Drexel Burnham Lambert

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was a major Wall Street investment banking firm, which first rose to prominence and then was driven into bankruptcy in February 1990 by its involvement in illegal activities in the junk bond market, driven by Drexel employee Michael Milken. At its height, it was the fifth-largest investment bank in the United States.[1]

Early history
I.W. "Tubby" Burnham, a 1931 graduate of the Wharton School of the University of Pennsylvania, founded the firm in 1935 as Burnham and Company, a small New York City-based retail brokerage. Burnham started the firm with $100,000 of capital, $96,000 of which was borrowed from his grandfather and the founder of a Kentucky distillery.[2]

It became one of the more successful brokerages in the country, eventually building its capital to $1 million.[1] Burnham eventually branched out into investment banking. However, the company's ability to expand was limited by the structure of the investment banking industry of that time. A strict unwritten set of rules assured the dominance of a few large firms by controlling the order in which their names appeared in advertisements for an underwriting. Burnham, as a "sub-major" firm, needed to connect with a "major" or "special" firm in order to further expand,[2] and in 1967 found a willing partner in Drexel Firestone, an ailing Philadelphia-based firm with a rich history.

Drexel and Company had been founded in 1838 by Francis Martin Drexel. His son, Anthony Joseph Drexel, became a partner in the firm at age 21, in 1847. The company made its money in the opportunities created by gold discoveries in California. The company was also involved in financial deals with the federal government during the U.S.-Mexican War and the U.S. Civil War. A. J. Drexel became the head of Drexel & Company when his father died in 1863. He partnered with J.P. Morgan and created one of the largest banking companies in the world, Drexel, Morgan & Co.[3]

In 1940, several former Drexel partners and associates formed an investment bank and assumed the rights to the "Drexel and Company" name. The old Drexel, which chose to concentrate on commercial banking after the Glass-Steagall Act regulated the separation of commercial and investment banking, was completely absorbed into the Morgan empire. The new Drexel grew slowly, coasting on historic ties to the larger securities issuers. By the early 1960s, it found itself short on capital. It merged with Harriman, Ripley and Company in 1965,[2] and renamed itself Drexel Harriman Ripley. In the mid-1970s, it sold a 25 percent stake to Firestone Tire and Rubber Company, renaming itself Drexel Firestone.

However, it was a mere shell of its former self; despite having only two major clients by the dawn of the 1970s it was still considered a major firm, and thus got a large chunk of the syndicates formed to sell stocks and bonds. In 1973, a severe drop in the stock market sent the firm reeling. Drexel management soon realized that a prominent name was not nearly enough to survive, and was very receptive to a merger offer from Burnham.[4]

Even though Burnham dominated the merged firm, the more powerful investment banks (whose informal blessing the new firm needed to survive on Wall Street) insisted that the Drexel name come first as a condition of joining the "major" bracket. Thus, Drexel Burnham and Company, headquartered in New York, was born in 1973[5] with $44 million in capital.[2]

In 1976, it merged with William D. Witter, a small "research boutique" that was the American arm of Belgian-based Groupe Bruxelles Lambert. The firm was renamed Drexel Burnham Lambert, and incorporated that year after 41 years as a limited partnership.[2] The enlarged firm was privately held; Lambert held a 26 percent stake and received six seats on the board of directors. Most of the remaining 74 percent was held by employees.[4]


Business
Drexel's legacy as an advisor to both startup companies and fallen angels remains an industry model today. While Milken (a holdover from the old Drexel) got most of the credit by almost single-handedly creating a junk bond market, another key architect in this strategy was Fred Joseph. Shortly after buying the old Drexel, Burnham found out that Joseph, chief operating officer of Shearson Hamill, wanted to get back into the nuts and bolts of investment banking and hired him as co-head of corporate finance. Joseph, the son of a Boston taxicab driver, was a good fit for the firm's culture. He promised Burnham that in 10 years, he would make Drexel Burnham as powerful as Goldman Sachs.[5]

Joseph's prophecy proved accurate. The firm rose from the bottom of the pack to compete with and even top the Wall Street bulge bracket firms. While Milken was clearly the most powerful man in the firm (to the point that a business consultant warned Drexel that it was a "one-product company"),[6] it was Joseph who was named company president in 1984 and CEO in 1985.[2]

Drexel, however, was more aggressive in its business practices than most. When it entered the mergers and acquisitions field in the early 1980s, it didn't shy away from backing hostile takeovers—long a taboo among the established firms. Its specialty was the "highly confident letter," in which it promised it could get the necessary financing for a hostile takeover. Although it had no legal status, Drexel's reputation for making markets for any bonds it underwrote was such that a "highly confident letter" was as good as cash to many of the corporate raiders of the 1980s.[2] Among the deals it financed during this time were Boone Pickens' failed runs at Gulf Oil and Unocal, Carl Icahn's bid for Phillips 66, Ted Turner's buyout of MGM/UA[2] and Kohlberg Kravis Roberts successful bid for RJR Nabisco.[7]

Organizationally, the firm was considered the definition of a meritocracy. Divisions received bonuses based on their individual performance rather than the performance of the firm as a whole. This often led to acrimony between individual departments, who sometimes acted like independent companies rather than small parts of a larger one. Also, several employees formed limited partnerships that allowed them to invest alongside Milken. These partnerships often made more money than the firm itself did on a particular deal. For instance, many of the partnerships ended up with more warrants than the firm itself held in particular deals.[4]

The firm had its most profitable fiscal year in 1986, netting $545.5 million—at the time, the most profitable year ever for a Wall Street firm. In 1987, Milken was paid executive compensation of $550 million for the year.[6][4]


Downfall
According to Dan Stone, a former Drexel executive, the firm's aggressive culture led many Drexel employees to stray into unethical, and sometimes illegal, conduct. Milken himself viewed the securities laws, rules and regulations with some degree of contempt, and often condoned unethical and illegal behavior by his colleagues at Drexel's operation in Beverly Hills.[4] However, he personally called Joseph, who believed in following the rules to the letter, on several occasions with ethical questions.[6]

The firm was first rocked on May 12, 1986, when Dennis Levine, a Drexel managing director and investment banker, was charged with insider trading. Levine had spent virtually his entire career on Wall Street trading on inside information, unknown to Drexel management when he was hired in 1985. Levine pleaded guilty to four felonies, and implicated one of his recent partners, super-arbitrageur Ivan Boesky. Largely based on information Boesky promised to provide about his dealings with Milken, the Securities and Exchange Commission initiated an investigation of Drexel on November 17. Two days later, Rudy Giuliani, the United States Attorney for the Southern District of New York, launched his own investigation. Ominously, Milken refused to cooperate with Drexel's own internal investigation, only speaking through his attorneys. [4]

For two years, Drexel steadfastly denied any wrongdoing, claiming that the criminal and SEC cases were based almost entirely on the statements of an admitted felon looking to reduce his sentence. However, it was not enough to keep the SEC from suing Drexel in September 1988 for insider trading, stock manipulation, defrauding its clients and stock parking (buying stocks for the benefit of another). All of the transactions involved Milken and his department. The most intriguing charge was that Boesky paid Drexel $5.3 million in 1986 for Milken's share of profits from illegal trading. Earlier in the year, Boesky characterized the payment as a consulting fee to Drexel. Around the same year, Giuliani began seriously considering indicting Drexel under the powerful Racketeer Influenced and Corrupt Organizations Act, under the doctrine that companies are responsible for an employee's crimes.[4]

The threat of a RICO indictment unnerved many at Drexel. A RICO indictment would have required the firm to put up a performance bond of as much as $1 billion in lieu of having its assets frozen. This provision was put in the law because organized crime had a habit of absconding with the funds of indicted companies, and the writers of RICO wanted to make sure there was something to seize or forfeit in the event of a guilty verdict. Unfortunately, most of Drexel's capital was borrowed money, as is common with most Wall Street firms (in Drexel's case, 96 percent—by far the most of any firm). This debt would have to take second place to this performance bond. Additionally, if the bond ever had to be paid, Drexel's stockholders would have been all but wiped out. Due to this, banks will not extend credit to a firm under a RICO indictment.[4]

By this time, several Drexel executives—including Joseph—concluded that Drexel could not survive a RICO indictment and would have to seek a settlement with Giuliani. Senior Drexel executives became particularly nervous after Princeton Newport Partners, a small investment partnership, was forced to close its doors in the summer of 1988. Princeton Newport had been indicted under RICO, and the prospect of having to post a huge performance bond forced its shutdown well before the trial. Joseph said years later that he'd been told that if Drexel were indicted under RICO, it would only survive a month at most.[5] Nonetheless, negotiations for a possible plea agreement collapsed on December 19 when Giuliani made several demands that were far too draconian even for those who advocated a settlement. Giuliani demanded that Drexel waive its attorney-client privilege, and also wanted the right to arbitrarily decide that the firm had violated the terms of any plea agreement. He also demanded that Milken leave the firm if the government ever indicted him. Drexel's board unanimously rejected the terms. For a time, it looked like Drexel was going to fight.[4]

Only two days later, however, Drexel lawyers found out about a limited partnership, MacPherson Partners, they previously hadn't known about. This partnership had been involved in the issuing of bonds for Storer Broadcasting. Several equity warrants were sold to one client who sold them back to Milken's department. Milken then sold the warrants to MacPherson Partners. The limited partners included several of Milken's children, and more ominously, managers of money funds. This partnership raised the specter of self-dealing, and at worst, bribes to the money managers. At the very least, this was a serious breach of Drexel's internal regulations. Drexel immediately reported this partnership to Giuliani, and its revelation seriously hurt Milken's credibility with many at Drexel who believed in Milken's innocence—including Joseph and most of the board.[4][5]

With literally minutes to go before being indicted (according to at least one source, the grand jury was actually in the process of voting on the indictment), Drexel reached an agreement with the government in which it pleaded nolo contendere (no contest) to six felonies—three counts of stock parking and three counts of stock manipulation. [4] It also agreed to pay a fine of $650 million—at the time, the largest fine ever levied under the Great Depression-era securities laws. The government had dropped several of the demands that had initially angered Drexel, but continued to insist that Milken leave the firm if indicted—which he did shortly after his own indictment in March 1989.[5][2] Most sources say that Drexel pleaded guilty, but in truth, Drexel only admitted that it was "not in a position to dispute the allegations." Nonetheless, Drexel was now a convicted felon.

In April 1989, Drexel settled with the SEC, agreeing to stricter safeguards on its oversight procedures. Later that month, the firm eliminated 5,000 jobs by shuttering three departments—including the retail brokerage operation. In essence, Drexel was jettisoning the core of the old Burnham & Company.[4] The retail accounts were eventually sold to Smith Barney.[8]

Due to several deals that didn't work out, as well as an unexpected crash of the junk bond market, 1989 was a difficult year for Drexel even after it settled the criminal and SEC cases. Reports of an $86 million loss going into the fourth quarter resulted in the firm's commercial paper rating being cut in late November. This made it nearly impossible for Drexel to reborrow its outstanding commercial paper, and it had to be repaid. Rumors abounded that the banks could yank Drexel's lines of credit at any time. Unfortunately, Drexel had no corporate parent that could pump in cash, unlike most American financial institutions. Groupe Bruxelles Lambert refused to even consider making an equity investment until Joseph improved the bottom line. The firm posted a $40 million loss for 1989—the first operating loss in its 54-year history.[4]

Drexel managed to survive into 1990 by transferring some of the excess capital from its regulated broker/dealer subsidiary into the Drexel holding company—only to be ordered to stop by the SEC in February out of concerns about the broker's solvency. This sent Joseph and other senior executives into a near-panic. After the SEC, the New York Stock Exchange, and the Federal Reserve Bank of New York cast doubts about a restructuring plan, Joseph concluded that Drexel could not stay independent. Unfortunately, concerns about possible liability to civil suits scared off prospective buyers.[4][5]

By February 12, it was obvious Drexel was headed for collapse. Its commercial paper rating was further reduced that day. Joseph's last resort was a bailout by the government. Unfortunately for Drexel, one of first hostile deals came back to haunt it at this point. Unocal's investment bank at the time of Pickens' raid on it was the establishment firm of Dillon, Read—and its former chairman, Nicholas F. Brady, was now Secretary of the Treasury. Brady had never forgiven Drexel for its role in the Unocal deal, and would not even consider signing off on a bailout. Accordingly, he, the SEC, the NYSE and the Fed strongly advised Joseph to file for bankruptcy. Later the next day, Drexel officially filed for Chapter 11 bankruptcy protection. [5] DBL Trading, a subsidiary, was involved in the temporary gold loan default with the Central Bank of Portugal at that time.[citation needed]

Even before the firm's bankruptcy, Tubby Burnham spun off the firm's funds management arm as Burnham Financial Group, which currently operates as a diversified investment company. Burnham was reportedly still arranging deals until his death at age 93.[8] The rest of Drexel emerged from bankruptcy in 1992 as New Street Capital, a small investment bank with only 20 employees (at its height, Drexel employed over 10,000 people).[2] In 1994, New Street merged with Green Capital, a merchant bank owned by Atlanta financier Holcombe Green.[9]


Criticism
By the late 1980s, public confidence in leveraged buyouts had waned, and criticism of the perceived engine of the takeover movement, the junk bond, had increased. Innovative financial instruments often generate skepticism, and few have generated more controversy than high yield debt. Some argue that the debt instrument itself, sometimes dubbed "turbo debt," was the cornerstone of the 1980s "Decade of Greed." However, junk bonds were actually used in less than 25% of acquisitions and hostile takeovers during that period. Nevertheless, by 1990 default rates on high yield debt had increased from 4% to 10%, further eroding confidence in this financial instrument. Without Milken's cheerleading, the liquidity of the junk bond market dried up. Drexel was forced to buy the bonds of insolvent and failing companies, which depleted their capital and would eventually bankrupt the company.

Survivors
A few other firms emerged from Drexel's collapse, besides Burnham Financial.

Drexel Burnham Lambert Real Estate Associates II operates as a real estate management firm. Apollo Management, the noted private equity firm, was also founded by Drexel alumni led by Leon Black. Fred Joseph helped establish Morgan Joseph, a middle-market investment bank. Although the firm carries his name, he is only co-head of corporate finance. In 1993, the SEC barred him from serving as president, chairman or CEO of a securities firm for life for failing to properly supervise Milken. Morgan Joseph's CEO is John Sorte, Joseph's successor as president and CEO of Drexel from 1990 to 1992.[10] CNBC named Fred Joseph as one of the "Worst American CEOs of All Time", stating that "his poor management left the company without a crisis plan".[11]