Banking on Fraud

Drexel, Junk Bonds, and Buyouts

Mary Zey

• Publisher: Routledge
• Year: 2017
• eBook ISBN: 9781351314824
• Topic: Business
• Subtopic: Management
• Index: Business

In analyzing the fraud-facilitated leveraged buyouts engineered by Michael Milken and the firm of Drexel Burnham Lambert, the author suggests that such buyouts have multiple and extensive consequences for the organization of business and the economy. Zey also demonstrates how ordinary bond trading networks were linked to the extraordinary networks of the Boesky Organizations and Employee Private Partnerships in order to defraud bond issuers and buyers.

This book debunks the myth of rational economic organization in the 1980s and establishes broad implications for theories of organizational deviance.

Part I

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Doing Fraud and Its Consequences

Chapter 1

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An Error and Its Chain Reaction

MARCH 21, 1986—BOESKY AND MOORADIAN’S ERRORS

Michael Milken had agreed to raise $660 million for Ivan F. Boesky from the sale of bonds through Drexel. Boesky needed one billion dollars by March 21, 1986, for arbitrage purposes. He prepared to dissolve Ivan F. Boesky Corporation and create a new privately owned entity, Ivan Boesky Limited Partnership. The Boesky $660 million bond fund was known as the Hudson Fund and was scheduled to close on March 21, 1986, giving Boesky access to one billion dollars in capital. (A list of central actors appears at the end of the book.)

At the Hudson Fund closing, Drexel would earn $24 million in financing fees (3.6 percent). Milken would receive a $5 million equity interest in Ivan Boesky Limited Partnership (a conflict of interest, given that Milken, as an investment banker, would have an interest in an arbitrage organization). But Boesky still owed Milken $5.3 million from various Milken and Boesky collaborative trading. Boesky and Milken generally made trades at below the market value or did trading “favors” for each other (these favors are elaborated on in Chapter 2). When he learned that Milken would not let the closing for the $660 million proceed until he received his $5.3 million, Boesky knew he had to do something.

That very day, accountants at the accounting firm OAD, Inc., were reviewing Boesky’s books for the purpose of issuing a “comfort letter.” This was not a full audit, but was designed to reassure investors of the financial health of Boesky’s new partnership. Ivan F. Boesky Corporation was dissolved at 4:00 p.m. However, Peter Testaverde, the OAD auditor, had found an unexplained ten-thousand-dollar account payable some time after 4:00 that afternoon. Setrag Mooradian, Boesky’s accountant and bookkeeper, thought it was minor and told Testaverde that he did not know what the entry on the ledger was. Mooradian had a much more pressing matter to worry about—Milken’s $5.3 million (U.S. v. Michael Milken 1990e, p. 65).

But Testaverde insisted that he had to have some documentation on the ledger entry. Mooradian testified that he thought Testaverde could overlook such a small amount, given that there was a billion dollars hanging in the balance. After several protracted attempts to change Testa verde’s mind, the pressure of coming up with and transferring Milken’s money caused Mooradian to blurt out, “Why the fuck do you care about ten thousand dollars when I’ve got $5.3 million sitting over here?” Mooradian immediately knew he had made a mistake because the Milken debt was not part of the corporate record. It was in the secret set of books where Mooradian and Charles Thurnher, one of Milken’s bookkeepers, kept separate tallies. Mooradian was planning to make the payment to Milken later that day or the next, after the audit.

Testaverde immediately asked, “What $5.3 million?” Mooradian told Testaverde, “Forget I ever mentioned this. We can’t talk about it now.” Testaverde retaliated by preparing to leave without giving Mooradian the requisite comfort letter. Mooradian persuaded Testaverde to stay, but he had to admit to Testaverde that he had a $5.3 million account payable with no documentation, no bills, no invoices, nothing but Boeksy’s usual when dealing with Milken: undocumented instructions. Testaverde had to confer with OAD senior partner Steven Oppenheim to confirm that the accounting firm would accept what ever documentation Mooradian could produce.

The accounting firm called Boesky. Boesky called Mooradian, according to the accountant’s testimony, and cursed him, hung up on him, and then called him back to continue, “You stupid fucking bastard.” Now Boesky had to document his clandestine dealings with Milken. If he did not pay Milken the $5.3 million, Milken would not sell bonds to raise the $660 million for the Ivan Boesky Limited Partnership. If he paid Milken the money, he had to document the ledger entry because of Mooradian’s inadvertent outburst in front of Testaverde. If he could not acquire documentation from Milken, OAD would not issue the comfort letter, which was essential. Mooradian reported Boesky called him four or five times, with new epithets on each occasion. Mooradian reported that he feared he would lose his job (U.S. v. Michael Milken 1990e, p. 66).

Because the market was closed, cutting him off from other sources of revenue, Boesky, under pressure to complete the transaction, did something he had never done before as far as the records demonstrate. First he called Milken and asked him to provide a bill for the $5.3 million, thus creating the paper trail that could damn them both. Second, he told Mooradian to issue a check for $5.3 million to Milken.

MILKEN’S ERROR

Milken tried to cover the gaffe by billing Boesky for “consulting,” without elaborating in the typical invoice fashion, which included a statement of the services performed, the hours worked, the dates of each service, and the associated fees. The memo arrived in Boesky’s office on March 24 and read, “For consulting services as agreed upon on March 21, 1986, $5,300,000.00.” The cover letter from Thurnher was equally cryptic and read, “Mr. Boesky, Please send your remittance check for the attached invoice directly to me at the address listed below.” It was the High-Yield Bond Department address at Drexel, Milken’s turf, not the firm’s New York corporate headquarters. The Ivan Boesky Limited Partnership was born with nearly one billion dollars in assets.

The government would use this transaction as evidence that Boesky’s and others’ testimonies specifying trading relationships between Milken and Boesky were true.

THE ANNUAL PREDATORS’ BALLS

The 1986 Predators’ Ball, as the Drexel High-Yield Bond Department Annual Conference was called by bond issuers and buyers, featured Larry Hagman of “Dallas” flashing his Drexel Express titanium card with a ten-billion-dollar credit line while admonishing, “Don’t go hunting [for takeover target firms] without it.” This was a direct reference to Drexel’s prowess in corporate takeovers. This preceded a Madonna look-alike dancing and lip-synching to her “Material Girl,”: “I’m a double-B girl living in a material world,” an obvious play on junk bond ratings and bra sizes. Then Dolly Parton sang in person. This was a dazzling spectacle demonstrating the personality endorsements money could buy. Even more important, however, it was a presentation of Drexel’s power and corporate flash, a corporate culture unusual in the investment banking world.

In addition to Drexel’s stated aim of advertising the success of the High-Yield Bond Department, the annual conference had other purposes. A second outcome of these meetings was that they supplied a direct link between the corporate buyers and sellers of bonds. Here they met and came to know the particular nature of each other’s financial status. As a consequence of this information, raiders could more easily select their next targets. Here, where power was defined as the ability of one firm to take over another, was the arena in which acquirers defined their relationship to their next acquisition.

The balls had a third purpose. They were a massive legitimizing process in which the use of junk bonds to finance mergers and acquisitions was validated to buyers and sellers by the congressmen who had the greatest power over financial legislation. Representative Timothy Wirth of Colorado, and Senators Bill Bradley of New Jersey, Alan Cranston of California, Edward Kennedy of Massachusetts, and Howard Metzenbaum of Ohio all attended.

Academicians legitimized the junk bond process for both the legislators and the corporate executives. Edward Altman, a prominent New York University professor of finance, speaking at the 1985 conference, demonstrated that market data from 1978 through 1984 (a period that did not include a major recession) confirmed Milken’s thesis that a diversified portfolio of junk bonds yielded substantially higher returns with no greater risk than U.S. Treasury Bonds. These were the data used by Keating and his sales staff at Lincoln Savings and Loan (LSL) to sell bonds issued by American Continental Corporation (ACC), the parent company of LSL, through Drexel, to unsuspecting LSL bond customers. However, the pitch used by the sales staff reportedly was that these bonds were not only as safe as government bonds, but were guaranteed by the Federal Deposit Insurance Corporation (FDIC). These actions later led to the indictment and trial in both California and the federal courts of Keating, who was also the chief executive officer (CEO) of ACC. Keating was found guilty on seventeen of eighteen counts of securities fraud in California and was ordered by the federal courts to pay plaintiffs $3.3 billion (Salwen 1991b).

The fourth purpose of the Predators Ball was to serve as a mechanism for political contacts and payoffs. Congressmen were paid large sums of money to make fifteen- to twenty-minute addresses that advocated the expansion of the junk bond market. Drexel would subsequently hold fund-raising dinners for many of these same congressmen. For example, Timothy Wirth, a Colorado Democrat, who chaired the Subcommittee on Telecommunications, Consumer Protection, and Finance of the House Committee on Energy and Commerce in 1984 and 1985, had introduced several antimerger bills, one outlawing greenmail. In 1985 Wirth was a speaker at the annual conference. Drexel employees donated $23,900 to his successful Senate campaign. The antimerger legislation was dropped.

David Aylward, who worked as Wirth’s assistant, left his job researching antimerger legislation to help organize the Alliance for Capital Access, which became the official Drexel lobby opposing federal limits on junk bond financing. Prior to 1985, when this lobby was established, Drexel did not have a strongly visible lobby.

Drexel executives also contributed $56,750 to the campaign of Senator Alfonse D’Amato of New York, who was at the time chairman of the Securities Subcommittee of the Senate Banking Committee. In 1985 alone, D’Amato received over $17,000 from Drexel. Although he had been drafting legislation to limit corporate takeovers, by the time his bills were brought to the Senate floor in December 1985 they had been purged of all antitakeover statutes.

Senator Alan Cranston, one of the Keating Five, received $41,740 from Drexel in 1986. Another of the Keating Five, Senator Dennis DeConcini, received an equivalent sum from Drexel. In the end, of the more than thirty bills drafted in 1984–1985 to regulate corporate takeovers, not one passed.

SEPTEMBER 17, 1986—BOESKY’S SURRENDER

On September 17,1986, Boesky surrendered to federal authorities, gave evidence against Drexel, Milken, and others, and became an undercover operative for the Department of Justice. Boesky had approximately six months from the time the Ivan Boesky Limited Partnership was founded until he surrendered to federal authorities in which to realize benefits from his newly formed partnership.

Drexel was implicated. Although the company had reported to the Wall Street Journal that it had over one billion dollars in capital plus over half a billion dollars in a litigation budget, legal counsel for Drexel knew that the firm could survive the financial hardships of a government RICO (Racketeering Influenced and Corrupt Organizations Act) indictment for only a short time. Estimates of survival were no more than a year, and indictment was an imminent threat.

THE PARADOX

Drexel’s relationship to the social order is a paradox. Employees of Drexel saw the firm as the great American success story. Throughout the mid-1980s, Drexel was the fastest-growing securities firm in the United States and the most profitable Wall Street firm, with a net income of $545.5 million in 1986. Revenues exceeded $4 billion and the firm’s capital grew to more than $1.8 billion (Smith 1988). Michael Milken was dubbed the “junk bond king” by the prestigious Wall Street Journal. He had achieved legendary status and was credited with creating the market in junk bonds almost single-handedly. These achievements alone must have made the employees of Drexel feel they were “doing the right thing”. Society was rewarding the firm and its employees. There is no doubt they felt invincible.

Drexel controlled the largest portion of the high-yield bond market in 1986 and 1987 (Smith 1988). The annual salaries of the traders and salespeople in the High-Yield Bond Department were in the millions. Michael Milken made over $550 million in 1986 in bonuses alone. However, within months Dennis Levine, a Drexel investment banker, pleaded guilty to securities fraud. He was the first. Ivan Boesky followed suit in 1987.

Not only did Wall Street and academicians sing Drexel’s praises but Milken himself contributed to the legitimation process. On Thursday, September 8,1988, the day after Drexel was indicted by the Securities and Exchange Commission (SEC) in one of the largest indictments in the history of Wall Street, Milken said:

During the almost 20 years that I have worked in the financial services industry, I have always tried to create value for society, investors, and the many companies that we have had the privilege to finance and the millions of employes [sic] they employ. Drexel Burnham and I have a record of ethical dealings with thousands of community leaders, customers and clients of which I am proud.’ (Stewart and Hertzberg 1988b, p. 1A)

It is probable that Milken believed this statement when he made it, as it is consistent with the press’s portrait of him, his employees’ support of him, and the public’s idolization of him.

However, by April 1988, he must have begun to doubt the image he had helped create. Although he had testified several times before, when a congressional committee subpoenaed Milken to testify on April 28, 1988, he appeared but refused to answer questions, invoking his Fifth Amendment right against self-incrimination. Drexel supported Milken’s taking the Fifth Amendment, reminding the public that Milken had “made an enormous contribution to financing the country.” Milken also refused to testify because he had been under grand jury investigation by the Southern District of New York for nearly eighteen months. However, despite his legal problems, the press continued to refer to him as “the most powerful figure in U.S. finance” (Ricks 1988).

In 1987 Drexel’s net income fell 79 percent to $117 million (Drexel 1987), the largest percentage drop among investment banking firms. It was a dramatic contrast with Drexel’s previous year’s performance, which topped the industry at $545.5 million (Drexel 1986a). When the stock market crashed in October 1987, Drexel took heavier than average losses because of the decline in the junk bond market, which did not bottom out until 1989. Drexel’s 1987 annual report did not attribute any of the decline to the government’s ongoing investigation of the firm.

DECEMBER 1988—DREXEL PLEADS GUILTY

In December 1988, Drexel pleaded guilty to six felony counts. In the midst of Drexel’s financing of the largest takeover in the history of capitalism, Kohlberg Kravis Roberts’s (KKR) acquisition of RJR Nabisco, the Justice Department approved the filing of RICO charges against Drexel and brothers Michael and Lowell Milken. Indictment under the RICO statute meant bond would have to be posted for the amount of any assets identified in the government’s fraud charges. The Justice Department’s tactic of threatening indictment under RICO was a critical blow to Drexel because its ability to conduct business depended on its assets. Drexel’s assets would be effectively frozen at the same time it was participating in its largest deal ever with its most profitable client, KKR.

Ultimately survival of the firm was the major objective. Drexel’s CEO Frederick Joseph and Drexel’s lawyers negotiated with Rudolph Giuliani, U.S. attorney general for the Southern District of New York, Bruce Baird, assistant U.S. attorney, and the U.S. Attorney’s Office.² Drexel pleaded guilty in exchange for two concessions from the government: that Drexel’s pleas would not speak to Michael Milken’s guilt or innocence (Joseph did not want it to appear as though he was selling Michael Milken out to the government) and, more importantly, that the fines assessed on Drexel would not bankrupt the firm. The agreement consisted of the following major points:

1. Drexel was allowed to say that it could not disprove the government’s claims against it and Milken.

2. Drexel would not have to admit Milken’s guilt, but would have to cooperate in the government investigation of Milken.

3. Drexel would agree to plead guilty to six of the nearly one hundred charges the government had brought against it.

4. Drexel would have to pay $650 million in fines and restitution.

5. Drexel could not pay Michael and Lowell Milken their 1989 bonuses. (Michael Milken’s bonus was reported to be $200 million.)

6. Michael and Lowell Milken would have to leave Drexel or be fired.

The settlement was announced by the Justice Department shortly before Christmas 1988. Drexel survived the fines and guilty pleas and successfully completed its part in KKR’s takeover of RJR Nabisco for a record $25.07 billion (later reported by KKR to be over $26 billion). Drexel’s fees for the acquisition were approximately $600 million, nearly the same amount it was fined for all its fraudulent dealings up to that time.

A COLLAPSING HOUSE OF...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Dedication
• Table of Contents
• Preface
• Acknowledgments
• Part I Doing Fraud and Its Consequences
• Part II Toward Understanding Fraud
• Part III Toward Understanding Fraud as Structurally Embedded
• Part IV Toward Theory
• Central Actors
• Glossary
• References
• Index