The rise of Drexel Burnham Lambert as a major trader in the new market for junk bonds provided opportunities for illegal insider trading, the crime with which Dennis Levine was charged.
In the 1980’s, the emergent market for junk bonds offered opportunities for violations of insider trading laws. Those laws had prohibited stock and bond traders from profiting from transactions about which they had privileged information. The nature of placing such issues with buyers, however, blurred the line between information that was privileged and information that was not. On May 12, 1986, investment banker Dennis Levine, who worked for the banking house of Drexel Burnham Lambert and had represented Pantry Pride in its battle with Revlon, was accused of trading on nonpublic information. As part of the deal Levine worked out with prosecutors, he testified against other insiders, including Ivan Boesky. Eventually Boesky received a deal from prosecutors for agreeing, along with Levine, to provide testimony against Drexel Burnham Lambert banker Michael Milken. In March, 1989, the U.S. government indicted Milken.
Businesses traditionally have raised capital by selling either stocks or bonds. Stock prices reflect immediate changes in companies’ assets, profitability, net worth, or future prospects. Bonds, however, as a loan from the buyer to the company, usually carry a specified return payable at a future date. To convince buyers that certain bonds are sound, large investment banking houses grade the bond issuers as to their quality (or, inversely, as to the risk of their bonds). A company carrying a rating of AAA on its bonds is considered to be extremely creditworthy; a company with a B rating will have a more difficult time obtaining capital.
The rating system in the 1980’s tended to favor older, established companies and heavy industries at the expense of newer, rapidly growing companies and growth industries such as telecommunications, computers, and biotechnology. Another problem with the rating system was that by the 1980’s some eight hundred companies had bond ratings of BBB or better—considered the minimum investment grade—and yet were in poor financial shape. Penn Central Railroad qualified for a BBB rating two weeks before it went bankrupt, and foreign nations such as Argentina and Mexico also received high bond ratings on the eve of their defaults to U.S. creditors.
Moreover, not one business owned by a woman or a member of a minority group qualified for an investment-grade rating. On the contrary, by 1989 more than twenty-one thousand companies, mostly smaller businesses, failed to qualify for a BBB rating or better. For such companies, obtaining capital proved difficult. To receive an investment-grade rating on its bonds, a company had to have a long history of growth, but it could not grow without capital. A number of profitable, well-known companies found themselves in that situation, including Holiday Inns, Safeway, the MGM/UA and Orion motion picture studios, and MCI Communications.
In 1973, none of the major investment houses had any interest in those companies. Morgan Guaranty Trust, Shearson Lehman Brothers, Merrill Lynch, and the other large investment bankers had a bias toward older industrial companies. Virtually the only banking house that saw any profit in trading in the newer companies was Drexel Burnham Lambert in New York City (commonly referred to as Drexel), a banking house descended from the partner of J. P. Morgan’s father, Junius. Even within Drexel, only one banker, Michael Milken, saw the potential of bond issues by such businesses. Milken, impressed with a study that found that yields on a diversified portfolio of low-grade bonds exceeded those of a higher-grade portfolio even after defaults were accounted for, decided to specialize in low-grade issues. He researched companies relentlessly, simply outworking almost everyone else. Like Boesky, Milken had the exceptional ability to work on four hours of sleep a night, and both men were consistently in their offices before 6:00
The rise of a junk-bond market irritated the old-line investment houses, which suddenly found themselves losing their ability to dictate financial life and death through their ratings system. Drexel soon had more than a thousand clients wanting to issue junk bonds. Milken’s financial democracy also undercut the established houses from below, opening up a new network of customers whom the traditional houses had scorned, such as Sol Steinberg,
Drexel grew rapidly as a dealer in junk bonds. In 1978, the company issued $439 million in junk, accounting for 70 percent of the market. Certainly not all junk-bond deals were profitable. American Communications Industries, for which Drexel issued $20 million in bonds, became the first company to default without making a single interest payment. Risks came with junk, but so did potentially high returns. Increasingly, Drexel issued new debt paper to replace old debt a company carried. That built in an immediate pressure to conclude deals, requiring Milken to develop a new unregistered type of security that did not have to languish in the offices of the Securities and Exchange Commission (SEC). Under section 3(a)9 of the Securities Act of 1933,
In the early 1980’s, over a five-year period, Drexel completed 175 3(a)9 exchange offers totaling more than $7 billion in junk-bond debt. Drexel’s default rate was an astoundingly low 2 percent, whereas other traditional houses generally had default rates as high as 17 percent on their standard exchanges. In an era during which critics complained of the recklessness and high risk associated with junk bonds, Drexel’s issues were the safest of any except government bonds. Drexel spotted firms primed for fantastic growth, such as MCI Communications (in which Drexel itself held $250 million in bonds) and businesses no other house would touch, such as the Golden Nugget casino in Atlantic City, New Jersey. The firm’s profits soared from $6 million in 1978 to $150 million in 1983.
Milken developed another device, called the “highly confident” letter, known to insiders as the Air Fund, because nothing was in it. Drexel could raise a billion-dollar line of credit by claiming it had an account to purchase securities itself. In fact, the “highly confident” letters represented self-fulfilling prophecies: The issue of such a letter convinced others that Drexel had capital, so others invested until Drexel ultimately did have capital. Using that strategy, Milken financed T. Boone Pickens’s
The difficulties and potential illegalities in junk bonds involved the requirement to move the bonds from the first tier of investors to the second tier, who generally wanted to avoid junk bonds publicly. Bonds had to change hands rapidly, far more quickly than they could be registered with the SEC, and technically, if the first-tier buyers intended to resell their bonds all along, they violated the law by doing so. Proving intentions in such cases was impossible without the testimony of insiders. Thus, when federal authorities finally found Dennis Levine, on whom they could hang enough charges to persuade him to turn state’s evidence, jurors had to choose between Milken’s description of his buyers’ intentions and Levine’s account of events.
In March, 1989, after more than five years of SEC investigations, federal authorities charged Michael Milken with ninety-eight counts of securities fraud violations.
The indictments of Levine, Boesky, and Milken reaffirmed the power of the federal government and its intent to regulate the securities markets. Certainly by 1980 technological changes in the exchanges themselves and the evolution of new instruments of debt, such as the 3(a)9 and the “highly confident” letter, had far outpaced the capability of the government to regulate securities exchanges. Neither the 3(a)9 nor the “highly confident” letter was illegal, but the pace at which deals were negotiated encouraged blurring the lines between a statement of a company’s financial status and an illegal prediction of performance. The government took the view that the notices of offerings constituted “tips.”
No public presentation of evidence was ever held. Both Levine and Boesky had personal incentives to slant their testimony for the purposes of the government prosecutors, as they bargained with the government and offered evidence intended to implicate others. Milken originally pleaded not guilty and seemed prepared to fight, but the indictment of his brother Lowell in March, 1989, put more pressure on Milken. Most observers believed the prosecution of Lowell Milken
Those factors caused Milken to change his plea to guilty on six felony fraud charges in April, 1990. On November 21, 1990, Judge Kimba Wood
In the Milken case, the government used the Racketeer Influenced and Corrupt Organizations (RICO) Act,
Not everyone agreed that Milken was a greedy opportunist. Supporters claimed that he had offered hope to companies that other firms were unwilling to help. His bond deal with MCI Communications made it possible for the firm to challenge American Telephone and Telegraph (AT&T) in the long-distance telephone market, for example. Despite his guilty plea, serious questions remain as to whether Milken actually broke any laws or merely struck a plea agreement to save his family and fortune. His own guilty pleas, if essentially obtained under duress, are not the smoking gun that critics have tried to find.
Milken’s activities raised the more difficult question of what constitutes “insider” trading. Some economists have contended that the very concept of “insider” information is problematic. In an industry in which information is worth money, such as the stock and bond markets, all data about any company potentially are privileged.
Of greater significance is the reputation that junk bonds acquired. The collapse of the savings and loan
As long as Milken and Drexel had control of junk-bond offerings, the ratio of winners to losers was high. When other houses started to offer junk, quality depreciated as firms accepted clients with lower creditworthiness once the best prospects had been taken. That in no way diminished the role of low-grade bond instruments, which offered capital to new companies or to “outcasts.” Drexel’s success and low default rates on its issues showed that markets had overlooked some worthy companies. Drexel’s success also led to high expectations of performance for other instruments of lesser quality. Junk bonds in that respect became victims of their own success.
The insider trading scandals prompted new efforts to tighten securities laws. At the same time, the scandals reinforced the notion that the United States had become a nation that merely moved paper and made money from money rather than from products. The success of Milken and others encouraged business students to concentrate on investment banking in their search for the most lucrative careers. Buying and selling companies came to be perceived as a quicker route to financial success than developing a strong company with a good product.
Milken operated on the frontiers of securities innovation, and often no law regulated or guided what he did. Although he frequently may not have known if his activities were strictly legal, most of the time the authorities would not have been able to ascertain the legality of those activities either. Milken can be compared to a biogeneticist developing new life-forms long before the law considered the ramifications of creating artificial life. Milken has been compared to early twentieth century financier J. P. Morgan for his democratization of the capital markets. Milken and his junk-bond raiders arguably made the management of American companies much more responsive to their stockholders, as inefficient managers could find themselves bought out of their jobs by raiders who thought they could manage better.
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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. An earlier edition was the first book to deal with Drexel Burnham Lambert and the rise of junk bonds. Provides a reporter’s analysis of Wall Street. Never excuses Milken’s excesses but is nevertheless more balanced than others in assessing the value of junk bonds and the revolution Milken created in financing small, growing companies. Indispensable 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. -
Stein, Benjamin J. A License to Steal: The Untold Story of Michael Milken and the Conspiracy to Bilk the Nation. New York: Simon & Schuster, 1992. Stein, a lawyer and longtime critic of leveraged buyouts and financial innovations, takes a negative view of Milken and Drexel’s activities. His disgust with virtually all the new financial mechanisms, such as leveraged buyouts and junk bonds, puts him at variance with most other conservative writers on the subject, such as Jude Wanniski and George Gilder. -
Stewart, James B. Den of Thieves. New York: Simon & Schuster, 1991. Takes a “detective story” approach to the scandals, with Milken, Boesky, and others cast as the villains and a courageous group of government detectives as the heroes. Stewart is as critical as Stein (cited above) but much more thorough in his research. Presents evidence from the public record and testimony by Boesky; lacks any inside testimony by Milken.
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