Drexel’s West Coast operation, introduced the use of junk bonds on a massive scale for a very different function. They became the prime fiscal instrument for leveraged buy-outs, which allowed corporate raiders to finance hostile takeovers—later redeemed by selling off the targeted company’s assets.

During testimony, Milken claimed that he could not recall many details of his trading activities because, he insisted, when he was talking to someone, he would usually be carrying on 10 other conversations. Testified Milken: “I would say that I listen to no more than 25 per cent of the conversation I have during any trading day... I would come in and out, buy and sell securities during any conversation.” (That may even be true. During a recent interview with the San Francisco Chronicle, Milken couldn’t recall the name of the best man at his wedding or his wife’s middle name.)

The $780-million fine, the largest ever levied in any stock fraud investigation, may sound like a devastating blow, but for Drexel it’s small change—the profit from a few junk bond deals. The company had already created $480 million in reserves for the fines it expected to pay (does that mean that its officers knew they were breaking the law?) and has $2.8 billion in retained capital that can easily be tapped to pay the levy. The junk bond business is so obscenely profitable that its practitioners keep their bank account totals to themselves, but Fortune recently made a good stab at estimating Milken’s 1987 income. American law allows the rich to set up foundations as tax dodges, but limits donations to 30 per cent of earnings. Because his family foundations gave away $236 million during the year, Milken must have earned at least $780 million in 1987—or more than $2 million per working day.

The highlight of Milken’s trading year was the annual Predators’ Ball, held at the Beverly Hilton in Los Angeles. The annual Drexel conference and social gathering—which in the past showcased entertainers Frank Sinatra and Dolly Parton—is being held on schedule (April 1) this year. Not only that, Drexel is so unconcerned about its criminal charges that it is busy expanding. To Canada. At the end of this month, the firm will be opening a Toronto office under a Drexel vice-president named Stanley Sapery. In the past, Drexel has raised junk bonds for several Canadian corporations. Presumably more Canadian companies will now be granted the privilege of adding their names to Drexel’s roll of honor.

Fear and greed have always been the two main motivating impulses of the stock market. But there have to be limits, so that even the investor who is wise enough to realize the risks he or she takes at least knows that the basic ground rules of supply and demand—rather than the hidden inside dealings of firms like Drexel—are dictating share price levels. By allowing individuals and companies who have demonstrably broken and trampled on the law to get away with easily swallowed fines, the regulators are breaking the social contract under which the rest of us live and work.