Eagle on the Street

  Controlling access to billions of dollars in capital and, in the process, creating whole new companies and even industries; being strong enough to dictate prices on your own terms; having clients and customers who do what you tell them and become extensions of your own ambition; deciding whether and when a huge corporate takeover would occur—these were the facets of Michael Milken’s financial power that Hewitt both admired and resented. As he saw it, Milken had directed trading in certain stocks late in 1981 to manipulate their prices upward, partly so that he, under the terms of a special employment agreement with Drexel, would receive a bigger paycheck. And there was more, Hewitt thought. Through a complex scheme that involved the trading of shares of the Reliance insurance company headed by Saul Steinberg, Milken had rigged a corporate takeover by helping Steinberg buy his company’s shares in a series of trades that involved secret accumulations of stock by certain Drexel clients and by other accounts Milken controlled, Hewitt concluded. He called it a “warehousing” scheme, since he believed Milken and his clients held the Reliance shares temporarily and had no real economic risk—they made secret arrangements to sell the shares later, if necessary, without suffering any financial loss. If Hewitt were right, these phony purchases violated securities laws. So sophisticated, in Hewitt’s view, was the scheme that Milken could direct trades to assist one of his clients one day and then involve that client in trades helping Drexel or yet another client the next day. It wasn’t a simple quid pro quo, where there were direct cash payoffs or bribes. It was more of the “You scratch my back, I’ll scratch yours” variety, complex and insidious and effective, with Milken sitting at the helm deciding who would scratch whom and when.

  The rapidly growing Drexel firm “appears to have a major supervision problem,” Hewitt wrote in his revised memo. Moreover, secret buying and selling by Milken and his cadre violated certain SEC rules requiring disclosure of the purchase of securities, he charged. At the least, Hewitt figured, even if his superiors did not accept his market-manipulation theory, they would be willing to pursue a case pressuring Drexel to beef up its internal management supervision and fraud-detection procedures, which were handled by most Wall Street firms in a “compliance department.” Wall Street firms like Drexel stood at the bottom of a totem pole of federal securities regulation, with the SEC on top and so-called self-regulatory organizations, like the New York Stock Exchange, in between. One of the actions the SEC could bring against a brokerage house such as Drexel was a “failure to supervise” proceeding, with potentially serious sanctions, though under the former brokerage executive Shad, the commission’s approach to such cases was changing.

  Late in October, Hewitt finished his thirty-three-page, single-spaced memo, and handed it back to Kopel and Levine. It had taken about two years’ work to finish it—and this, Hewitt hoped, was just the beginning of a new phase.

  What are we going to do with this? Levine asked Kopel when they had both read Hewitt’s new memo. They both saw major problems with the case, not the least being that they did not believe Hewitt could prove his sweeping allegations of fraud in a court of law.

  Kopel kept tinkering with the memo and talking with Levine. He said he wanted to find a smaller piece of Hewitt’s broad case to pursue. Kopel had only taken over the branch a few months earlier; Hewitt was one of his lawyers, and it was a general imperative of bureaucratic turf that it was better to hold on to what you had, not to let anything go, lest your authority be undermined. Kopel didn’t want his first act as a branch chief to be one that took something away from him.

  But Levine wasn’t so sure. Back when the investigation began, Levine had favored a case focusing on Cincinnati’s Carl Lindner. Hewitt had gone off on his own and he had come back, after questioning numerous witnesses and spending thousands of dollars on travel, with an enforcement memo focused on Milken and Drexel that wasn’t strong enough to lead to immediate action against anyone, Levine said. Perhaps Lindner had committed some technical violations in his securities trading, but the enforcement staff would be embarrassed if it brought a narrow case like that to the commission after so much work. Enforcement would look like it was stretching, trying to bring any case to justify its work, and it would lose credibility with Shad and the other commissioners.

  Moreover, in reviewing the transcripts of testimony that Hewitt had taken, Kopel, Levine, and others in the division saw major holes, and concluded that many of the subjects would have to be questioned again if the investigation were going to be pursued any further. Though he seemed to ask many of the right questions initially, Hewitt failed to ask the follow-up questions that Kopel perceived to be crucial—as in the time he had asked Milken about his relationship with stock speculator Ivan Boesky, but didn’t press when he got no answer.

  Hewitt was a competent lawyer, a solid litigator, but the truth was that the average SEC staff lawyer, even in its vaunted enforcement division, was no match for the three-hundred-dollar-an-hour litigator from the big Wall Street firm who typically defended the target of a commission investigation. That sort of mismatch often created problems in SEC investigations, and this one was no exception. Though he was assisted by a financial analyst from the SEC, Hewitt suffered because he was operating on his own without the direct involvement of a seasoned SEC enforcement lawyer. It wasn’t necessarily a matter of talent; the most successful lawyers generally had decades of experience, whereas many of the enforcement division’s staff attorney’s were in the early stages of their careers. In his drive to recruit exceptional young lawyers to the SEC, enforcement chief Fedders was hiring a flock of associates from the most prestigious firms in Washington and New York. But when these former associates, many of them in their twenties and thirties, went into the field to conduct investigations, they were matched against the most senior partners of their old firms. Milken’s lawyer, Thomas Curnin, for example, had been through deposition proceedings countless times before, and he knew how to control the flow of the interrogation. When Hewitt attempted to review complex trading records from Milken’s Beverly Hills office, Curnin successfully held him at bay.

  Hewitt’s problems reflected a larger difficulty at the commission: There was simply no way for the SEC to match the legal and financial resources of the individuals and companies it was charged to police and investigate. This was true for many federal regulatory agencies, but at the commission the problem was especially acute. SEC investigations were often complicated and protracted, requiring a commitment of legal manpower that sometimes stretched over years. Moreover, the facts and issues involved in SEC cases were almost uniformly complex, requiring mastery of the law, finance, accounting, and the ability to interpret regulatory codes creatively in defense of one’s position. Targets of SEC investigations, particularly those at large Wall Street firms or corporations, could afford to meet this challenge—they had the money both to sustain a defense for years and to hire the best legal minds in New York and Washington. The Manhattan and D.C. bars had developed a subindustry of legal specialists in SEC cases, experienced and frequently brilliant attorneys at large firms whose own work was backed by research and support from dozens of young associates who were from the country’s best law schools. Because of its strong reputation, interesting work, and the kind of legal experience it offered, the SEC—especially in its enforcement division—was able to attract some bright young attorneys from the best schools. But these lawyers often worked without adequate secretarial or paralegal support, with little supervision from seasoned attorneys, and then, after they gained experience, they often left the commission for lucrative private practice, where they defended financiers and corporations against SEC probes. Division directors at the SEC often were excellent lawyers, capable of matching the skills of blue-chip private-sector partners, but below the directors, the ranks were uneven and frequently mediocre. Young lawyers might be talented but were inexperienced. Older SEC staff frequently hadn’t displayed the abilities that would permit them to leave the commission for a lucrative j
ob at a private firm. During the 1980s, the financial gap between attorneys at the SEC and their private-sector adversaries grew, aggravating the problem. A young attorney several years out of school could expect to earn more than $100,000 annually at one of Manhattan’s best corporate law firms, while at the SEC, he or should would have to accept less than half of that.

  The problems with the Milken investigation that fall were by no means all Hewitt’s fault or the result of his being outmatched legally. There were other complications, including the fact that Milken operated out of Beverly Hills. A California court had ruled that autumn that the SEC was required to provide all the witnesses in its private investigations with extensive information about their status—whether or not they were potential targets of fraud charges, for example—as well as detailed information about the testimony of other witnesses. Though the ruling was later overturned in the Supreme Court, that fall it was creating major obstacles for anyone at the commission who contemplated pursuing an enforcement case with a California connection.

  As associate director, one notch below Fedders, responsibility for the Milken probe lay with Levine, and the choices were clear. They could send HO-1395 up to the commissioners and recommend charges; they could send Hewitt and perhaps other attorneys back into the field to do more investigative work; or they could drop the matter altogether.

  As they talked Levine and Kopel agreed first off about one thing: There was no sense passing Hewitt’s memo upstairs to the commissioners. With enforcement chief Fedders shying away from long-shot litigation and Shad opposing any enforcement case that smacked of marginality, they would only be inviting trouble.

  Enough time and money has been spent without conclusive results, Levine finally told Kopel. Let’s bring this thing to a close.

  The word was passed to Hewitt—a decision had been made to kill the case, although rather than shutting the file entirely, Hewitt’s memo would be sent to the SEC’s Los Angeles Regional Office, which was pursuing certain Drexel inquiries on its own. Some of Hewitt’s superiors rationalized their decision by saying that since Hewitt’s work had been sent to Los Angeles, it hadn’t really been quashed. But they were willing to admit, too, that the chances anything would come of the L.A. Regional Office’s work were slim. Perhaps it was only hubris, but many senior enforcement attorneys at SEC headquarters in Washington regarded the regional offices, with the exception of the New York regional branch, as poor stepchildren of the commission, unable to retain qualified lawyers or mount sophisticated prosecutions.

  Hewitt was bitterly disappointed—not only did the investigation represent two years of his working life, he thought he had uncovered a major fraud in a powerful quarter of the financial markets. He understood that his proof wasn’t perfect, but after all, much of the information that would be needed to establish the fraud incontrovertibly had been inaccessible because the subjects of the investigation, especially Milken, were so uncooperative. Shouldn’t that reveal something to his superiors? Didn’t it matter, even if they didn’t accept his arguments about market manipulation, that the Drexel firm had a major supervision problem?

  Hewitt understood that it was hard for Levine, Kopel, and the others to accept his theory that a single individual could dominate sectors of the financial markets the way Hewitt thought Milken was doing. But didn’t it look suspicious that one man and his brother directed trading in scores of personal accounts, while at the same time trading on behalf of Drexel and clients?

  While Hewitt didn’t know it—one of the questions he had failed to ask Milken was an omission that hurt his ability to sell the case to his superiors—Drexel Burnham paid Michael Milken $45 million in salary and bonus in 1983, which came out to more than $123,000 per day if Milken worked 365 days that year. If Hewitt had known that one small fact, he might well have piqued the interest of Levine and Kopel enough to salvage his case. In Los Angeles the year before, Hewitt had asked Milken what, exactly, he did for a living, and it seemed to Hewitt that Milken evaded him elaborately. No wonder. How could a bond salesman justify to a government lawyer what he had done to deserve annual compensation greater than the revenues of all but the largest corporations in the country?

  Perhaps the real question was whether the Securities and Exchange Commission, with its limited resources and limited talents, had the vision to pursue a complex enforcement case of that magnitude in 1983, especially one that did not fit neatly into the campaign against insider trading sponsored by John Fedders and Jack Shad.

  The fact was that Jack Shad had come to admire Michael Milken. For one thing, there was an important friendship that linked their careers. And unlike Jack Hewitt, Shad thought he understood why Milken’s innovations in the financial markets helped to explain Drexel’s enormous profits.

  On Wall Street, Shad had helped companies raise money through the traditional method of selling stocks and bonds to the public, subject to the SEC’s regulations. The traditions and protocols of the business were well established, and in many cases, it wasn’t that difficult a job. If a company already had shares of stock that were traded on the New York Stock Exchange or another major market, it was easy enough to convince investors to buy new shares, since the existence of a public-trading market gave them confidence that the stock could be readily convertible into cash at any time, simply by picking up the phone and placing a sell order with a broker. In Shad’s vision, that sort of liquidity—the routine conversion of stock to cash—helped capital to wash through the economy to the dry patches where it was needed to create jobs. If a company had no stock already trading in the market, the sale of a new issue of shares was more difficult, but such “initial public offerings” were commonplace and usually easy to complete if the company was well-known and the price was right.

  What was true of the stock market was also true of the bond market: During the decades Shad worked on Wall Street, the country’s largest corporations had no difficulty selling bonds to the public. While stock represented an ownership interest in a company, and share prices fluctuated with the company’s future earnings and growth prospects, bonds were more stable investments—they were borrowings that a company agreed to pay back at some future date. A bond investor typically held on to the securities and received periodic interest payments. The more risky the company, the higher the interest rate investors demanded on the bonds. Unlike stocks, publicly traded bonds were sold on the basis of a well-developed rating system. For years, at Hutton, Shad had used the services provided by the Moody’s and Standard & Poor’s rating services when evaluating bonds. These services rated bonds on the basis of the perceived risk of a default, with AAA (triple A) being the highest, or safest rating. Any bond blessed with a superior rating was called investment grade, and the rating was a key factor in determining a bond’s interest rate. The existence of a liquid public-trading market for top bonds, in which the bonds could easily be converted to cash on demand, was at the heart of the system by which giant corporations borrowed money from investors.

  If a young, growing company—a company too small or too new or too risky to receive an investment grade rating—wanted to borrow money from investors by selling bonds, it normally couldn’t. There was no public bond market similar to the “initial public offering” market for stocks. Small companies, then, were forced to try their luck with the banks, which often would not provide them with as much cash as the companies wanted. The only other alternative was the so-called private-placement market, a kind of ad hoc market for risky debt, which was expensive and heavily regulated. The result was that some companies simply couldn’t raise the capital they needed to grow—and when that happened, one of the things they often did was complain to their Wall Street investment banker. Shad heard such complaints from his stable of smaller clients at Hutton, a second-tier firm that had to compete ferociously for corporate-finance business. In the 1970s, Shad tried to help some companies to sell newly issued, riskier bonds to the public, but while he managed to complete a few deals, he found t
he whole enterprise exceedingly difficult. There just weren’t enough investors willing to take chances on high-risk bonds. The attraction of the bonds Shad tried to market was their high interest rates—considerably higher than the interest paid by investment grade bonds. The problem was that no ready market existed if an investor wished to convert them to cash on the spur of the moment. The liquidity that Shad had seen as the raison d’être for stock index futures was lacking for these bonds; the market was dry.

  Michael Milken had changed all that by the time Jack Hewitt wrapped up his fraud investigation in the summer of 1983. He had changed the world of finance irrevocably by creating a liquid, multibillion-dollar market for newly issued bonds that were shunned by the Wall Street bond-rating services. The bonds Milken traded became known as junk bonds, a term Drexel and Milken would unsuccessfully strive to replace with the friendlier “high-opportunity bonds” and later “high-yield bonds.” While creating his market, Milken earned millions of dollars for Drexel by trading junk bonds and selling new junk issues for princely fees. One of his strategies was to sell more bonds to investors than a company actually needed to finance its economic growth. Then Milken would encourage the company, now a loyal and grateful client, to use its excess proceeds to buy a piece of his next junk bond offering. Thus many of Milken’s clients became both issuers of, and investors in, junk bonds. The web of financial relationships that grew up around Milken, and his power at the center of things, had prompted Hewitt’s suspicions that there was foul play at work. But Shad looked at the same picture and saw something else: liquidity, capital flowing freely to the very same kinds of companies Shad had tried but failed to assist during his years on Wall Street. In Shad’s eyes, it was as if Milken had developed a new product, like the videocassette recorder, and profited first by being the inventor and then through salesmanship—Milken was the sort of innovator-implementer that a free market capitalist system was designed to motivate and reward. Drexel deserved to be profitable and Milken deserved to be rich, Shad thought.