The Secret World of Mike Milken (page 4)

September 1987

by Edward Jay Epstein

Milken pointed out that whereas the entrepreneurs using his junk-bonds owned 30% of their companies, the managers (and Directors) of "Corporate America" owned less than 1% of their company. This swing in the "delicate balance" between entrepreneurial and managerial companies was causing "some pain," as he put it. Although he conceded it "was unfair to blame the manager if the owner had not showed up for 30 years"; now, through his junk bonds, they were showing up. As leader of the junk bond movement, he had to rationalize what was happening in terms of "doing good."

He spoke of the conflict was between value and size. Owners sought the former. They wanted to see the value of their investment increase, even if it meant reducing the size of the overall company by selling divisions that they couldn't themselves manage efficiently to others. The example, he gave was the new owners of Beatrice, who sold its coca cola bottling plant back to Coke, and its Playtex division back to its original founder, increased the value of their investment by over a billion dollars but reduced the size of the conglomerate. Managers, on the other hand, tended to be concerned with the size of their domain, which, in many cases, defined their standing in the community. Milken argued this focus often led to inefficient, citing in the case of Beatrice, that the previous management had spent over 100 million dollars sponsoring auto races, which they evidently personally enjoyed, and for an advertising campaign to create a corporate image for Beatrice-- though none of its products were sold under the Beatrice brand.

The idea that values could be increased by reducing the size of corporations provided an appealing logic for financing takeovers. If the new owners could increase the cash flow by selling off parts of the company, this increment could be committed to repaying the bonds. Moreover, to make this takeover financing less risky, Milken arranged the transaction so that the bonds were only bought when, and if, the raider acquired control of the company. In addition, in case the deal failed to come to fruition-- as most did-- they buyers-in-waiting received a handsome "commitment fee" from the raider. Institutions, seeing a profit with a minimum apparent risk, rushed in to provide this take over financing. (The American Lutheran Church' pension, for example, received a $750,000 commitment fee for agreeing to be a buyer-in-waiting of 10 millions dollars of bonds, without putting up any money). These pledges which Milken lined up allowed Drexel to provide raiders with a letter stating it was "highly confident" the financing could be arranged. For its part, Drexel received a cut of the "commitment fees"-- which rarely involved anything more than a promise -- which amounted to hundreds of millions of dollars.

In terms of sheer power, Milken was reached his zenith in the fall of 1986. Over 900 companies had become issuers of junk bonds -- which was larger than the number of companies issuing investment-grade bonds, and the junk bond market was channeling up to four billion dollars a month to companies excluded from the traditional bond market. Because of Milken's money machine, corporations signed on with Drexel (whether they needed the money-- or out of feared, if they didn't, Drexel would supply the money to their competitor). Drexel, which had been a minor brokerage house 5 years earlier, now, in terms of profit, had become America's leading investment bank. Drexel's pre-tax profits were reportedly over $1.5 billion in 1986.

Suddenly, as Business Week warned on its cover, no one was safe anymore. Felix Rohatyn, a senior partner in Lazard Frere, warned "The takeover game as it is practiced today is a really a little like the arms race. You have to stop it before it gets out of control." Lane Kirkland, the President of the AFL-CIO, called it "an outrage and a bloody scandal." Senator William Proxmire, a Democrat from Wisconsin, stated "The rising tide of hostile takeovers threatens the foundation of the American business system."

Sir James Goldsmith, who has been both a client and an opponent of Milken's, saw the conflict proceeding from the threat to take power away from those who had held it. "I don't know whether or not Mike Milken realized at the time that he had found a way of financing an immense revolution in America, but now he has witnessed the full power of the establishment triangle: big business, big unions and big government." He then added, " As I European, I witnessed the same alliance trying to avoid change and neutralizing those responsible for it."

"It is nothing short of war," declared one of America's leading industrialists, who asked not to be identified out of fear of being caught in the cross-fire.

Wall Street was only one front in this war. It was fought also in court rooms, board rooms and back rooms of state legislatures, as well as on television and op pages, where accusations were made that corporate managers were "corpocrats," and raiders "assassins in three piece suits." It even was waged even on the streets of Akron, Ohio, were Goodyear organized workers, wearing rubber face masks, to march in protest against Sir James Goldsmith.

At the center of the conflict is an almost philosophic disputation about the purpose of the large corporation in the scheme of American capitalism. In one camp, the defenders of the present system of corporate stewardship, argue that the corporation must be regarded not just as a private profit-making but as a public institution. As such, they must serves not only their legal owners--the share-holders-- but broader interests, including their workers, suppliers, the local community and the nation. They hold that management, which represents these community interests as well as shareholders, is best suited to run these institutions.

In the other camp, the raiders and their allies, argue that corporation best serve others by serving their legal owners-- the shareholders. In this view, they benefit other constituencies--such as labor, suppliers and communities-- not by being charitable institutions but by making the most efficient use of their resources-- which may mean selling or closing down unproductive divisions. They hold that only managers who are accountable to owners have the incentive to make such hard choices. Such accountability comes down to owners having the ability to fire them-- which may may mean taking over the corporation.

Behind these different rationales (which belligerents may-- or may not-- sincerely believe), both sides are after the same prize: control of the corporate wealth of America. The means for waging this battle is money.

By opening up the capital market, like some Aladdin's cave, to outsiders, Milken has made himself central to this war. To end the threat to take away their stewardship, and power, corporate managers had to somehow close the cave. No unrated bonds, no take overs.

Under siege, corporate managements turned in increasing numbers to State and Federal government for help. By November 1986, some 30 bills had been proposed in Congress, while a dozen states passed or considered anti-take over laws. With the Business Round Table, which represents the Fortune 500, warning that junk bond take overs could bring on a 1929-type depression, the Federal Reserve Bank raised margin requirements on junk bond financing, State Insurance Commissions mandated reduced investment in junk bonds, and Congressmen called for new restrictions on their purchase.

Milken tried to explain these attacks on his junk bond empire to money-managers with a baseball metaphor. "Just imagine there was a baseball team, like the N.Y. Yankees, that won all the time. It even came to believe it had a divine right to win. Then a new team came along whose pitchers knew how to throw curve balls and sliders which its hitters couldn't hit. It began to lose. So its manager decided, rather than teaching them how to hit these pitches, to go to the Commission -- and have them banned."

Senators on the Banking Committee listened, the Chairman, William Proxmire, opened a special hearing on Wall Street by asking "How much do we really about the corporate takeover game and the complex network of information that circulates among investment bankers, takeover lawyers, corporate raiders, arbitrageurs, stock brokers, junk bond investors and public relations specialists?"

This question, which raised the specter of finding a vast criminal conspiracy behind the battle for corporate control, was directed to Rudolph Giuliani, a prosecutor who had made his reputation proving criminal conspiracies against the Mafia, and Gary Lynch, the Director of the SEC's enforcement division. Senator Proxmire explained that in 1933, the same Senate Banking Committee had "recruited" a young attorney named Ferdinand Pecora to go after "white collar criminals" on Wall Street. Pecora, as the Senate's chosen instrument, went after the villain of that era: The House of Morgan-- who had turned the nation's capital markets into a private preserve.

The Chairman then came to his point: "Mr. Giuliani and Mr. Lynch, you are the Ferdinand Pecoras of the 1980s; through your vigilance, Wall Street is being rid of some of its criminals whose greed has cut a sorry path through our American system." His message--and charge-- was clear. The new Pecoras' target would be Mike Milken, who ironically was responsible for breaching the walls around J.P. Morgan's preserve.

Giuliani had already cut his deal with Boesky. He also cut deals with the seven other participants in the Boesky ring (who worked for such firms as Lazard Frere, Shearson, Wachtell Lipton, Kidder Peabody and Drexel)-- thus ending the case with 8 guilty pleas. The New Pecora abruptly shifted his investigative focus from the inside-trading scam to possible irregularities in Mike Milken's operation.

Giuliani suggested the tough tactics he planned to employ when he was asked what he believed was the difference between culprits in organized crime and those on Wall Street. He answered the latter "roll easier"-- meaning that Wall Street financiers, when threatened with doing hard-time in prison, could be more easily induced to implicate others to save themselves. To this end, he arrested Timothy Tabor, who had worked in the Kidder Peabody Arbitrage Department, too late in the afternoon for him to arrange bail-- or even a lawyer. No indictment had been obtained, nor was he ever advised he was being investigated. He was then told he would have to spend the night in prison if he did not cooperate with Giuliani's investigation by making a taped phone call to his ex-boss. Giuliani candidly explained "This isn't an invitation to a tea party-- people are arrested in the hope they will tell you everything that happened." (In this case , Tabor proved an exception to Giuliani's prediction and, rather than "cooperating" spent the night in jail. (Giuliani subsequently dropped these charges when it came time for him to have a day in court).

Parking violations, as the name implies, involves a brokerage house or bank keeping a client's stock in its own name in disregard of its reporting requirements. Such "parking" may allow the client to temporarily bypass his margin requirements, keep secret his position in a company that otherwise he would have to disclose, or stay within limits imposed by other rules. It may also sometimes used by portfolio managers who "window dress" their fund's holdings for public reporting purposes. Such infractions of the myriad of reporting requirements was not a rare occurrence. As one Wall Street executive observed,"There is not a firm on Wall Street that can be sure it has not, at one time or another, committed some technical violation of these laws." Although clearly a breach of the securities law, up until now no one ever went to prison for such an infraction. The "new Pecoras" have,according to their testimony, a very different idea about "parking violations." They have over the past 7 months subpoenaed numerous Drexel employees and clients, attempting to unravel relations Milken may have had with clients that, in one way or another violated reporting requirement.

Whatever the final disposition of Mike Milken, the financial world will never be the same. With his multi-billion dollar resources and secret alliances, he has created the image of a viable and liquid market in junk bonds. By any standard, this is a truly extraordinary accomplishment which has changed the way that funds held in trust are invested.


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