For Romano, the settlement was also an opportunity to serve his friend and mentor Giuliani, now caught up in the heat of the mayoral campaign. Disposing of the case that summer would eliminate it as a continuing electoral issue, demonstrating that the man Giuliani had arrested had in fact been guilty of a crime and not the innocent victim Giuliani’s critics were holding up. Romano sided with Baird. Though the younger prosecutors continued to grumble, they were finally won over with a promise that they could introduce evidence of all of Freeman’s other transgressions at his sentencing hearing.
On August 17, Freeman appeared in federal court and agreed to plead guilty to a felony. He simultaneously resigned from Goldman, Sachs, the firm that had been “an integral part of my life” for 19 years, he said. In his letter of resignation to Goldman, Sachs senior partner John Weinberg, he admitted his guilt in Beatrice but didn’t apologize. He insisted he wasn’t guilty of any other wrong-doing in his entire career and, saying the investigation had been “a nightmare for me and my family,” implied that he was pleading guilty largely to end the investigation. The plea didn’t require Freeman to cooperate with the government, and he never did.
Goldman, Sachs tried to minimize the impact, seizing the opportunity to attack the prosecutors rather than a partner who had just admitted a felony. In a statement distributed to everyone at the firm, Goldman, Sachs said, “Bob has been subjected to an arrest that the prosecutors have since characterized as a mistake, a withdrawn indictment, the promise of new charges in record time followed by a grueling two-year investigation, and a series of highly-publicized formal allegations and innuendoes that far exceed anything he actually did.”
But some at Goldman, Sachs were deeply disturbed by the admission that accompanied Freeman’s plea. Freeman described a world in which, as Goldman, Sachs’s top arbitrageur, he had routinely gained market information denied other investors. In the Beatrice situation, for example, he acknowledged that he had talked to Henry Kravis about the deal; that he had learned that Richard Nye was selling his Beatrice stock because Goldman, Sachs handled Nye’s trading; that he had spoken to Nye; that Lasker had called him reporting problems in the Beatrice deal; and that he had then called Siegel.
Even if it weren’t criminal, the free swapping of confidential information unavailable to other investors was scandalous, showing the hazards of allowing a large investment bank to engage in arbitrage trading. Nonetheless, unlike Kidder, Peabody, which volunteered to get out of arbitrage after concluding that it represented an inherent conflict of interest, Goldman, Sachs’s arbitrage department remains one of Wall Street’s most active and lucrative.
The investigation of Wigton and Tabor was closed. Wigton showed remarkably little bitterness over his earlier handcuffing, displaying to the end the stiff upper lip of the Kidder, Peabody he had known. As the Freeman plea hearing began, and the prosecutors announced that his ordeal was over, Wigton was on an exercise bike at his health club; he’d left word he didn’t want to be disturbed. After absorbing the news, he proceeded to play his usual round of golf at the country club. He said later that he felt the prosecutors had been “gentlemen.”
Siegel was sitting in his kitchen, having completed the day’s shopping in his role as househusband, when the phone rang and his lawyer Audrey Strauss broke the news of Freeman’s plea. Siegel was stunned. He couldn’t believe he’d gone through such an ordeal only to have it collapse in a single felony plea. He’d actually begun to look forward to testifying. He knew he was telling the truth, and he was sure a jury would believe him. Finally he’d get the vindication he felt he deserved. The public would see that he had tried to do the right thing.
The end of the case shattered Siegel’s remaining faith in the government, which he had once assumed would make everything work out. Even worse, he still couldn’t be sentenced, because now he was being held in reserve as a possible witness at Freeman’s sentencing hearing. Siegel complained bitterly to Cartusciello, who told him he’d tried to hold out for a Freeman plea to at least two felony counts. “I can’t say this in open court,” Cartusciello told Siegel and Rakoff, “but we totally mishandled this.”
A week after Milken’s indictment, as more than 3,000 participants packed the Beverly Hilton for the 1989 Predators’ Ball, his loyalists again confronted Joseph about the Milken tribute video. Led by Lorraine Spurge, they met with Joseph in his hotel suite and told him they’d walk out of the conference if he didn’t allow the video to be shown. Joseph was once more thrust into the impossible task of managing a Milken-dominated firm. As he had so often, he relented. On Thursday evening, the emotional tribute ran, complete with Milken voice-overs and stirring music. Even in absentia, Milken was the star of the Predators’ Ball.
Hovering over the proceedings was a giant banner that read DREXEL BURNHAM PRESENTS HIGH-YIELD CITY 2089; under it was a model of a revolving space station featuring products of Drexel clients. But Don Engel had a premonition that this Predators’ Ball would be the last. Even the surprise entertainer—singer Sheena Easton—seemed second-rate. At the RJR presentation, Engel felt lonely and isolated without Milken at his side. When the session was over and the participants had left the room, Engel lowered his head and wept.
Shortly after the conference ended, Drexel at last concluded its SEC negotiations and the terms of the settlement were announced. In a sweeping consent decree, the SEC all but took control of Drexel. Most startling was the announcement that John Shad, the recently retired SEC chairman, would become chairman of Drexel. Joseph would remain chief executive. SEC-approved Drexel officials would be required to scrutinize all of Drexel’s continuing activities. Drexel won its battle to keep its high-yield operations in Beverly Hills, but the settlement still included a condemnation of Milken and Lowell, and required that Drexel buy out their equity in the firm and have no further contacts with them.
“Assuming these agreements are approved in due course,” Joseph told the firm’s employees, “we can get along with the rest of our lives and careers. I think we can all be proud of how we’ve come through. Ninety-six percent of the most important people in the firm are still here. I think that’s an extraordinary performance.”
Drexel agreed to pay Milken $70 million for his equity stake in the firm. Milken announced that he had formed a new company, International Capital Access Group. He issued a press release, drafted by Robinson, Lake, that said the new company would devote its resources to “the creation of ownership opportunities for employees, minorities, and unions.” Lerer denied that Milken was trying to appeal to potential blue-collar and minority jurors.
Pro-Milken dissent was still an issue at Drexel. To keep top performers, Joseph continued to buy their loyalty with lavish bonuses. He guaranteed that everyone’s 1989 compensation would be at least 75% of what they earned in 1988—regardless of the profitability of the firm. Black, for example, was to be paid $20 million; Kissick, $11 million. Kissick took charge of the former Milken empire and Black became co-head of corporate finance. They were replaced on the firm’s underwriting assistance committee, the group that reviewed the quality of potential deals, by junior employees with neither the experience nor stature to question senior officials, no matter how risky some of the deals appeared to be. It was a recipe for disaster.
Black and Peter Ackerman seemed bent on doing deals and generating up-front fees no matter what the future risks or consequences, in a campaign they had begun even before the Drexel agreement to plead guilty. In fall 1988, at Black’s insistence, Drexel had agreed to back a hostile takeover for West-Point Pepperell by Milken loyalist William Farley, whose Fruit of the Loom was already heavily leveraged with Drexel-backed junk bonds. In early January 1989, Ackerman brought in a deal proposed by former Boesky investor Meshulam Riklis, a $175 million buyout of Trans Resources, a company that owned the Haifa Chemical Co. in Israel.
Stephen Weinroth, the member of the underwriting assistance committee who had argued against financing Boesky, was appalled by both the Wes
t-Point and Trans Resources deals. Weinroth’s objections were shouted down by Black and Ackerman. The more junior members of the committee sat meekly as Black and Ackerman forced the deals through. Disgusted, Weinroth stopped bothering to attend the meetings. He couldn’t get Joseph’s attention; the chief executive was too busy dealing with the government and trying to restructure a firm that could survive the settlement.
The new deals showed that without Milken to sell the bonds—bribing buyers if necessary—the Beverly Hills sales force couldn’t find a market for them. The era when Milken could force-feed product to captive clients had vanished. Potential buyers actually began scrutinizing the terms of Drexel-backed bond deals and, in some cases, they were appalled. Drexel ended up having to buy most of the junk paper out of its own capital, which left the firm with a growing portfolio of its own bonds. The firm was stuck with $250 million in Farley loans alone—nearly a quarter of Drexel’s equity capital. By the end of the summer, the firm had a huge portfolio of junk bonds in companies such as Resorts International, Braniff, Integrated Resources, SCI Holdings, Gillett Holdings, Simplicity Pattern, Consolidated Oil and Gas, Hillsborough, and Southmark—all highly leveraged Drexel deals.
Joseph was alarmed. He managed to prevent Black from financing a ruinously high bid for Prime Computer by Drexel client Bennett LeBow, and he tried to rein in Ackerman after a disastrous private placement for Paramount Petroleum that cost Drexel $50 million. Ackerman was furious, and despite his $100 million guarantee, quit working for all practical purposes. He moved to the London office, ostensibly to develop business opportunities in Europe. Instead, Ackerman told colleagues, he planned to begin work on a book. In Beverly Hills, a cartoon circulated depicting Ackerman escaping over a wall at night with a large bag of money.
Despite the large bonus promises, Ackerman wasn’t the only problem. Lorraine Spurge and Bob Davidow, still angry over Joseph’s attempt to suppress the tribute to Milken, quit the firm, withdrawing their equity stakes. Other Milken loyalists also defected, and many parts of the firm suffered, especially the retail brokerage network. As individual investors troubled by the guilty plea left, Drexel had to offer its brokers higher and higher salaries to stay. Even with the large salaries, the number of brokers shrank from about 1,400 to 1,200. It was impossible to recruit new brokers—no one wanted to work at Drexel. And as expenses rose, economies of scale declined. Joseph projected a loss in the retail system of $40 to $60 million in 1989 alone.
By the time of the Predators’ Ball bond conference in April, Joseph had known that a drastic restructuring was imminently necessary. The brokerage system, once the foundation of the firm, would have to be slashed. Joseph felt terrible. Throughout the investigation, he had called on the loyalty of Drexel’s brokers, and most had given it without question. Joseph had pledged repeatedly that Drexel would stay in the retail brokerage business “forever.” In a mid-April speech, however, he said, “The world has changed for Drexel. We’re reviewing all our businesses.” The audience of brokers gave him a standing ovation anyway, and Joseph couldn’t understand why.
A few days later, on April 8, Joseph announced that Drexel was abandoning the retail brokerage business, as well as municipal bonds and foreign stocks. It was the end of Joseph’s dream of building a full-service firm to rival Goldman, Sachs. The 10,000 employees he had so often invoked to justify the settlement with the government were now slashed to just over 5,000. Brokers, suddenly thrown out of work, were bitter at what they considered a betrayal. For Joseph, the choice had been painful but clear: the firm’s survival was at stake.
As Joseph wrestled with mounting administrative problems, more threatening trends appeared in Milken’s vast junk-bond empire. In the past, whenever Drexel’s large bond issuers had begun to threaten default on the bonds, Milken had simply arranged an exchange offer, restructuring the debt, usually with even more leverage. The process, resembling a pyramid scheme, had masked credit problems and given Drexel’s bonds an enviably low default rate. Now the Beverly Hills sales force found it impossible to roll over weak debt into new bonds. Any crack in the junk-bond façade had dire potential, because Milken’s big clients—from savings and loans like Columbia to insurance companies like Executive Life—were already so loaded with junk paper that any decline in the value of their junk portfolios would curb their ability to absorb more.
The crack, when it came, was an earthquake. Just days after Milken’s formal resignation in June, Integrated Resources, a seller of tax-shelter partnerships that had diversified with $2 billion in Milken-financed junk bonds into a $15 billion insurance and real estate empire, defaulted on its interest payments. The quintessential Milken success story, Integrated had loyally issued junk bonds, invested in them, and become one of Milken’s biggest captive clients. Integrated had attracted millions of dollars, the savings of unwitting investors, in its financial products. Its stock price had soared from $7 in 1981 to $46 in 1983. Even though the tax reform act of 1986 had curbed its profits on sales of tax shelters, Milken debt had propelled it into new lines of business. Top executives and major owners—members of the Zises family—had paid themselves huge salaries.
But with its underlying business eroding, Integrated was a house of cards, a microcosm of the whole junk-bond empire. Infusions of new debt could mask its financial deterioration for only so long. Recognizing that, Milken himself had been arranging an equity infusion and acquisition of control by another captive client, ICH Corporation, a Louisville-based insurer (which eventually did buy out the Zises’ interests) in December 1988. It was a typical Milken maneuver to prop up a deteriorating junk issuer, but the pressures of the investigation and Drexel’s guilty plea intervened. The ICH deal was never completed. Without Milken, the Beverly Hills sales force couldn’t hope to sell more Integrated junk debt, and the company lurched inevitably toward a cash crisis.
In February 1990, Integrated would file for bankruptcy, wiping out the value of all of its junk bonds, including a sizable position held in Drexel’s own inventory. Among the victims were thousands of investors, policyholders, and employees—a broad cross section of Americans, most of whom never knew Integrated had any connections to Drexel.
The collapse of Integrated caused alarm in the financial community, especially among the many former Milken clients who had to write off the value of their Integrated bonds. Alarm changed to panic in September, when giant retailer Campeau Corporation disclosed a liquidity crisis that meant it couldn’t meet obligations on the billions in junk bonds it had issued to acquire first Allied Department Stores and then Federated (with such high-profile names in retailing as Bloomingdale’s). The Campeau crisis was startling because the nation’s economy was still growing. What might happen to the bonds of leveraged companies in a slow-down or recession?
It was as if the nation’s investors had awakened from a decade-long dream and recognized finally that high returns could not be realized without increased risk. Even though Drexel wasn’t involved with Campeau—the deal had been the brainchild of star investment banker Bruce Wasserstein and First Boston—investors now rushed to dump junk bonds at almost any price. Values across the board cascaded, affecting Drexel’s most credit-worthy customers. It devastated the value of Drexel’s own junk-bond portfolio, which couldn’t be sold without flooding the market and further driving down prices. And Drexel’s portfolio of junk bonds made up a dangerously high percentage of its assets.
Drexel’s capital was further weakened when it paid the government $500 million, the bulk of its $650 million settlement payment. Its capital was also reduced by the issuance of promissory notes to Milken and Lowell for their Drexel stock, as well as by payments to Milken loyalists who were quitting and selling their equity stakes in the firm. To stem the defections, Joseph refused to allow firm officials to withdraw all their equity interest at once.
Joseph took one other symbolically significant step: he reined in Milken’s and Lowell’s legal expenses. As he had with Milken’s skyrocketi
ng compensation, Joseph felt he had to honor their original agreement: Drexel would pay Milken’s legal costs. Even after Drexel’s guilty plea, the firm had continued to pay all of Milken’s legal fees, including his Robinson, Lake fees which were funding, among other things, the public-relations firm’s efforts to sabotage the Drexel settlement. Milken’s bills were running at a clip of $3 million a month. Payments to Paul, Weiss totaled about $2 million a month. When Joseph questioned the size of the billings and asked Paul, Weiss to itemize the fees and disbursements, Liman flatly refused.
Joseph, while not reneging on the agreement to pay for Milken’s defense, put a cap on the fees of $1.25 million a month. As he put it, Milken might be entitled to the best legal defense money could buy, but he wasn’t entitled to all the legal defense that money could buy. Liman was irate, telling a reporter, “The quality of Michael Milken’s representation will not be affected by Drexel’s nickeling and diming their lawyers.”
Soon Joseph was also wrangling with Milken over what he was still owed by the firm. In the wake of the guilty plea, Joseph had recalculated the bonus pool for the year, charging Milken’s high-yield operation with a pro rata share of legal defense costs. Though he was no longer at the firm; though payment was being held up by the government, and though he presumably had weightier matters at hand, Milken still fought the cost allocation with tenacity. Drexel and Milken’s lawyers never reached an agreement.
As internal bickering mounted, Drexel’s capital was plunging, from $1.5 billion in January 1989 to less than $700 million by October. In mid-October, another event beyond Drexel’s control battered the firm. UAL Corporation, the parent of United Air Lines, announced that it couldn’t complete a leveraged buyout that had pushed the company’s stock above $200 a share. The UAL failure crystallized the symbiotic relationship between the health of the junk-bond market and the ability to mount the takeovers that had so pushed up prices in the stock market. Wary buyers were no longer willing to invest in junk bonds; without that market, stocks couldn’t command stratospheric prices. The bubble burst on October 13, 1989, in a smaller-scale rerun of Black Monday. With takeover stocks leading the plunge, the market dropped nearly 200 points, In terms of points, it was the the second-largest drop ever.
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