The October “minicrash,” as it was quickly dubbed on Wall Street, proved a more long-lasting harbinger of trouble than the dramatic October 1987 crash. Beginning with Integrated and Campeau, and then continuing with alarming regularity, junk-bond issuers began to default on their obligations. Payment terms in highly leveraged deals, especially those completed in the frenzied days prior to the 1987 crash, had managed to disguise the underlying folly of the investments, often through the issuance of so-called “zero-coupon” bonds, “payments in kind,” and “re-sets” which required no payments whatsoever for several years. Eventually the piper had to be paid. Like Integrated, the whole junk market began to tumble as companies admitted they couldn’t fulfill the promises they had been so eager to make just several years before.
By the time the financial data for 1989 were collected and analyzed, a growing suspicion of many participants in the junk-bond market, even of some Milken loyalists, was confirmed: Milken’s oft-repeated premise that “investors obtained better returns on low-grade issues than on high-grades” was false. It was the criminals who earned astronomical returns. During the decade ending in 1990, Lipper Analytical Services reported, money invested in the average junk-bond fund grew 145%. That was, in fact, worse than returns on the same amount of money invested in stocks (207%); investment-grade corporate bonds, so often ridiculed by Milken (202%); U.S. treasury bonds (177%); and equal to returns from low-risk money market funds. During the decade’s last year, junk bonds returned a negative 11.2%.
With benefit of hindsight, Milken’s “genius” seemed his ability to make so many believe his gospel of high return at low risk. As David Scheiber, a junk-bond portfolio manager at Far West Financial Services and a big Milken customer, told The Wall Street Journal in 1991, “Some people believed whatever Mike Milken said.” But the way things turned out, “Bondholders got all the risk and very little of the upside.”
Data also undercut the vigorous Robinson, Lake claims that Milken-raised capital had been the savior of entrepreneurs and small businesses. Of the 104 small firms involved in public issues of nonconvertible Drexel junk bonds since 1977, 24% had defaulted on their debt or were bankrupt by mid-1990—five times the default rate of comparable firms, according to Dun & Bradstreet.
With astonishing speed, some of Milken’s biggest boosters began to collapse under the weight of the debt burdens they had embraced with such enthusiasm. Ralph Ingersoll lost control of his U.S. newspaper empire when he failed to make payments on his Drexel-generated bonds. William Farley couldn’t complete the West-Point Pepperell acquisition. Even Tom Spiegel, the Milken apostle at Columbia Savings, was ousted and his savings and loan taken over by government regulators. Eventually, nearly every savings and loan that was a major player in Milken’s ring of purchasers was declared insolvent and placed in the hands of government receivers.
Could Drexel itself survive? Joseph knew how grave the situation had become. He had already faced the possibility of the loss of Drexel’s independence. In September—even before the October debacles in the junk-bond and stock markets—he had secretly begun a series of phone calls to top executives at every other major Wall Street firm, seeking an equity infusion or even a merger partner. It was a humiliating experience for the chief executive of the firm that had once terrorized the very firms he was calling. Many didn’t even return his phone calls, and those that did dismissed the possibility, citing Drexel’s still-unresolved liability in investors’ civil lawsuits as an uncertainty that would prohibit any thought of merger. The truth was probably even worse: Drexel’s reputation and admission to felonies made it anathema to its rivals, even if they still coveted the remnants of Drexel’s junk-bond prowess. Joseph quickly learned the cost of Drexel’s years of arrogance, its insistence on dominating offers, its refusal to share underwriting fees. Drexel had no friends on Wall Street.
Even as the firm’s plight was becoming desperate, Joseph faced the prospect of making good on his promise that 1989 bonuses would be no less than 75% of those of 1988. The promise now looked foolhardy, but Joseph felt that if he reneged, he would lose all credibility and mass defections would destroy the firm. Instead, he began a series of meetings to persuade top performers to take a portion of their 1989 bonuses in Drexel preferred stock rather than cash. For the first time, Joseph asked employees to put the survival of the firm ahead of their own immediate financial interests. After all, he thought, no one among Drexel’s top officials truly needed more cash. They were already rich.
Amazingly, Joseph had misunderstood the ethic of the Drexel culture, the mindset fostered by the firm and embodied in Milken: Drexel was nothing but a corporate vehicle for personal gain. When Joseph asked his stars to accept lower bonuses, howls of protest rose from Black and his allies. Ultimately Joseph persuaded Black to accept some preferred stock, though they fought bitterly over the exact amount. Kissick was more amenable, and he got the Beverly Hills group to agree. Joseph took all of his own $2.5 million bonus in preferred stock. Still, he could get his people, on average, to accept only 18% of their bonuses in stock. Drexel saved only $64 million in cash, as it paid out over $200 million of its desperately needed capital.
As 1990 began and the scope of Drexel’s problems became more apparent, Drexel’s short-term lenders refused further financing. The firm couldn’t sell short-term commercial paper. As previous short-term loans came due, it had to make the payments out of its dwindling capital and couldn’t refinance the debt. By February 1990, Drexel had paid out $575 million to cover commercial paper alone.
Joseph believed the firm still had $1 billion in capital, admittedly in investments like unsaleable junk bonds and equity interests in leveraged buyouts. He began planning some kind of an equity infusion, perhaps through a packaging and sale of the firm’s best LBO stakes, as well as a shift of $300 million in capital from its regulated broker-dealer subsidiary into the Drexel holding company.
But it was the end of the road. On Friday, February 9, the SEC and New York Stock Exchange notified Drexel that it would not be permitted to reduce the capital of its regulated subsidiary. Joseph was stunned—he believed Kidder, Peabody had been allowed to go far below the regulatory minimums prior to its cash infusion from GE. But Kidder, Peabody had had the promise of the GE deal. The regulators considered Joseph’s schemes for raising capital to be pipe dreams, and they valued Drexel’s assets at far less than Drexel did. Once again, Joseph had underestimated how much damage the firm’s fierce resistance and guilty plea had done with regulators. Unlike Drexel, Kidder, Peabody had cooperated. No one was inclined to do anything that even hinted at favorable treatment for Drexel.
Drexel collapsed with unnerving speed. Bankruptcy lawyers descended on the firm that weekend. On Monday, February 12, Joseph called Gerald Corrigan, the powerful head of the Federal Reserve Board of New York, desperately hoping that Corrigan would pressure the big New York banks he regulated to extend emergency loans to Drexel. Representatives of a group of banks convened in Drexel’s Broad Street offices at 4 P.M. as Drexel made a plea for loans. Given the haste of the rescue effort, Joseph was ill prepared for their questions, and even though he discounted the value of Drexel’s portfolio to a new low—$850 million—he failed to persuade them that it would yield substantial value over time. The banks left without making any commitments.
Joseph called Corrigan that night at about 11 P.M. Wasn’t the Fed doing anything to help? Corrigan replied enigmatically that, while he wasn’t telling Joseph how to run his business, “If I were you I’d talk to the chief executives of some of these banks directly.” Joseph, grasping at any straw, took that as an indication that Corrigan must have pressured them.
He began an immediate series of calls, but got nowhere. When Joseph pressed the bankers on whether the Fed had encouraged them to help Drexel, he got no encouragement. Gradually he realized that the Fed had done nothing.
Now frantic, Joseph again called Corrigan, about midnight. “Is there some misunderstanding?” Joseph
asked. “The banks aren’t doing anything.”
Corrigan sighed, and then replied, “Call Treasury. I’m afraid we have a different agenda.”
Joseph knew he was doomed. The Secretary of the Treasury was none other than Nicholas Brady, the former head of Dillon, Read, who, Joseph believed, had never forgiven Drexel for the hostile raid on one of his largest clients, Unocal.
At 1 A.M. Corrigan called Joseph back. They were linked by conference call to Bush’s new SEC chairman, Richard Breeden, and Corrigan told Joseph they spoke for Treasury Secretary Brady as well. Corrigan got directly to the point. “We see no light at the end of the tunnel here,” he said. If Drexel entered voluntary bankruptcy proceedings, he added, the government would not have to step in and seize control of the firm and liquidate its remaining assets. They wanted Joseph’s answer by 7 A.M.
Joseph hastily convened a meeting of the board at 6 A.M. As he told the gloomy and despairing gathering, “The four most powerful regulators”—Brady at Treasury, Corrigan at the Fed, Breeden at the SEC, and Phelan at the Stock Exchange—“have told us to go out of business.” The board voted unanimously to file for Chapter 11.
Joseph recognized that everything he and the board had fought for the last three years, and everything they’d spent their careers building, was about to be gone. Drexel’s guilty plea had bought the firm another year of life, but in the end, Milken, the man who made Drexel what it was, had also destroyed the firm.
At 11:15 P.M. on Tuesday, February 13, 1990, Drexel filed for bankruptcy protection.
By the spring of 1990, Milken had outlasted them all. Levine, Siegel, Boesky, Freeman, Regan, even the great Drexel, were gone from Wall Street.
The two top government officials in the Milken case were gone, too. During the previous summer, Bruce Baird at the U.S. attorney’s office and Gary Lynch at the SEC had announced their resignations, Lynch after the Drexel settlement was hammered out, and Baird after the Freeman plea.
Both were exhausted, especially Lynch, who had devoted himself to the case with hardly a break since the beginning of the Bank Leu investigation more than four years earlier. Both had undergone grueling public attacks from well-armed opponents and had stayed in their low-paying government jobs long beyond the usual call of duty. New regimes were arriving to take charge of their respective offices, and the opportunity to shift to private practice would never be better.
Even though their biggest target, Milken, remained at large, the two lawyers knew what few others did: Milken had already capitulated once, his lawyers were again seeking a plea bargain, and sooner or later he would be convicted. The case was ready. Most of their work was done. With little public fanfare, they stepped aside, leaving the cases to John Carroll, Jess Fardella, and Baird’s successor at the U.S. attorney’s office, Alan Cohen. John Sturc at the SEC agreed to stay on for the duration of the case even though he was passed over for promotion to Lynch’s position as chief of enforcement.
The Milken team continued to produce propaganda. Robinson, Lake employees were summoned for a crash project ordered by Milken: a book, to be published and distributed by Milken, featuring company success stories that depended on Milken’s junk bonds. But no sooner would the writers finish a chapter on a company such as Ingersoll Communications, than the company would threaten to default. Even Lerer began to despair over the project.
The desperation of the Milken forces was perhaps best exemplified by their handling of a letter from a Lompoc prison inmate, sent to both Liman and Thomas Puccio, Mulheren’s lawyer and former U.S. attorney in Brooklyn. In lurid detail, the letter claimed that Boesky had been bribing prison officials, was allowed to have a male lover in prison, was engaging in sex with other prisoners, and was having women imported into the prison for further sexual escapades. Despite the fact that the letter had been written by a convicted felon, Liman called Puccio, intrigued by the revelations and their potential for use in cross-examining Boesky, still expected to be the government’s star witness. When Puccio questioned the relevance of Boesky’s alleged sexual preferences or promiscuity—not to mention their accuracy—Liman brushed his objections aside. Paul, Weiss hired an expensive Los Angeles detective firm comprised of former prosecutors to investigate the letter’s allegations. No expense was spared. Puccio, too, tried to confirm the letter’s contents independently. Predictably, the allegations couldn’t be verified.
Even Liman apparently now realized that Milken’s trial wouldn’t depend heavily on Boesky’s testimony. Prosecutors had added even more cooperating witnesses in the early months of 1990. They were threatening to bring a new indictment, one that focused much more on deals unrelated to Boesky: Milken’s alleged manipulation of thrifts, the bribing of fund managers, the excessive spreads and cheating of Drexel. The new indictment would be a far more damning portrait of a thoroughly corrupt operation. The prosecutors took a far tougher position in the negotiations than they had the prior year, when they were willing to offer just two felony counts. Now they wanted six, and a payment of over $600 million.
Even though a plea to six felonies exposed Milken to a potential prison term of nearly 30 years (conviction at trial on even more counts would increase the exposure accordingly), Milken’s lawyers minimized to him the likely length of any prison term. Liman convened a meeting of Milken lawyers that included Flumenbaum, Sandler, Armstrong, and Litt, and asked each lawyer to estimate Milken’s likely prison sentences if he went to trial and were convicted, and if he pleaded to the six felonies. Except for Litt and Flumenbaum, the stiffest estimate was for a 1-year term—if Milken went to trial and were convicted. Flumenbaum estimated 5. Litt attracted glares when he estimated 15 to 20 years if Milken went to trial, and 3 to 10 years if he agreed to plead. “No way he does less than Boesky,” Litt muttered.
The plea negotiations were as cantankerous and difficult as they had been the year before. Liman’s and Flumenbaum’s relations with Carroll and Fardella were so strained that they brought in another lawyer, Steve Kaufman, to deal with the U.S. attorney’s office. Negotiations were at an impasse throughout the fall and winter of 1989-90, even as the world Milken had created crashed into ruins. Finally a compromise was struck: the U.S. attorney agreed it wouldn’t prosecute Lowell—despite an overwhelming amount of evidence—and it would allow that Milken’s interviews with prosecutors—his “cooperation”—would begin only after he was sentenced. Dropping the charges against Lowell was the most difficult decision for the prosecutors. It was justified on the rationale that he had been little more than a lieutenant, faithfully carrying out Milken’s master plan.
As for cooperation, it meant little if the defendant still intended to resist, as Milken gave every sign he would do. But in a departure from precedent, the prosecutors agreed that Milken’s plea bargain would stand even if he lied during the cooperation phase. By contrast, Boesky’s and Siegel’s plea bargains were revocable if they lied—giving their versions of events inherently more credibility than Milken’s.
In return, the prosecutors extracted a concession that was vitally important to them: Milken would admit publicly that what he had done was wrong. They weren’t going to allow Milken to claim a moral victory.
Carroll and Fardella made their final offer of six felonies, a $600 million fine, no charges against Lowell, and no cooperation until after sentencing. They gave Milken a deadline of 3 P.M. Friday, April 20. Employees at Robinson, Lake knew something was afoot when Lerer and Robinson, looking grim, disappeared behind closed doors the night of the 19th. Sandler, who had never accepted Milken’s guilt, was devastated.
The day of the deadline was an eerie replay of the previous year. Carroll and Fardella expected an agreement, but they had learned to take nothing for granted. As the deadline approached, they heard nothing.
Milken was again at home with his wife Lori. They had been talking together since the early hours of the morning, taking no phone calls. She advised him to maintain his innocence. His brother Lowell had told him not to plead gu
ilty for his sake. His mother, too, told him not to give in.
Liman, Flumenbaum, Litt, Sandler, and the other Milken lawyers gathered in New York in the conference room next to Liman’s office, waiting for the call. Only Litt had advised a guilty plea. Privately, many of them thought Milken couldn’t hold up under the stress of a trial. Lately, cut off from his trading desk, he had seemed a broken man.
Just before 3 P.M., Carroll and Fardella joined Cohen in his office, sitting across from the desk where Levine had been frisked over four years earlier. Wearily, they began to contemplate the prospect of gathering the grand jury to vote on the new Milken indictment.
Finally the phone rang at Paul, Weiss. Liman took the call in his office as other lawyers got on the extensions. Milken had reached a decision. “I’ll do it,” he said, his voice flat.
Liman placed the call to St. Andrews Plaza. Cohen put him on the speaker phone so Carroll and Fardella could hear. “He’ll plead,” Liman began. The prosecutors barely heard the rest of his message. It was over. Carroll and Fardella jumped up and, in a rare display of emotion, hugged each other.
The following Tuesday, April 24, hundreds packed the Manhattan federal courthouse’s largest courtroom and hundreds more gathered around the building, congregating on the broad front steps along with television crews. Milken arrived in a dark limousine, and, in contrast to his earlier back-door appearances, walked up the main steps as police held back the crowds. He looked pale. He seemed to have lost weight, and his eyes appeared sunken.
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