When Drexel Burnham Lambert was charged with insider trading in 1988, a chain of events was triggered that included the firm’s declaration of bankruptcy and incarceration of its star investment banker, Michael Milken.
During the 1970’s, the United States experienced inflation and economic stagnation. The prices of common stocks gyrated wildly but on average wound up about where they were in the late 1960’s. Meanwhile, earnings and dividends rose steadily. Because of inflation, the underlying values of many companies increased, but this was not reflected in the prices of their shares. Large firms often had less value as ongoing businesses than if they were sold in pieces. This situation helped set the stage for hostile takeovers, in which Drexel Burnham Lambert (commonly known as Drexel) became the leader. Drexel’s leadership and innovation in financing business dealings ultimately led to charges of illegal activity against the firm in December, 1988.
Michael Milken is sworn in before a hearing of the House Oversight and Investment Subcommittee in Washington, D.C., on April 27, 1988.
Midsized companies whose bonds were not deemed of investment quality by rating services had difficulties raising money for expansion during the 1970’s and early 1980’s. These companies found bank loans difficult to obtain, and they had problems selling shares because many had not proved their performance, so stockbrokers and analysts did not promote the companies’ stocks.
Interest rates climbed, harming savings and loan
The combination of these factors had two major consequences: Many companies sought financing, and raiders looked for undervalued companies, hoping to take them over and carve them up for profits. Large numbers of people looked for and expected high yields. This set the stage for the activities of Drexel and Michael Milken.
Milken started as a bond salesman at Drexel in 1969, specializing in low-rated bonds.
In 1977, Drexel started underwriting new issues of junk bonds, or bonds that were not rated as investment grade, and by the early 1980’s it was the leader in this area. In 1974, Frederick Joseph arrived at Drexel from Shearson Hayden Stone; he became Drexel’s chief executive officer (CEO) in 1985. Joseph had observed the rise of hostile takeovers through leveraged buyouts, or buyouts financed with debt, and realized that junk bonds might be used as means to take over large companies.
Large profits could be made by individuals who had inside information regarding these raids. Those who knew of takeovers in advance could buy stock to sell once the takeovers became public knowledge and stock prices rose. Such trading, however, is illegal. Throughout the late 1980’s, when hostile takeovers and leveraged buyouts were fueling a major bull market, rumors circulated regarding them. At the same time, leaders of large corporations, realizing their security was threatened, lobbied Congress for legislation to limit hostile takeovers and the issuance of junk bonds. Their most important organization in this effort was the Business Roundtable, which comprises the CEOs of some of the largest companies in the United States. In 1986, it appeared that these activities would result in laws prohibiting or at least limiting the use of high-yield bonds in corporate takeovers. Had this occurred, the hostile takeover movement would have ended.
On May 12, 1986, while Congress debated several antitakeover bills, Drexel banker Dennis Levine was arrested on charges of insider trading in fifty-four stocks. Gary Lynch,
One of those whom Levine implicated was Ivan Boesky. On November 14, 1986, Boesky pleaded guilty to securities fraud and agreed to assist in identifying and prosecuting other malefactors. On April 23, 1987, Boesky received a sentence of three years in prison.
Giuliani went after other bankers, hoping to catch the “big one.” Given the nature of the market, that could be none other than Milken. In his operations, Giuliani utilized provisions of the 1970 Racketeer Influenced and Corrupt Organizations (RICO) Act,
On August 4, 1988, RICO was used against Princeton/Newport Partners,
In 1988, Giuliani turned on Drexel. In mid-December, he told Joseph that he would indict the company on RICO charges unless it agreed to a settlement. The company had no choice but to bow, since seizure of its assets as allowed by RICO would have ruined it. On December 26, Drexel agreed not to contest charges, to pay $650 million in fines and restitution, and to accept outside management. In addition, the firm would place Milken on leave of absence and withhold $200 million of his earnings. On February 13, 1989, after being denied assistance, Drexel filed for bankruptcy.
Milken had formed a new company, International Capital Access Group
After protracted negotiations, on April 20, 1990, Milken agreed to plead guilty to six felony charges, none of which involved insider trading, bribery, racketeering, or manipulating the prices of stocks, the key elements of Boesky’s plea bargain. He also agreed that after sentencing he would cooperate with the Justice Department. The government would not file additional criminal charges, but Milken remained subject to civil actions and criminal charges from other jurisdictions.
Milken’s sentence included ten years in a federal penitentiary, eighteen hundred hours of community service a year for three years, and $200 million in fines. This was in addition to $400 million already extracted from him for a restitution fund. Later, there would be an additional $500 million fine to settle anticipated legal actions, which numbered more than 150.
By the end of 1989, it seemed that the junk-bond market had ended as the result of a decline in customers and clients. Congress passed the Financial Institutions Rescue, Recovery, and Enforcement Act
The state of New York ruled that state pension funds could no longer invest in junk bonds, and California declared that its pension funds would sell off their junk holdings, with face value of $530 million, for $380 million. The Resolution Trust Corporation
Several failures of corporations that had large junk issues outstanding led to price declines for the bonds, which were reflected in the share prices of high-yield mutual funds. Declining share prices led to massive redemptions. The funds sold junk bonds to pay for redeemed shares, further depressing the market. The hostile takeover movement came to an end in the wake of the collapse of the junk-bond market. Unable to obtain backing, the raiders disappeared.
The panic selling in the junk-bond market turned out to be overdone. Bargain hunters appeared, and new high-yield mutual funds were organized to capitalize on the situation. Leon Black, who had been one of Milken’s chief aides, was one of the more sophisticated individuals in this market, picking up hastily sold portfolios and making more money at it in the 1990’s than he had when dealing in junk bonds during the 1980’s.
Merrill Lynch and Goldman Sachs led the way in the new creation of junk, most of which was used in restructurings or was issued for midsized companies. In 1986, a record $31.9 billion in junk had been sold before placements declined. In 1990, $1.4 billion was taken to market. In 1991, the price of junk rose sharply, and demand reappeared. More than $40 billion in junk was sold that year, and slightly less than $38 billion was sold in 1992. Junk was the best-performing financial asset in 1991 and close to the top in 1992. By then, some critics wondered whether any of Drexel’s transgressions merited the destruction of a firm that had employed seven thousand workers.
Milken entered prison at Pleasanton, California, on March 4, 1991. On August 5, 1992, after Milken had served seventeen months, Judge Kimba Wood
The government had gone after Milken in part to stop hostile takeovers, which endangered the security of leaders of large, mismanaged companies. With the end of hostile takeovers, such individuals felt more secure, but the security did not last. Large pension and trust funds introduced measures to limit salaries and bonuses, indicating displeasure with executives who appeared to place their own interests above those of their corporations. Even though takeovers were rare, the threat of them encouraged managements to be more responsive to shareholders. Increased emphasis on managerial responsibility can be counted as one legacy of the junk-bond revolution.
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Bailey, Fenton. Fall from Grace: The Untold Story of Michael Milken. New York: Birch Lane Press, 1991. Story of Milken’s prosecution was written with his cooperation and is generally sympathetic to him. -
Bainbridge, Stephen M. Securities Law: Insider Trading. New York: Foundation Press, 1999. Presents selected cases to illustrate how the laws concerning insider trading have evolved over time in the United States. Includes index. -
Bruck, Connie. The Predators’ Ball: The Inside Story of Drexel Burnham and the Rise of the Junk Bond Raiders. Rev. ed. New York: Penguin Books, 1989. The first edition of this volume was the first book to deal with Drexel Burnham Lambert and the rise of junk bonds. An indispensable resource for research on this topic. -
Geisst, Charles R. Wall Street: A History—From Its Beginnings to the Fall of Enron. Rev. ed. New York: Oxford University Press, 2004. Comprehensive history of Wall Street includes discussion of the rise of the junk-bond market in chapter 11. -
Johnston, Moira. Takeover: The New Wall Street Warriors—The Men, the Money, the Impact. New York: Arbor House, 1986. One of the best books available on the merger mania of the mid-1980’s, but written before the biggest and most important deals were concluded. -
Kornbluth, Jesse. Highly Confident: The Crime and Punishment of Michael Milken. New York: Morrow, 1992. Informative concerning Milken’s personality and the trial, but weak in explaining how investment banking is conducted. Written with Milken’s cooperation and displays sympathy toward him. -
Smith, Roy C. The Money Wars: The Rise and Fall of the Great Buyout Boom of the 1980’s. New York: Dutton, 1990. Presents a clear and informed discussion of the takeover movement, with special attention to Drexel. -
Sobel, Robert. Dangerous Dreamers: The Financial Innovators from Charles Merrill to Michael Milken. 1993. Washington, D.C.: Beard Books, 2000. Attempts to place the merger movement in the context of post-World War II markets. Focuses on the merger movement and the sources of Milken’s ideas and activities. -
Stewart, James B. Den of Thieves. New York: Simon & Schuster, 1991. Contentious best seller about the decline of Drexel and Milken, apparently based on leaks from the SEC and the U.S. attorney’s office. -
Yago, Glenn. Junk Bonds: How High Yield Securities Restructured Corporate America. New York: Oxford University Press, 1990. One of the more prominent Milken defenders presents a scholarly defense of the use of junk bonds in corporate creation and takeovers.
Insider Trading Scandals Mar the Emerging Junk Bond Market
U.S. Stock Market Crashes on “Black Monday”
Lincoln Savings and Loan Declares Bankruptcy