Public meetings at the Federal Reserve Board in Washington do not lend themselves to scenes of high drama. The Fed, as it is commonly known, is responsible for the dry work of setting U.S. interest rates and other monetary policies. But this week fireworks were expected when Federal Reserve Board Chairman Paul Volcker and his fellow board members met to rule on a proposed curb announced last month on the use of so-called “junk bonds” to finance corporate takeovers. For many American financiers and corporate executives, Volcker’s proposal is seen as a way of slowing down the U.S. merger mania that has involved $250 billion worth of corporate deals since 1984. But others interpret the proposed rule change as a way of ending the recent trend of buying huge companies on credit. Declared Felix Rohatyn, an influential merger expert at New York investment bank Lazard Frères & Co.: “This may be a first step, but it is important.”
The action has also been highly controversial. Since the announcement of the Federal Reserve’s proposal last month, a high-level dispute has erupted over financial policy, placing the White House against the Fed and nervous big business executives against fast-lane financiers and corporate “raiders.” Half a dozen cabinetlevel agencies of the administration of President Ronald Reagan, orchestrated by White House chief of staff Donald Regan, have denounced the Fed for meddling with the free market.
At stake, according to many political observers in Washington, is the continuing clout of the powerful Volcker. And at the heart of the debate is whether the U.S. government should have any role in regulating the merger activity of American business. The issue centres on the Federal Reserve’s regulation of the high-risk, high-yield bonds, dubbed “junk bonds” by Wall Street. Technically, junk bonds are debt issues that fall below the top, or “investment grade,” rankings of U.S. credit rating agencies such as Standard & Poor’s. Those bonds have traditionally fitted in two categories: issues for small or young companies with scanty credit track records, or bonds from major firms, such as Chicagobased International Harvester, which
have fallen on hard times—“fallen angels” in Wall Street parlance.
Until late 1983 the junk market was small. Then, the leading junk bond underwriter, New York-based investment bank Drexel Burnham Lambert Inc., hit on the idea of using the bonds to finance takeover bids mounted by clients with established credit ratings,
such as Mesa Petroleum’s maverick chairman, T. Boone Pickens. The combination was electrifying. By establishing “shell” companies to issue junk bonds—which then pledged to pay the bonds off with the earnings or assets of a target company—Drexel’s raider clients were able to vastly increase their financial strength. In effect, they
used the stock of the very companies they were bidding for as collateral in their actions. Pickens himself deployed that tactic in his attempted acquisition of Gulf Oil Corp. in 1984. In the end, the deal earned a $760-million profit for Pickens when Gulf management instead sold out to Chevron, at a price of $80 per share, compared with the $45 per share that Pickens had paid for his stake in Gulf.
In Canada, however, junk bonds have seldom been used. A few Canadian companies, such as Calgary-based Financial Trustco Capital Ltd., have raised money through the U.S. junk bond market to fund operations. According to Fraser Ladda, the company’s vice-president, high-yield or junk
securities have not been widely used in Canada because institutional investors, who are the major buyers of debt securities, often have strict guidelines limiting them to grade A securities. At the same time, junk bonds have not been needed for takeover financing in Canada because there are relatively few large acquisitions compared with the United States, and Canadian banks are able to fund domestic takeovers. As well, says Larry Schwartz, policy adviser for the Ontario Securities Commission, U.S. corporate raiders need to raise money quickly and secretly, making investment companies preferable to bank syndicates. But although junk bonds are not used, another kind of high-risk, high-yield financing involving preferred shares instead of bonds was instrumental in at least one recent Canadian takeover—Unicorp Canada Corp.’s acquisition of much larger Union Enterprises Ltd. last March.
The financing curb proposed by the Fed would limit the use of junk bonds in takeovers by requiring potential buyers to put up at least 50 per cent of the purchase price in cash or other assets, a principle called a “margin requirement” which applies to anyone making a stock purchase. But that action took place after a sharp increase in the overall junk bond volume—to approximately $16 billion in 1984. When the final statistics are in for 1985, the figure may even be surpassed.
About half of the junk bond business in 1984 was underwritten by Drexel, which in November arranged $700 million in junk bond financing for Florida-based Pantry Pride’s $1.8-billion
takeover of much larger Revlon Inc. of New York. Drexel’s fee on that deal was $60 million—large by ordinary financing standards but typical of junk bond deals.
Indeed, the bitterly fought Revlon takeover sparked complaints from American business about highly leveraged takeover bids and gave Volcker the ammunition he needed to propose the rule change. Volcker was apparently concerned as much by the buildup of debt among U.S. corporations—an increase of $145 billion last year to a total of $1.6 trillion—as by junk-financed takeover tactics. Some corporate raiders have financed as much as 80 per cent of their purchase of a target company’s stock by means of junk issues. That growing reliance on borrowed money is part of a larger problem of mushrooming corporate, government and consumer debt that is making Volcker’s job as head of the central bank more difficult.
In his attempts to tighten up financing methods, Volcker faces powerful opposition. On the December vote to propose the rule change, two of five board members—both of them Reagan appointees—voted against it. Then, in an unusual display of White House anger, the justice department issued a 40-page legal critique of the proposed ruling two days before Christmas. “We believe it is important to keep the markets open and the market forces free,” said Council of Economic Advisers chairman Beryl Sprinkel, who also signed the strongly worded protest.
That view is shared by acquisitionhungry companies and investment firms such as Drexel, the Wall Street firm with the most to lose under Volcker’s rule change. Said Frederick H. Joseph, Drexel’s chief executive: “As drafted, the rule could shut us down totally. There is no evidence that these financings are harmful to the financial system.” For his part, T. Boone Pickens declared it was another example of how “entrenched management is trying to set up rules and regulations to cut down on opportunities to shareholders.”
Still, Volcker also has strong allies. Andrew Sigler, for one, chief executive of Connecticut-based paper company Champion International and chairman of a Business Roundtable committee that is looking into the merger wave, declared that the expected crackdown on junk bond buy-outs was “a logical, moderate first step to putting some sanity back in takeovers.” Said merger expert Rohatyn of Lazard Frères: “There are extreme cases of leverage that create risks to the credit system that the Fed has the right and obligation to control.”
Volcker’s supporters in corporate America say they are fearful of the potential of junk bond financing. Only a fraction—less than $2 billion—of the money raised through junk bonds in 1984 was used directly to finance unfriendly bids. But executives at companies that until recently were considered too big to be vulnerable, have grown increasingly nervous about the ability of the corporate raiders to gain access to vast sums of money. Indeed, Drexel claims to be able to raise $3 billion within one week.
Whether the proposed rule change is approved or not, battle lines have clearly been drawn on Wall Street. Observed brokerage analyst Perrin Long of New York-based Lipper Analytical Securities: “What we’re seeing is old corporate America rising up against aggressive law firms and aggressive investment banks whose primary interest is in making a buck.”
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