Eagle on the Street

  Certainly, Milken felt no guilt about his immense wealth. The more he came to prominence and influence, the more he talked about his work as some grand mission of public service. He had long been fascinated by the market for riskier bonds, and had even bought and sold them as an undergraduate on the tumultuous Berkeley campus during the 1960s. Milken convinced some of his father’s accounting clients to give him some money to manage on their behalf—the deal was that Milken would agree to absorb 100 percent of the losses if they would give him 50 percent of the gains. The terms of his arrangement gave Milken a strong incentive to be careful, but it pushed him to find an edge. At Berkeley he read a historical study that argued that investors who bought a diverse mix of riskier bonds with high interest rates tended to do better than those who bought the corporate bonds blessed by the Wall Street rating services. It was true that junk bonds had a slightly higher rate of default, but their exorbitant interest yields appeared to more than make up for the increased risk. Milken preached that the bond-rating system so revered for decades, with its reassuring lettered codes and strict gradations, was an economic anachronism. Investors clung to the rating system because it provided them with a false sense of security, reinforced by the institutional power of the biggest firms on the Street. But the emperor, Milken saw, was wearing no clothes. There was more money to be made by ignoring the bond ratings than by adhering to them.

  It was Fred Joseph, whom Jack Shad hired out of the Harvard Business School and trained as one of his first recruits at E. F. Hutton, who helped to make Michael Milken into something more than just a wealthy bond trader. In the mid-1970s, Joseph joined Drexel in New York as an investment banker in charge of its corporate-finance department. Just as Shad had done years before at Hutton, Joseph directed Drexel’s attempts to develop new business toward small and medium-sized companies, cognizant that he had little chance to snare giant, blue-chip corporate clients away from Wall Street’s old-line investment firms like Salomon Brothers, Morgan Stanley, and Goldman Sachs. Early on, Joseph stopped by the bond-trading floor to meet Milken, whom he had heard was making a lot of money for the firm, buying and selling junk bonds. Milken told Joseph the market was potentially enormous, and that if he had additional supply, he was confident he could sell more and more junk bonds.

  Joseph and Milken became a tandem. Joseph identified the companies that needed capital, and Milken sold the junk bonds. Soon Milken became involved in all facets of the business, advising companies, trading, selling. He succeeded where others had failed, by guaranteeing investors that if they wanted to get rid of their “junk”—if they wanted to turn their bonds into liquid cash—Milken and Drexel would stand ready to buy them back. The fees for selling new junk bond issues were 3 or 4 percent, meaning Drexel made about $4 million for every $100 million in new bonds Milken sold. By tradition, Wall Street firms invited other houses to participate with them when they sold new issues, but over time, Milken did that less and less, believing that since he was the one who had developed the market, and the buyers, there was no need to play by the old rules. In every way, Milken bucked Wall Street tradition. And since only about 1,000 corporations in the country actually qualified for investment-grade ratings, the potential for issuing new junk bonds was huge. Meanwhile, insurance companies, savings and loans, wealthy individuals, specially designed junk bond mutual funds catering to individual investors—and even pension funds—flocked to Milken to buy the high-yielding bonds.

  By 1983, the junk bond market had nearly doubled from about $20 billion in 1977 to $40 billion, largely because of Milken and Joseph. Shad watched them with respect and admiration from the commission’s headquarters in Washington. In the age of Reagan, in a period of economic recovery and celebration of the country’s self-imagined entrepreneurial culture, Milken symbolized all of what Shad believed was good and right in the financial markets. His troops in Beverly Hills were making liquid capital available to companies like MCI Communications, the long-distance upstart that raised $1 billion through Drexel in 1983 to fund its challenge to the establishment bulwark of the telephone business, AT&T. Officials at the Wall Street firms whose business was threatened by Milken’s rise warned that he was adding billions of dollars in debt to the balance sheets of scores of companies, leaving them and the economy vulnerable to catastrophe during the next economic downturn. But that summer of 1983, there was no recession in sight, and when Jack Shad looked ahead, he seemed to see an auspicious horizon.

  Late that year, Milken and Joseph hatched another golden plan. Drexel was making mountains of money in the junk bond market, more than any other Wall Street firm. But ever since the wild takeover fight between Bendix and Martin Marietta, Drexel’s rivals on the Street had been reaping millions of dollars in fees by advising companies on corporate takeovers. Drexel was on the sidelines—it didn’t have the big corporate clients involved in such deals. At a series of meetings in the Beverly Wilshire Hotel and next door in Milken’s offices at the posh corner of Rodeo Drive and Wilshire Boulevard, the firm’s top executives laid plans to transform the junk bond into a takeover warhead. During the prior year Drexel had sold some junk bonds to help finance friendly leveraged buyouts—corporate takeovers in which the management of a public company and other investors bought all the company’s outstanding stock with borrowed money. Former Treasury Secretary William Simon had provided Milken and Joseph with a model. In 1982, Simon had purchased the Gibson Greeting Card Company from RCA Corporation with mostly borrowed money, and in 1983, he sold stock in Gibson to the public, making an apparent $70 million profit virtually overnight. In Beverly Hills, Milken, Joseph, and other Drexel executives decided to explore a similar plan: they would finance multibillion-dollar hostile corporate takeovers—raids by renegades on the bastions of the corporate establishment—by selling, or promising to sell, junk bonds.

  It was an idea that would alter radically the corporate-takeover game and the nation’s economy during the 1980s. And it would pose, too, the greatest challenge of all to John Shad’s tenure as chairman of the Securities and Exchange Commission.

  Through the double doors at 11 Wall Street they came, past the security checkpoint, into the attended elevator, through the hushed, carpeted hallways on the sixth floor, and finally into a majestic boardroom beneath high stained-glass ceilings. Shad had called them here, and when the meeting began, he sat in an emerald-colored chair before a colossal walnut table.

  It was an informal tradition at the New York Stock Exchange that you had to be dead fifty years before they hung your portrait in the boardroom, which perhaps explains the sternness of the visages gazing down on the members of Shad’s takeover advisory committee that morning in 1983. The portraits were of the stock exchange’s founders and caretakers during the nineteenth and early twentieth centuries, men in frock coats and top hats, with pink skin and elaborate gray whiskers. Artifacts of the exchange’s self-conscious history adorned the room. In one corner stood a gargantuan, solid-marble-and-sterling-silver urn, a gift of the Russian czar Nicholas II upon the successful sale of a bond issue to finance construction of the Siberian railway—a junk bond deal if ever there was one.

  To some of the commission staff 250 miles away in Washington, the meeting that day symbolized the growing ties cultivated by Shad between Wall Street and the SEC. The tender-offer advisory committee had been formed under considerable political pressure from Capitol Hill, and amid disagreements within the commission, to recommend how the SEC should respond to the boom in wild corporate-takeover fights. The meeting had been convened in New York solely for the convenience of its members, who happened to include a number of Jack Shad’s old friends from Wall Street. Joe Flom, who had attended the Aetna meeting, was there. Martin Lipton, the takeover lawyer whom Shad consulted before accepting the SEC chairmanship, was invited. There was Irwin Schneiderman, the attorney and friend who advised Shad about his hiring of John Fedders; and Bruce Wasserstein, the investment banker who had played a central role in the fight between B
endix and Martin Marietta.

  Months earlier, when Shad announced the appointment of seventeen Wall Street takeover experts to a blue-ribbon SEC advisory committee on mergers, there had been those on the Hill and inside the commission bureaucracy who voiced resentment about Shad’s decision to look outside the agency to Wall Street for advice. But to Shad it made perfect sense. Staff lawyers at the commission who had never traded a share of stock in their lives certainly didn’t know what it was like to be in the middle of a hostile corporate-takeover fight, he thought. How could the staff possibly know what should be done? Shad had wanted to appoint professional experts to the committee, though after hearing of the views of key congressmen, he agreed to add an elder statesman, the sort of person who always showed up on Washington policymaking committees.

  Arthur Goldberg, the liberal former Supreme Court justice, was a late addition. The committee had met previously, but the session at the New York Stock Exchange was Goldberg’s first. When they asked him to make some introductory remarks early on, he said what few of them wanted to hear.

  “The principal interest of the committee should be that of the public,” he announced baldly. He added that takeovers had an increasingly bad reputation because of perceived manipulative and abusive practices and that the committee had to help the SEC “reassure the public that regulatory agencies are acting to prevent gross abuses.”

  “Thank you for your comments,” said Dean LeBaron, the committee chairman, when Goldberg was through. LeBaron was the head of Batterymarch Financial Management, a Boston-based money-management firm that relied on computers and quantitative analysis to manage billions of dollars in pension-fund money and other assets, much of which was invested in stocks. Reflecting his bias toward the rights of stockholders, Shad had picked LeBaron as committee chairman. LeBaron directed the committee’s attention to the day’s detailed agenda, which included discussion of a host of proposals designed to modify complex laws and SEC rules governing takeovers. Throughout the hours of discussion that followed, the public wasn’t mentioned again.

  There were undeniable limits on what a group of financiers and takeover lawyers gathered in the august boardroom of the New York Stock Exchange was going to recommend about curbing corporate takeovers. The takeover game was making most of them wealthy beyond their wildest imaginings. There was much talk, as the discussion wound on, about protecting shareholders, which was the sector of the public whose interests Shad thought the commission should defend. But the bottom line was that experts like these were destined to find a way to keep the takeover game going by balancing the interests of bidders and targets, to permit an unlimited number of takeover fights.

  Gregg Jarrell, the Chicago School economist and academic who was a member of the advisory committee, watched his colleagues that day and thought he saw another purpose in their work—while preserving a level playing field that would encourage takeovers, Shad’s friends from Wall Street wanted to create just enough regulatory delays during the battles to enhance the market for legal and financial advice. In the committee’s work Jarrell thought he saw Wall Street using Washington to create a demand for its services. To do it, it seemed to Jarrell, they were willing to adopt the language and protocols of public servants, and to push for complex regulations, even though at heart their economic views were as radically conservative as any economist’s at the University of Chicago. “When they got together in this committee setting [with the] audience and the big chairs, they wanted to sound like concerned policymakers,” Jarrell said afterward. “What you had were a bunch of diehard capitalists apologizing for making $4 million the previous month.… It was a strange thing to watch.” Underlying the committee’s position was the Williams Act, the 1968 law which called for a balance between bidders and targets in takeovers.

  When it was over, the SEC advisory committee approved an enormous document of commentary and advice that was remarkable for what it did not do. Shad’s experts declared that they had no opinion on whether takeovers were good or bad for America.

  “On the strength of the evidence presented, the committee does not believe there is sufficient basis for determining that takeovers are, per se, either beneficial or detrimental to the economy or to the securities markets in general, or to issuers or their shareholders, specifically.… The purpose of the [Securities and Exchange Commission’s] regulatory scheme should be neither to promote nor to deter takeovers; such transactions and related activities are a valid method of capital allocation, so long as they are conducted in accordance with the laws deemed necessary to protect the interests of shareholders and the integrity and efficiency of the capital markets,” the committee’s final report said. Later, when the hefty document was transmitted to Congress, the committee went further: “Takeovers … should be allowed to take place. For this reason, the committee does not believe the government should act to encourage or to discourage or to evaluate the merits of takeovers.”

  Thus was born an essentially amoral school of economic ideology about takeovers, articulated by some of the most influential financiers on Wall Street, and protected by the political and financial power of the Street’s institutions. Its central doctrine was the notion that it was not possible to know what was right or wrong, whether takeovers were good or bad.

  Still, the committee recommended dozens of detailed regulations aimed at balancing offensive and defensive interests in a takeover fight. That approach outraged Chicago School economists like Jarrell, who wanted to push Shad toward policies in which the commission would retreat from regulation, not adopt new rules. And partly from his conversations with key commission staff close to Shad, Jarrell understood the buzz words favored by the SEC chairman. In a strong dissent, Jarrell and a Chicago School colleague played explicitly to Shad’s campaign within the commission to focus less on legal reasoning and more on economics and cost-benefit analysis. “The most striking thing about the advisory committee’s report is that the committee offers no explanation of tender offers, no treatment of costs and benefits, indeed, not even a definition of ‘abuse,’ which is the cornerstone of the recommendations for ‘reform.’ How can we identify, let alone rectify, ‘abuses’ without some idea about why [takeovers] exist, what costs and benefits are associated with them, and what effect our ‘reforms’ would have on the number of offers.… The best of all worlds is the termination of federal regulations.”

  As senior SEC staff read this dissent that fall many of them recognized that Jarrell’s arguments would appeal naturally to Shad. The question was whether or not the SEC chairman—and his commission—would go along.

  9

  Naked Options

  T. Boone Pickens, Jr., looked out at the sea of Texas rich and Republican faithful gathered before him. The scene was redolent with diamonds and designer dresses, wildcatters and wine.

  “I hear Ringling Brothers is thinking of buying Cities Service,” Pickens said into the microphone, referring to the staid, giant oil company against which he had launched a hostile takeover bid a few weeks earlier. “They want to get the clowns that are running that company.”

  President Ronald Reagan chuckled at the dais; a ripple of laughter fanned across the cavernous Albert Thomas Convention Center in downtown Houston. It was a June evening in the midst of the president’s triumphant first term. Reagan had flown to Texas to spur on the conservative political movement then sweeping what formerly had been Democratic bastions in the South. The Reagan ethos—entrepreneurialism, Chicago School economic and social theory, a misty optimism about the American people—was taking hold nowhere more than in Texas, battered though the state’s economy was by a sharp fall in oil prices. For his part, Boone Pickens, who was the evening’s master of ceremonies, considered himself a standard-bearer of the Reagan way. The hostile takeovers he pioneered would shake up the musty, entrenched corporate establishment centered on the East Coast, he said, creating wealth and opportunity and growth for the nation. Reagan, by his laughter, seemed “in sync” if not in ag
reement.

  Superlatives swirled from the podium. The political fund-raising dinner that evening would add a record $3.5 million to the reelection coffers of Texas Governor Bill Clements, it had been announced. This was a triumph shared by Pickens, who was rapidly becoming the best-known corporate raider in the country, as well as one of the most successful money men in the Republican Party. Moreover, if his $5 billion chase for reluctant Cities Service Company succeeded, Pickens would have pulled off the third-largest corporate takeover in history. Cities Service, the country’s nineteenth largest oil company, was roughly six times the size of Pickens’s Mesa Petroleum; an oil man for three decades, Pickens liked to think big.

  Yet the truth was that despite his glibness and the glamour all around him, Pickens felt uneasy. Mesa Petroleum was under attack that night because of the battle he had initiated with Cities Service. As a tactical defense against Pickens’s $50-per-share takeover offer, Cities Service had launched a retaliatory $21-per-share takeover bid for Mesa—a version of the controversial “Pac-Man” defense that stirred Shad to form the SEC’s takeover advisory committee. (The committee of Wall Street specialists recommended to Shad that Pac-Man defenses be permitted by the SEC.) There was a chance that Pickens’s company could be swallowed whole before Mesa’s takeover offer for Cities Service succeeded. Pickens was anxious to fly, in his private jet, to New York, where his team of advisers—led by the ubiquitous takeover attorney Joe Flom—was plotting to save Mesa and defeat “the clowns” at Cities Service.