by Connie Bruck
Some at Drexel maintained that the real problem of the IBG lay in the firm’s generally freewheeling, unstructured approach—exemplified in part by the Centronics situation. The Drexel culture encouraged entrepreneurism at every turn. Compliance, capital allocation, exposure and accounting were centralized, but all other decisions were left to the head of each group, so that the firm was run as a loosely connected association of free enterprises.
“Drexel was made up of little fiefdoms, with no rules,” recalled one former IBG member. “Joseph wanted it to be that way. It was supposed to be more entrepreneurial, and I guess it had worked for a while, especially when the place was smaller, but it didn’t anymore. You’d [as a member of the IBG] call on a company and find out that, four weeks before, someone from corporate finance had been there; three weeks before, someone from M&A; and two weeks before, one of Mike’s guys. No one had any idea what anyone else was doing. It was chaos.”
Now, in January ’87, Engel was brought back to the firm to be co-head (with Andersen) of the IBG. Engel invited one of the IBG members, a recent recruit from a premier Wall Street firm, to break fast. He reportedly told this associate that he, Engel, was his new boss (not Andersen) and that he would be dealing directly with Milken. Symbolic of his stewardship, Engel had rechristened the IBG the “Relationship Group.” He is said to have explained that it was emphasizing relationships that would win the new clients, that that was the style of business at which he excelled and that the way to establish relationships was by “getting in the minds” of prospective clients, and providing them what they wanted.
This associate had heard Engel’s analysis before. At the Tokyo bond conference, when he had first met Engel, Engel had allegedly remarked to him, “I understand CEOs, CEOs don’t care about money, power or fame. They have all that. What they want is pussy. And I’m going to make sure they get it.”
Then, however, Engel had been only a consultant to the firm. Now he was this young investment banker’s boss, ready to school the IBG in his kind of business-getting. One Drexel executive recalled, “He [the associate] said, ‘Omigod, everything they told me about Drexel over at . . . , it was all true, the place is a total slime-bucket!’ ” He immediately resigned from Drexel and returned to his former firm.
At Drexel, the melodrama continued. Word had circulated about what had precipitated the associate’s resignation. Younger employees at the firm did not know why Engel had been forced to resign in 1984; many, knowing Engel as a notorious, compulsive womanizer, believed it had been for the kind of incident that had just occurred. But whatever the reason had been, it was clear to these fresh-faced Harvard M.B.A.’s, who had had their pick of the firms on Wall Street and had chosen Drexel, that Engel (like his longtime client Victor Posner) was an unsavory reminder of the old Drexel, which would be better forgotten. If there was ever a time for the firm to cultivate a straight-arrow image, they thought, surely this was it.
Andersen and Weinroth, who both had opposed Engel’s reinstatement, now threatened to resign unless he was forced to resign again. And within two weeks, by early February, there was such a popular groundswell against Engel that people were calling it a “revolution.” When Engel tried to enter an IBG meeting on February 6, Andersen ordered him out. Engel left the room and called John Kissick in Beverly Hills, who was participating in the meeting via a hookup. Engel’s strongest support had always come from the Coast. Kissick said he thought it was OK for Engel to attend. As soon as the meeting broke, Andersen walked across the street to Drexel’s executive offices to deliver his resignation to Joseph. Weinroth said he would resign, too. Another corporate-finance partner, Alan Brumberger, calling in from out of town, said he would join them.
Joseph—who in earlier, more upbeat times had described himself as the “Dr. Feelgood” of Drexel—reportedly asked for one week to try to resolve the problem in a way that would “make everyone happy.” That, however, was not possible, and Engel was forced to resign. He resumed his “consultant” status.
Engel’s reinstatement had lasted less than a month. It is true that in the larger scheme of Drexel’s troubles it was only a sideshow. But at a time when Drexel employees were already shell-shocked, depressed, embarrassed, defensive and fearful for their futures, it managed to make morale even worse, holding up a mirror to the firm and reflecting an unsightly image.
That image had nothing to do with what the government was investigating, and yet it had everything to do with it. Engel’s procurement of women for clients was not conduct the government would likely seek to prosecute, but its significance lay in the larger truth that it revealed about Drexel. For whether it meant procuring women, or threatening would-be clients, the resounding credo at Drexel was to do whatever it took to win.
Everything bowed before that credo. Morality and legality became mere conventions, accepted modes of conduct for the foot soldiers of the world—the less creative, less aggressive, less visionary. The iconoclastic Milken, in whose image the firm had been formed, had always disdained conventional ways of seeing, conventional ways of doing business. And, thanks to his flouting of convention, Drexel had apotheosized out of nothingness.
It was that credo that had led to Engel’s reinstatement. Joseph is said to have personally abhorred Engel. He may have also personally abhorred Engel’s function, though he must have known and accepted it for years. He had made a show of enormous though disingenuous indignation to Institutional Investor in an interview for its August 1986 Milken profile, when the subject of hookers at the Chasen’s dinner and Bungalow 8 was raised. Telling Institutional Investor that he “went bananas” when he heard the stories, Joseph added, “I discussed it with Michael and I said, ‘If there ever is a hooker there, I’ll fire everybody in sight, I’ll kill everybody . . .” And everyone said, ‘Fred, it’s not true, you’re overreacting, you’re nuts.’ I said, ‘All right, but not one woman who would embarrass us if someone knew exactly what she did for a living.’ And I think I can guarantee you that there isn’t a single woman there who doesn’t have a legitimate reason to be there and that none of them are hookers.”
It may well be that had history allowed Joseph to pursue his longtime vision of building an institution comparable to Goldman, Sachs, he ultimately would have done away with Engel and his cast of (in case anyone asked) aspiring actresses and would-be models. But when the firm began to disintegrate around him, Joseph applied Drexel’s one abiding test to the question of whether to bring Engel back. “He thought,” said one employee, with a shrug, “that Donnie would be good for business.”
That quintessentially pragmatic credo—whatever it takes to win—may have shaped Drexel’s response to the investigation, as well. In the first month or two after Boesky Day, the firm was in turmoil, apparently without a fixed defensive strategy, taking the crisis day by day. There was a considerable amount of anxiety about who might be cooperating with the government. Some days, corporate-finance executives in New York considered casting the West Coast adrift, telling the government that they had known things were not right out there (but never been sure of the specifics, so had not gone to the authorities) and that they wanted now to make their separate peace.
But ultimately this notion had been vetoed as too ignoble, too disloyal to the regent who had made them all richer than they would ever have been without him—and also impractical, since it would have been difficult for the firm to escape liability. Instead, Drexel would present a united front and—unless the government came up with a “smoking gun”—fight back.
Apparently, the closest thing to a smoking gun that the government had was that $5.3 million payment made from Boesky to Drexel in Beverly Hills. And after Boesky’s auditors had demanded some documentation, Lowell Milken and Donald Balser had signed the invoice stating the payment was a fee for “consulting and advisory services.” In an article in The New York Times in February by James Sterngold, several Drexel executives were quoted, elaborating on this, saying that the payment was for seve
ral takeover bids—for the Financial Corporation of Santa Barbara, Scott and Fetzer, and U.S. News & World Report magazine, among others—that Boesky had asked them to work on but had never consummated. One Drexel official added that in some instances Boesky had backed out at the last minute, and that part of the $5.3 million was meant as compensation to Drexel for its work on these deals.
After-the-fact explanations, however, accompanied by no corroborating documentation tend to fall rather flat—particularly when set alongside the “paper trail” of records kept by Boesky which corroborated his version and which the government was said to have collected, according to sources quoted by Stewart and Hertzberg in The Wall Street Journal.
One Drexel employee claimed that this problem—the lack of a paper trail for their side—had been solved by Drexel’s fabricating one. Interviewed in early April ’87, this employee claimed that “the books were cooked” in the previous month or so, to show at least one specific charge to Boesky that had never existed, as part of that $5.3 million: about $1 million for research, related to Boesky’s abortive takeover bids. If true, this was not only a desperate but an ill-considered gambit, since it appeared somewhat implausible on its face. While Drexel’s research has become well regarded in the last couple of years, it was considerably less strong back in 1984, when the work on these bids would have occurred. It is especially unlikely that Boesky, who prided himself on his research capabilities in his own shop, would have paid for Drexel’s. Moreover, when Boesky did utilize research from Wall Street firms, he was often given it gratis, in exchange for the commission dollars that the firms earned from his trading.
A Drexel spokesman has stated that contemporaneously with the billing of the $5.3 million fee in March 1986, an internal memorandum directed that the fee be allocated among the corporate-finance, research and high-yield-bond departments, and there have been no subsequent changes.
17
The Humbling
ONE YEAR AFTER Boesky Day, Drexel was still in limbo—its likely indictment spelled out in great detail in the press many months before but not yet issued by any grand jury. In the world at large, however, events had not stood still. On October 19, 1987, the stock market’s horrific crash was thought at the time to signal the end of an era—an era in which a five-year surging bull market whipped Wall Street into a frenzy of deal-making, an era in which financial fantasy routinely came true. In the wake of the crash, “debt” and “leverage”—which had seemed to possess magical properties for the conjuring of enormous wealth in the corporate arena—were demystified, seen as tools of excess which might now, in the harsh light of day and a possible recession, exact their toll. The spell—for the moment at least—was broken.
Milken had not created the M&A binge of the eighties. Indeed, he had been an outsider, relegated to the sidelines until he and his colleagues provided their chosen with war chests and refined the concept of the Air Fund (conceived of in a Gobhai seminar but never implemented) into the “highly confident” letter. But once Milken won entry to the game, he did more to shape it than any other individual. It seemed only appropriate, in a sense, that this era might draw to a close now that its impresario was so hamstrung (though by early 1988 M&A would again be thriving and Milken would not yet be enjoined from the scene).
For the past several years, while Drexel and its rivals were underwriting billions of dollars of junk bonds to finance scores of superleveraged acquisitions, critics had predicted that this mountainous debt’s test—and failure—would come in the next recession. They pointed out that in the early eighties’ recession the megadeals’ junk bonds had not yet existed, and that credit quality of junk had been deteriorating in the last couple of years. Therefore, they maintained, there had been no test of the junk market in its current, $150 billion form.
In the October 1987 crash, junk bonds did fall in price, with the average junk portfolio losing at worst about 10 percent of its value. This was not surprising, since they are really part debt, part equity, and their value tends to fluctuate with the equity markets as much as or more than with the bond markets, their key variable being less the direction of interest rates than the perceived ability of the issuer to service its debt. While investors fled to Treasury bonds, which staged a huge rally as the stock market plunged, junk bonds yielded a near-record 5.5 percentage points over Treasury bonds with comparable maturities. In the weeks after the crash, the market for new junk issues was scarce, even at interest rates of 17–18 percent. And a scattering of obituaries for junk began to appear in the press.
But they were wrong. For by mid-November, one month after the crash, the prices of the stronger junk issues had rebounded dramatically, while the weaker issues—among them credits which were dependent on asset sales to meet their debt obligations, for example—did not. At this point, it was a winnowing out of the junk market, not its demise.
Moreover, the issues and deals that got so badly pounded by the crash that they overnight became symbols of the changed world in junk were by and large not Drexel’s. Fruehauf bonds, for example—underwritten by Merrill Lynch—were at 82–84 just before the crash, and two weeks later were at 60–70. Also, in the wake of the crash the Thompson family’s management buyout of Southland Corporation was temporarily stalled, mid-deal, when its $1.5 billion of junk bonds could not be sold, even at rates of 18 percent. The investment banks at risk in Southland—at risk because they had been the lead lenders in a $600 million bridge loan extended to Southland the previous August, and now it was not at all clear that the bridge loan could be paid down—were Salomon and Goldman, Sachs. About two months later, however, the Southland deal was restructured to offer investors an added sweetener of warrants, and it proceeded. After the crash, too, bridge loans suddenly lost their panache. They were now seen for what they had always been—serious risks to the investment banks which had extended them. Drexel had extended some, but had been far charier than most of the other major firms.
Milken rejected the critics’ premise that the market had not been tested. Critics, he said in a late-November interview with this reporter, were using the wrong benchmark, because they lacked historical perspective. While it was true that broad public issuance of non-investment-grade securities had started in 1977, he repeatedly emphasized that there had been a large high-yielding market (comprised mainly of fallen angels and paper issued in exchange offers) by 1960. And this market, he asserted, had been tested in 1970–71, and even more severely in both 1974–75 and 1980–81. The success of high-yield investments during these three periods was testimony to the diversity and underlying strength of high-yield companies themselves, Milken added. “We were there to help provide advice and liquidity to both companies and investors during those periods, and we will be again,” he declared. “In reflecting upon it, the greatest opportunity to help, strengthen and build is during difficult economic times.”
By late ’87, those difficult times had not yet impacted the rest of the country, but they had hit Wall Street. The retrenchment had started earlier in the year, after several major firms suffered severe trading losses because of interest-rate volatility, but after the crash it proceeded with a vengeance. E. F. Hutton was purchased by Shearson Lehman Brothers. Some specialist firms were bought by Drexel; Merrill Lynch; Bear, Stearns; and others. Layoffs, bonus-cutting, and reduction of overhead expenses were pandemic. Drexel was no exception, though its cuts were less dramatic than some firms’; one hundred of its eleven thousand employees were laid off, and its bonuses were reduced (less so for star performers).
Corporate America, witnessing Wall Street’s distress, might have felt a certain mean-spirited gratification. For while hundreds of public companies had undergone paroxysms of restructuring, overhead-cutting, layoffs and elimination of research and development in order to escape an acquirer’s clutches, Wall Street, inciter of and handmaiden to all this frantic activity, had only grown fatter. But it could not last; most of the Wall Street firms, after all, had relinquished their private-
partnership status over the last decade and become public companies themselves.
Now the scythe had turned in their direction. Salomon, its earnings down and management poor, had become quarry for Ronald Perelman in August 1987. Salomon had managed to fend him off by selling a substantial stake to Warren Buffett’s Berkshire Hathaway. The event served not only as an indicator of Wall Street’s vulnerability but also as a reminder of how quickly this world had changed. Exactly two years earlier, the bid for Revlon by the unknown Perelman had seemed, almost, amusing. Now Perelman was a corporate titan to be reckoned with.
Barring an apocalypse—the chain-reaction collapse of dozens of junk-bond-financed, highly leveraged companies, which would then impact the junk portfolios of insurance companies, thrifts, pension funds, mutual funds and others—it will be ten years before Milken’s legacy becomes clear. Takeovers, buyouts and restructurings would have occurred if there had been no Michael Milken, but it is hard to imagine that they would have occurred in the size and volume that they did.
And it will take time to discern whether, on balance, those financial maneuvers created leaner, stronger companies, by imposing the discipline of debt, by dismantling inefficient giants and putting their parts into the hands of managers who owned a piece and so did a better job; or whether they created undernourished, nonproductive, noncompetitive companies, crippled by the debt which in many instances had served only to enrich the short-term investors—and, of course, their investment bankers. In all likelihood, both scenarios had occurred, and the question would be which was demonstrably more prevalent.