Drexel Burnham Lambert
Encyclopedia
Drexel Burnham Lambert was a major Wall Street
investment banking
firm, which first rose to prominence and then was forced 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
.
, 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.
It became one of the more successful brokerages in the country, eventually building its capital to $1 million. 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, 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 Mexican–American 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.
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, 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.
Even though Burnham was the senior partner in the merger, 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 with $44 million in capital.
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
. 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.
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
.
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. Michael 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"), but it was Joseph who was named company president in 1984 and CEO in 1985.
Drexel, however, was more aggressive in its business practices than most. When it entered the mergers and acquisitions
field in the early 1980s, it did not 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. 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, and Kohlberg Kravis Roberts successful bid for RJR Nabisco
.
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.
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.
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-arbitrage
ur Ivan Boesky
. Largely based on information Boesky promised to provide about his dealings with Milken, the SEC initiated an investigation of Drexel on November 17. Two days later, Rudy Giuliani
, then 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.
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
. Drexel was potentially liable under the doctrine of respondeat superior
, which holds that companies are responsible for an employee's crimes.
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.
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. 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.
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 fund
s. 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.
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. 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. 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. The retail accounts were eventually sold to Smith Barney
.
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.
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.
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. DBL Trading, a subsidiary, was involved in the temporary gold
loan default
with the Central Bank of Portugal at that time.
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. 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). In 1994, New Street merged with Green Capital, a merchant bank
owned by Atlanta financier Holcombe Green.
s 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.
There was also the 1838 Group named after the founding date of Drexel established by another group of investment fund managers. The funds suffered from under performance and the group folded. 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 that caters to many of the same kinds of clients as Drexel had. Although the firm carried his name, he was only co-head of corporate finance until his death in 2009. 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. Portfolio.com and CNBC
recently named Joseph the seventh-worst CEO in American business history stating that "his poor management left the company without a crisis plan".
Wall Street
Wall Street refers to the financial district of New York City, named after and centered on the eight-block-long street running from Broadway to South Street on the East River in Lower Manhattan. Over time, the term has become a metonym for the financial markets of the United States as a whole, or...
investment banking
Investment banking
An investment bank is a financial institution that assists individuals, corporations and governments in raising capital by underwriting and/or acting as the client's agent in the issuance of securities...
firm, which first rose to prominence and then was forced into bankruptcy in February 1990 by its involvement in illegal activities in the junk bond market, driven by Drexel employee Michael Milken
Michael Milken
Michael Robert Milken is an American business magnate, financier, and philanthropist noted for his role in the development of the market for high-yield bonds during the 1970s and 1980s, for his 1990 guilty plea to felony charges for violating US securities laws, and for his funding of medical...
. At its height, it was the fifth-largest investment bank in the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
.
Early history
I.W. "Tubby" Burnham, a 1931 graduate of the Wharton School of the University of PennsylvaniaUniversity of Pennsylvania
The University of Pennsylvania is a private, Ivy League university located in Philadelphia, Pennsylvania, United States. Penn is the fourth-oldest institution of higher education in the United States,Penn is the fourth-oldest using the founding dates claimed by each institution...
, founded the firm in 1935 as Burnham and Company, a small New York City
New York City
New York is the most populous city in the United States and the center of the New York Metropolitan Area, one of the most populous metropolitan areas in the world. New York exerts a significant impact upon global commerce, finance, media, art, fashion, research, technology, education, and...
–based retail brokerage
Stock broker
A stock broker or stockbroker is a regulated professional broker who buys and sells shares and other securities through market makers or Agency Only Firms on behalf of investors...
. Burnham started the firm with $100,000 of capital, $96,000 of which was borrowed from his grandfather and the founder of a Kentucky
Kentucky
The Commonwealth of Kentucky is a state located in the East Central United States of America. As classified by the United States Census Bureau, Kentucky is a Southern state, more specifically in the East South Central region. Kentucky is one of four U.S. states constituted as a commonwealth...
distillery.
It became one of the more successful brokerages in the country, eventually building its capital to $1 million. 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
Underwriting
Underwriting refers to the process that a large financial service provider uses to assess the eligibility of a customer to receive their products . The name derives from the Lloyd's of London insurance market...
. Burnham, as a "sub-major" firm, needed to connect with a "major" or "special" firm in order to further expand, 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
Francis Martin Drexel
Francis Martin Drexel was a Philadelphia banker and artist. He was the father of Anthony Joseph Drexel, the founder of Drexel University and the grandfather of Saint Katherine 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
California
California is a state located on the West Coast of the United States. It is by far the most populous U.S. state, and the third-largest by land area...
. The company was also involved in financial deals with the federal government during the Mexican–American War
Mexican–American War
The Mexican–American War, also known as the First American Intervention, the Mexican War, or the U.S.–Mexican War, was an armed conflict between the United States and Mexico from 1846 to 1848 in the wake of the 1845 U.S...
and the U.S. Civil War
American Civil War
The American Civil War was a civil war fought in the United States of America. In response to the election of Abraham Lincoln as President of the United States, 11 southern slave states declared their secession from the United States and formed the Confederate States of America ; the other 25...
. A. J. Drexel became the head of Drexel & Company when his father died in 1863. He partnered with J. P. Morgan
J. P. Morgan
John Pierpont Morgan was an American financier, banker and art collector who dominated corporate finance and industrial consolidation during his time. In 1892 Morgan arranged the merger of Edison General Electric and Thomson-Houston Electric Company to form General Electric...
and created one of the largest banking companies in the world, Drexel, Morgan & Co.
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
J.P. Morgan & Co.
J.P. Morgan & Co. was a commercial and investment banking institution based in the United States founded by J. Pierpont Morgan and commonly known as the House of Morgan or simply Morgan. Today, J.P...
. 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, and renamed itself Drexel Harriman Ripley. In the mid-1970s, it sold a 25 percent stake to Firestone Tire and Rubber Company
Firestone Tire and Rubber Company
The Firestone Tire and Rubber Company is an American tire company founded by Harvey Firestone in 1900 to supply pneumatic tires for wagons, buggies, and other forms of wheeled transportation common in the era. Firestone soon saw the huge potential for marketing tires for automobiles. The 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.
Even though Burnham was the senior partner in the merger, 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 with $44 million in capital.
In 1976, it merged with William D. Witter, a small "research boutique" that was the American arm of Belgian
Belgium
Belgium , officially the Kingdom of Belgium, is a federal state in Western Europe. It is a founding member of the European Union and hosts the EU's headquarters, and those of several other major international organisations such as NATO.Belgium is also a member of, or affiliated to, many...
-based Groupe Bruxelles Lambert
Groupe Bruxelles Lambert
Groupe Bruxelles Lambert is a Belgian industrial holding company. It is one of the ten biggest Belgian companies, and part of the BEL20. It has been listed in Brussels since 1956.Shareholdings as of 31 December 2010 were:...
. The firm was renamed Drexel Burnham Lambert, and incorporated that year after 41 years as a limited partnership
Limited partnership
A limited partnership is a form of partnership similar to a general partnership, except that in addition to one or more general partners , there are one or more limited partners . It is a partnership in which only one partner is required to be a general partner.The GPs are, in all major respects,...
. 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.
Business
Drexel's legacy as an advisor to both startup companies and fallen angels remains an industry model today. While Michael 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 BostonBoston
Boston is the capital of and largest city in Massachusetts, and is one of the oldest cities in the United States. The largest city in New England, Boston is regarded as the unofficial "Capital of New England" for its economic and cultural impact on the entire New England region. The city proper had...
taxicab
Taxicab
A taxicab, also taxi or cab, is a type of vehicle for hire with a driver, used by a single passenger or small group of passengers, often for a non-shared ride. A taxicab conveys passengers between locations of their choice...
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
Goldman Sachs
The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
.
Joseph's prophecy proved accurate. The firm rose from the bottom of the pack to compete with and even top the Wall Street
Wall Street
Wall Street refers to the financial district of New York City, named after and centered on the eight-block-long street running from Broadway to South Street on the East River in Lower Manhattan. Over time, the term has become a metonym for the financial markets of the United States as a whole, or...
bulge bracket
Bulge bracket
The bulge bracket comprises the "big banks," the world's largest and most profitable multi-national investment banks.- Technical meaning :The term 'bulge bracket' refers to the first group of investment banks listed on the "tombstone" notifying the public of a financial transaction or deal...
firms. Michael 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"), but it was Joseph who was named company president in 1984 and CEO in 1985.
Drexel, however, was more aggressive in its business practices than most. When it entered the mergers and acquisitions
Mergers and acquisitions
Mergers and acquisitions refers to the aspect of corporate strategy, corporate finance and management dealing with the buying, selling, dividing and combining of different companies and similar entities that can help an enterprise grow rapidly in its sector or location of origin, or a new field or...
field in the early 1980s, it did not shy away from backing hostile takeovers
Takeover
In business, a takeover is the purchase of one company by another . In the UK, the term refers to the acquisition of a public company whose shares are listed on a stock exchange, in contrast to the acquisition of a private company.- Friendly takeovers :Before a bidder makes an offer for another...
—long a taboo among the established firms. Its specialty was the "highly confident letter
Highly confident letter
The "highly confident letter" was a financing tool created by investment bankers at Drexel Burnham Lambert, dominated by Michael Milken, in the 1980s...
", 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. Among the deals it financed during this time were Boone Pickens' failed runs at Gulf Oil
Gulf Oil
Gulf Oil was a major global oil company from the 1900s to the 1980s. The eighth-largest American manufacturing company in 1941 and the ninth-largest in 1979, Gulf Oil was one of the so-called Seven Sisters oil companies...
and Unocal, Carl Icahn
Carl Icahn
Carl Celian Icahn is an American business magnate and investor.-Biography:Icahn was raised in Far Rockaway, Queens, New York City, where he attended Far Rockaway High School. His father was a cantor, his mother was a schoolteacher...
's bid for Phillips 66
Phillips 66
Phillips 66 is a brand of gasoline and service station in the U.S. It is owned by the ConocoPhillips Company.Phillips 66 will also be the name of the future downstream company created when ConocoPhillips repositions its integrated assets and businesses into two independent, publicly-traded...
, Ted Turner
Ted Turner
Robert Edward "Ted" Turner III is an American media mogul and philanthropist. As a businessman, he is known as founder of the cable news network CNN, the first dedicated 24-hour cable news channel. In addition, he founded WTBS, which pioneered the superstation concept in cable television...
's buyout of MGM/UA, and Kohlberg Kravis Roberts successful bid for RJR Nabisco
RJR Nabisco
RJR Nabisco, Inc., was an American conglomerate formed in 1985 by the merger of Nabisco Brands and R.J. Reynolds Tobacco Company. RJR Nabisco was purchased in 1988 by Kohlberg Kravis Roberts & Co...
.
Organizationally, the firm was considered the definition of a meritocracy
Meritocracy
Meritocracy, in the first, most administrative sense, is a system of government or other administration wherein appointments and responsibilities are objectively assigned to individuals based upon their "merits", namely intelligence, credentials, and education, determined through evaluations or...
. 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
Warrant (finance)
In finance, a warrant is a security that entitles the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiry date....
than the firm itself held in particular deals.
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
Executive compensation
Executive pay is financial compensation received by an officer of a firm, often as a mixture of salary, bonuses, shares of and/or call options on the company stock, etc. Over the past three decades, executive pay has risen dramatically beyond the rising levels of an average worker's wage...
of $550 million for the year.
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, feeling they hindered the free flow of trade. He was under nearly constant scrutiny from the Securities and Exchange Commission from 1979 onward, in part because he often condoned unethical and illegal behavior by his colleagues at Drexel's operation in Beverly Hills. However, he personally called Joseph, who believed in following the rules to the letter, on several occasions with ethical questions.The firm was first rocked on May 12, 1986, when Dennis Levine
Dennis Levine
Dennis B. Levine was a prominent player in merger and acquisition business and the Wall Street insider trading scandals of the mid-1980s...
, a Drexel managing director and investment banker, was charged with insider trading
Insider trading
Insider trading is the trading of a corporation's stock or other securities by individuals with potential access to non-public information about the company...
. 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-arbitrage
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
ur Ivan Boesky
Ivan Boesky
Ivan Frederick Boesky is an American stock trader who is notable for his prominent role in a Wall Street insider trading scandal that occurred in the United States in the mid-1980s.-Life and career:...
. Largely based on information Boesky promised to provide about his dealings with Milken, the SEC initiated an investigation of Drexel on November 17. Two days later, Rudy Giuliani
Rudy Giuliani
Rudolph William Louis "Rudy" Giuliani KBE is an American lawyer, businessman, and politician from New York. He served as Mayor of New York City from 1994 to 2001....
, then 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.
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
Felony
A felony is a serious crime in the common law countries. The term originates from English common law where felonies were originally crimes which involved the confiscation of a convicted person's land and goods; other crimes were called misdemeanors...
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
Racketeer Influenced and Corrupt Organizations Act
The Racketeer Influenced and Corrupt Organizations Act, commonly referred to as the RICO Act or simply RICO, is a United States federal law that provides for extended criminal penalties and a civil cause of action for acts performed as part of an ongoing criminal organization...
. Drexel was potentially liable under the doctrine of respondeat superior
Respondeat superior
Respondeat superior is a legal doctrine which states that, in many circumstances, an employer is responsible for the actions of employees performed within the course of their employment...
, which holds that companies are responsible for an employee's crimes.
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
Organized crime
Organized crime or criminal organizations are transnational, national, or local groupings of highly centralized enterprises run by criminals for the purpose of engaging in illegal activity, most commonly for monetary profit. Some criminal organizations, such as terrorist organizations, are...
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.
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
Princeton Newport Partners
Princeton/Newport Partners was an early alternative investment management company founded by pioneering mathematical financier Edward O. Thorp in late 1974. The company was developed by assuming the instruments of an earlier venture, Convertible Hedge Associates...
, 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. 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
Attorney-client privilege
Attorney–client privilege is a legal concept that protects certain communications between a client and his or her attorney and keeps those communications confidential....
, 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.
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
Storer Broadcasting
Storer Broadcasting, Inc. was an American company which owned several television and radio stations in the northeast United States. It was incorporated in Ohio in 1927, and sold its broadcasting properties in 1983.-1920s—1940s:...
. 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 fund
Money fund
A money market fund is an open-ended mutual fund that invests in short-term debt securities such as US Treasury bills and commercial paper. Money market funds are widely regarded as being as safe as bank deposits yet providing a higher yield...
s. 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.
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
Nolo contendere
is a legal term that comes from the Latin for "I do not wish to contend." It is also referred to as a plea of no contest.In criminal trials, and in some common law jurisdictions, it is a plea where the defendant neither admits nor disputes a charge, serving as an alternative to a pleading of...
(no contest) to six felonies—three counts of stock parking and three counts of stock manipulation. It also agreed to pay a fine of $650 million—at the time, the largest fine ever levied under the Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
-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. 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. The retail accounts were eventually sold to Smith Barney
Smith Barney
Morgan Stanley Smith Barney is a retail brokerage joint venture between Morgan Stanley and Citigroup.On January 13, 2009, Morgan Stanley and Citigroup announced that Citigroup would sell 51% of Smith Barney to Morgan Stanley, creating Morgan Stanley Smith Barney, which was formerly a division of...
.
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
Commercial paper
In the global money market, commercial paper is an unsecured promissory note with a fixed maturity of 1 to 270 days. Commercial Paper is a money-market security issued by large banks and corporations to get money to meet short term debt obligations , and is only backed by an issuing bank or...
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
Line of credit
A line of credit is any credit source extended to a government, business or individual by a bank or other financial institution. A line of credit may take several forms, such as overdraft protection, demand loan, special purpose, export packing credit, term loan, discounting, purchase of...
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.
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
New York Stock Exchange
The New York Stock Exchange is a stock exchange located at 11 Wall Street in Lower Manhattan, New York City, USA. It is by far the world's largest stock exchange by market capitalization of its listed companies at 13.39 trillion as of Dec 2010...
, and the Federal Reserve Bank of New York
Federal Reserve Bank of New York
The Federal Reserve Bank of New York is one of the 12 Federal Reserve Banks of the United States. It is located at 33 Liberty Street, New York, NY. It is responsible for the Second District of the Federal Reserve System, which encompasses New York state, the 12 northern counties of New Jersey,...
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.
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
Nicholas F. Brady
Nicholas Frederick Brady was United States Secretary of the Treasury under Presidents Ronald Reagan and George H. W. Bush, and is also known for articulating the Brady Plan in March 1989.-Early life:...
, 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. DBL Trading, a subsidiary, was involved in the temporary gold
Gold
Gold is a chemical element with the symbol Au and an atomic number of 79. Gold is a dense, soft, shiny, malleable and ductile metal. Pure gold has a bright yellow color and luster traditionally considered attractive, which it maintains without oxidizing in air or water. Chemically, gold is a...
loan default
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
with the Central Bank of Portugal at that time.
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. 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). In 1994, New Street merged with Green Capital, a merchant bank
Merchant bank
A merchant bank is a financial institution which provides capital to companies in the form of share ownership instead of loans. A merchant bank also provides advisory on corporate matters to the firms they lend to....
owned by Atlanta financier Holcombe Green.
Criticism
By the late 1980s, public confidence in leveraged buyoutLeveraged buyout
A leveraged buyout occurs when an investor, typically financial sponsor, acquires a controlling interest in a company's equity and where a significant percentage of the purchase price is financed through leverage...
s 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.There was also the 1838 Group named after the founding date of Drexel established by another group of investment fund managers. The funds suffered from under performance and the group folded. Drexel Burnham Lambert Real Estate Associates II operates as a real estate management firm. Apollo Management
Apollo Management
Apollo Global Management, LLC is a private equity investment firm, founded in 1990 by former Drexel Burnham Lambert banker Leon Black. The firm specializes in leveraged buyout transactions and purchases of distressed securities involving corporate restructuring, special situations and industry...
, the noted private equity firm, was also founded by Drexel alumni led by Leon Black
Leon Black
Leon David Black is an American businessman and money manager, with a focus on leveraged buyouts and private equity. He is a son of Eli M. Black , a prominent businessman who controlled the United Brands Company and committed suicide when caught paying bribes to the President of Honduras...
. Fred Joseph helped establish Morgan Joseph, a middle-market investment bank that caters to many of the same kinds of clients as Drexel had. Although the firm carried his name, he was only co-head of corporate finance until his death in 2009. 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. Portfolio.com and CNBC
CNBC
CNBC is a satellite and cable television business news channel in the U.S., owned and operated by NBCUniversal. The network and its international spinoffs cover business headlines and provide live coverage of financial markets. The combined reach of CNBC and its siblings is 390 million viewers...
recently named Joseph the seventh-worst CEO in American business history stating that "his poor management left the company without a crisis plan".
Former employees
- Guy AdamiGuy AdamiGuy Adami is a TV personality, author, financial analyst, & a professional investor. He is one of the original "Fast Money Five" on the show Fast Money . In 2008 he joined optionMONSTER with Pete Najarian and Jon Najarian as the lead analyst for equities research. He also came on board as managing...
, panelist on CNBC's Fast MoneyFast Money (CNBC)Fast Money is an American financial stock trading talk show that began airing on the CNBC cable/satellite TV channel on 2006-06-21. Since October 10, 2007, it has broadcast every weeknight at 5pm ET, one hour after the close of trading on the New York Stock Exchange, until mid-2011 when it was... - Paul Biddelman, President of Hanseatic Corporation
- Leon BlackLeon BlackLeon David Black is an American businessman and money manager, with a focus on leveraged buyouts and private equity. He is a son of Eli M. Black , a prominent businessman who controlled the United Brands Company and committed suicide when caught paying bribes to the President of Honduras...
, leader of Apollo ManagementApollo ManagementApollo Global Management, LLC is a private equity investment firm, founded in 1990 by former Drexel Burnham Lambert banker Leon Black. The firm specializes in leveraged buyout transactions and purchases of distressed securities involving corporate restructuring, special situations and industry... - Haig M. Casparian, former General Counsel for Drexel, retired.
- Joseph CassanoJoseph CassanoJoseph J. "Joe" Cassano is an American insurance executive who was an officer at AIG Financial Products from the division's founding in 1987 until his resignation in February 2008. Cassano is considered a key figure in the Global financial crisis of 2008–2009...
, founder of AIG Financial ProductsAIG Financial ProductsAIG Financial Products Corporation. is a subsidiary of the American International Group, headquartered in Fairfield, CT, with major operations in London, it is currently in the process of winding down all of its operations. The collapse of AIG Financial Products is considered to have played a... - Jeffrey Chanin, founder of Chanin Capital Partners
- Brett Clancy, CEO of Japan Assets
- Abby Joseph CohenAbby Joseph CohenAbby Joseph Cohen is an American economist and financial analyst on Wall Street. She is a partner and——Senior U.S. investment strategist at Goldman Sachs. Prior to that date, she was Chief Investment Strategist...
, partner and chief U.S. investment strategist at Goldman, Sachs & CoGoldman SachsThe Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients... - Gerald B. Dubey, leading Family Office and Private Client advisor at UBS
- Marc FaberMarc Faber-Background:Faber was born in Zürich and schooled in Geneva, Switzerland, where he raced for the Swiss National Ski Team. He studied Economics at the University of Zurich and, at the age of 24, obtained a Ph.D. degree in Economics magna cum laude...
, formerly managing director of Drexel's Hong Kong office, famous for the Gloom Boom Doom investment report "Dr Doom" - Steve FeinbergSteve FeinbergStephen A. Feinberg is an American businessman active in the field of private equity. He is the founder and head of Cerberus Capital Management.-Early life:...
, Cerberus Capital ManagementCerberus Capital ManagementCerberus Capital Management, L.P. is one of the largest private equity investment firms in the United States. The firm is based in New York City, and run by -year-old financier Steve Feinberg. Former U.S... - Todd Fisher, Senior Partner at Kohlberg Kravis Roberts & Co
- James Stephen Fossett, American aviator, sailor, and adventurer
- Bennett Goodman, co-founder of GSO Capital PartnersGSO Capital PartnersGSO Capital Partners is one of the largest credit-oriented alternative asset managers in the world and a major participant in the leveraged finance marketplace....
now part of The Blackstone Group - Joel GreenblattJoel GreenblattJoel Greenblatt is a value investor, and adjunct professor at the Columbia University Graduate School of Business...
, founder of Gotham Capital - Richard B. HandlerRichard B. HandlerRichard B. Handler , is currently Chairman, Chief Executive Officer, and President of Jefferies & Co. , having held these positions since 2001, 2000, and 2006 respectively. Handler grew up in Fair Lawn, New Jersey and Woodcliff Lake, New Jersey.-Career:Handler was first elected to Jefferies Board...
, current CEO of Jefferies & Company - James Howard Hemsley, Partner at Hamilton Bushard
- Roderick M. HillsRoderick M. HillsRoderick M. Hills served as Chairman of the U.S. Securities and Exchange Commission between 1975 and 1977. Later he worked at the investment bank of Drexel Burnham Lambert and then at the law firm of Donovan, Leisure, Newton & Irvine. In 1962, he founded the law firm of Munger, Tolles, Hills, and...
, former Chairman of U.S. Securities and Exchange Commission (SEC) - Frederick H. Joseph, co-founder of Morgan Joseph
- Mitchell R.Julis, Canyon Capital Partners
- Dennis LevineDennis LevineDennis B. Levine was a prominent player in merger and acquisition business and the Wall Street insider trading scandals of the mid-1980s...
, Chairman & CEO, Adasar Group, Inc. - Michael MilkenMichael MilkenMichael Robert Milken is an American business magnate, financier, and philanthropist noted for his role in the development of the market for high-yield bonds during the 1970s and 1980s, for his 1990 guilty plea to felony charges for violating US securities laws, and for his funding of medical...
, former head of the non-investment-grade bond department; almost single-handedly created the market for "high-yield bonds" (also known as "junk bonds") - Ken MoelisKen MoelisKen Moelis is an investment banker and founder of Moelis & Company, an independent investment banking firm.-Education:Ken Moelis holds a Bachelor in Business Administration and a Masters of Business Administration from the Wharton School of the University of Pennsylvania.-Career:Moelis began his...
, former President and Head of Investment Banking at UBS; founder of Moelis & CompanyMoelis & CompanyMoelis & Company is a global investment banking and merchant banking firm. The firm provides advisory services related to mergers & acquisitions, recapitalization & restructuring, capital markets advisory and risk advisory... - Terren PeizerTerren PeizerTerren S. Peizer, chronicled by the LA Times as a financial prodigy,sometimes called the "Zelig of Wall Street" is currently the Chairman of a Los Angeles-based investment company, Socius Capital Group . Since its inception in June 2009 to December 2010, SCG has provided companies with capital...
, current CEO of Hythiam Co - Richard Sandor, Current Chairman of the Chicago Climate ExchangeChicago Climate ExchangeThe now defunct Chicago Climate Exchange was North America’s only voluntary, legally binding greenhouse gas reduction and trading system for emission sources and offset projects in North America and Brazil....
- Peter Sidoti, Founder and CEO of Sidoti & Company
- Tripp Smith, co-founder of GSO Capital PartnersGSO Capital PartnersGSO Capital Partners is one of the largest credit-oriented alternative asset managers in the world and a major participant in the leveraged finance marketplace....
now part of The Blackstone Group - Gary WinnickGary WinnickGary Winnick is an American financier with a global investment career spanning three decades. He is Chairman and Chief Executive Officer of Pacific Capital Group, a diversified private investment firm founded in 1985...
, founder and former chairman of Global CrossingGlobal CrossingGlobal Crossing Limited was a telecommunications company that provides computer networking services worldwide. It maintained a large backbone and offered transit and peering links, VPN, leased lines, audio and video conferencing, long distance telephone, managed services, dialup, colocation and... - Joshua S. Friedman, Co-Founder of Canyon Capital Partners
- Lawrence A.Post, Founder of Post Advisory Group
- David Sydorick, Former Executive, and well-know Car Collector
- Arthur Bilger, Founder of Shelter Capital Partners
- James Taich, Former Senior Vice President/Head Of Equity Sales
- Carl R. DeRemer, Current CEO of DeRemer and Associates.