by Connie Bruck
BY 1980 THE recession had hit, and Milken’s business was especially vulnerable—for as interest rates skyrocketed, bond prices plummeted. But Milken was in his element. His friend Stephen Wynn asserted, “Mike does better in hard times than good. He goes hundreds of millions long. I remember I called him one day [in the early 1980s] and said, ‘How are you doing?’ ‘Wonderful,’ he said. ‘Down eleven million today, after sixteen million yesterday. I’m stuck for a hundred eighty million in all.’ He was cheerful.
“Mike knows the market is crazy, but it will come back,” Wynn continued. “But the people who run money panic, they want to get out, so they start selling everything—and Mike will make a bid. Then he sits there. And when it does come back, he makes out.”
Milken does not run with the herd. He is, said Joseph, “one of the greatest natural contra-thinkers I’ve ever seen. If you say, ‘It’s a nice day,’ he thinks about the fact that people think it’s a nice day, maybe it’s not nice somewhere else, maybe it’s not gonna be nice, compared to what, what do you mean, nice day? He really thinks that way. That is perfect for an investor, or a trader, to be a contra-thinker. It turns out it is perfect for a finance business, trying to figure out what’s going to happen in the future.”
In the early eighties, Milken took Drexel’s junk-bond business characteristically against the current. While other investment-banking firms, some of which had been only gingerly testing the waters in junk, pulled back in the recession, Drexel kept pushing ahead, taking ever greater chunks of market share. In 1979 there were sixteen firms in addition to Drexel in the junk market; in 1980 that number dropped to twelve, and in 1981 to five. The total amount of junk issued in these years did not vary that much, hovering between $1 billion and $1.5 billion—but Drexel came to be responsible for nearly all of it.
In 1979 the total issued was $1.22 billion, and Drexel had issued $408 million of it. By 1981, the total issued was $1.47 billion, and Drexel had issued $1.08 billion of that total. Drexel did twenty deals that year, and its closest competitor did three.
That competitor was Merrill Lynch—a firm that would try over the next two years to stay in the market and challenge Drexel’s hegemony. By this time, Milken was already known for the ferocity with which he responded to challenges on what he viewed as his domain. And he and his crew responded to Merrill with the kinds of tactics that would ultimately make them hated by all their rivals on the Street.
Drexel and Merrill were co-managing a junk issue for Volt Information Services in 1981. Drexel arranged the road show that introduced the company’s managers to prospective bond buyers. On the plane to Chicago the Merrill bankers found themselves in coach, while Drexel went first class with the Volt executives; and when they all arrived in Chicago, Drexel and Volt were in one hotel, Merrill in another. But the coup de grace came when the Merrill bankers arrived at the site of the road show and discovered—too late to notify their customers—that the location had been changed.
According to one Merrill Lynch banker, this was no anomaly but almost routine in the early eighties. “It got so that when we were co-managing a deal with Drexel and going to a road show, we always checked with their customers, to be sure that Drexel hadn’t changed the location, at the last minute.” Drexel stopped this practice by 1984–85, he added.
Drexel’s dominance was not founded on dirty tricks, only accompanied and perhaps protected by them. Fred Joseph emphasized that it was his and Milken’s creativity that allowed them to keep doing so much junk business in the recession. By 1980, soaring interest rates were already causing bondholders to suffer. So, in order to keep luring bond buyers into the market, Milken and Joseph came up with newfangled pieces of paper over the next several years. High-coupon, high-premium convertible bonds (if the related common stock declined, the high yield would offer significant downside protection). Bonds with warrants. Commodity-related bonds: four were exchangeable into silver, one into gold, two had returns related to the price of oil, and one had a coupon which would increase based on the volume of trading on the New York Stock Exchange.
“I used to sit with a company and say, ‘What do you want?’ ” Joseph recalled. “I’ve got to give the investor the potential to earn the return that he thinks is fair for this package. But I can give him the return any way I want. I can give it to him by giving the money back sooner, or by giving him a higher interest rate, or by giving him more stock, or the stock cheaper.
“ ‘Tell me the one thing that’s the least important to you, and if you give me control of one variable, there’s nothing we can’t do.’
“All the other firms didn’t have the confidence of having a Mike Milken who could sell this paper,” Joseph added. “So they had to look at spread sheets, figure out what had been done, and do one just like it. But we could just sit there with our minds wide open, smoke pot”—he laughs—“daydream, and say, ‘What do you want?’ ”
Even with its inventiveness, Drexel was having trouble finding companies willing to pay what it took to raise money in 1981–82. And in its push to keep doing junk deals, Drexel did a couple that were notably outrageous. One was a $30 million offer in 1982 for Flight Transportation, a company which billed itself as offering jets for private charter to the Caribbean. There were, however, no jets, only a scam, and the FBI closed in shortly after the offering, while most of the money was still in escrow. Many of the bondholders sued, and they eventually achieved nearly full recovery in a settlement with Drexel.
“It was deliberate fraud on the part of Flight Transportation, but if we had been more careful we should have been able to spot it,” conceded Stanley Trottman, the investment banker whose deal it was. After the Flight Transportation debacle, Drexel instituted some controls on the freewheeling junk-bond enterprise. A private investigator, Jules Kroll, was hired to do background checks on Drexel clients. And the Underwriting Assistance Committee (UAC) was formed (in response to Flight Transportation and a couple of other bad deals that occurred just prior to it). A group of about eight to ten senior corporate-finance people and executives, the UAC was to review and authorize every deal the firm underwrote.
Trottman, who described the aftermath of Flight Transportation as “the worst period of my life,” suffered financially as well as emotionally. For by this time Fred Joseph had added the accountability factor to his entrepreneurial system of compensation in corporate finance. “More than most other firms, we understand that we’re a middleman in the marketplace,” Joseph claimed. “We have clients on both sides. And because Mike is so powerful, we have really been serious about that ongoing responsibility to buyers. It is a long-term approach to your business, instead of just do the deal, get the fee and get out of there.
“If you do a deal here that goes bad, we’re the only firm that keeps you accountable down the road. You’ve gotta fix it. If you don’t try to fix it, I’ll kill you. If you try to fix it and do fix it, you’ll almost recover the ding. If you try to fix it real hard and don’t, you’ll recover some.”
There was nothing Trottman could do to fix Flight Transportation. He received $50,000 as his bonus for 1982, while others in corporate finance received bonuses as high as $250,000-$300,000.
At least in Flight Transportation, Drexel was able to plead ignorance in the face of outright fraud. But in Drexel’s deal for American Communications Industries (ACI), the situation was different. There, the risks were apparent.
In February 1981, Drexel issued $20 million of bonds for ACI, a movie production and distribution company which had been formed in 1978. The prospectus admitted that the company might not have sufficient earnings to cover the interest on the debentures. This was a foreshadowing of the statements that would later become boilerplate in Drexel’s junk-bond prospectuses in its megadeals—but in those deals, like the $1.9 billion issue done in 1984 for Metromedia Broadcasting Corporation, for example, there would be assets that could and would be sold. Here there were none.
There was considerable compensation t
o the investors for their risk. The investors got bonds with a 123/4 percent coupon (the coupon indicates how much interest is to be paid, usually semiannually) which were issued at a 70 percent discount. Warrants, included as sweeteners, were issued with the debentures in a unit.
These “unit” deals, which Milken had started issuing in 1980, had a special advantage for him. Typically, bond buyers and equity buyers are different groups, and many of Drexel’s bond buyers therefore would not be interested in a company’s warrants (exercisable into equity). Indeed, some high-yield mutual funds—which by the early eighties were still a giant part of this market—were not allowed to own equity. And these warrants were detachable from the bonds. So Milken would strip off many of the warrants, sell the bonds separately and—according to sources both inside and outside of Drexel—sell them to favored clients at very favorable prices.
How risky a deal ACI was viewed as at Drexel may be deduced by noting not only what the investors got but also what Drexel got. Drexel claimed its lion’s share of the 3 percent underwriting discount, which was $600,000. It also received stock in ACI, which the company had the right to repurchase up to a certain date at a maximum price of $700,000. Furthermore, ACI entered into a “consulting agreement” with Drexel, for which the firm would be paid $4,000 a month until April 1983 (for a sum total of $100,000). Such side deals were generally not a part of underwriting agreements at any major investment-banking firm.
The ACI offering took place in February 1981, and the first interest payment came due the following August. ACI became the first company in junk-bond history to default without making even one interest payment. One buyer said, “They didn’t do what they said in the prospectus they were going to do. They were supposed to make only low-budget films. They got the money, and five months later it was all gone—along with everything else.”
By late 1981, other companies for which Drexel had raised money began to falter and have trouble meeting their interest payments. This was not unique to Drexel clients. Corporate profits nationwide plummeted in 1981–82, and bankruptcies reached record post-Depression levels. But Drexel had carved out its niche with companies that were by definition high-risk, that few others would finance. One such marginal client in the midseventies had had to pay Drexel its fee in merchandise—thirty-three pinball machines—in lieu of cash.
“There were a bunch of these companies in trouble. We started a Special Planning Committee, which was the workout committee, except that Freddy [Joseph] didn’t want to call it Workout,” Weinroth recalled. “We met on Friday afternoons. We’d walk out late on Fridays, and I’d say, ‘Freddy, I want to kill myself,’ and he’d say, ‘Can I go first?’ We’d never dealt with issues going bad before.”
Joseph remembered a meeting of the corporate-finance group at the Manhattan apartment of David Kay, who was one of Joseph’s “Shearson Mafia” hires and was the head of the fledgling mergers-and-acquisitions group. Milken, in from L.A., came to the meeting.
“Mike was upset that all the deals hadn’t turned out the way we’d expected,” Joseph said. “We educated him that having access to a company’s numbers doesn’t make you a prophet. He allowed that, but said it was no reason for having him sell his clients paper that turned bad. So fix it.”
What evolved from this dialogue was Drexel’s creation and virtual monopoly of a new business: the unregistered exchange offer. In a registered exchange offer, a company goes through the months-long process of registering a security with the SEC before offering it to bondholders in place of a formerly issued security. These had been done for many years. Riklis’ exchange offers, for example, in which he extended the date of maturity again and again in each issue of his “Chinese paper,” were registered.
But whereas Riklis’ exchange offers were motivated by his desire to postpone into the far-distant future the day when he would have to repay the principal, these Drexel-created exchange offers were designed to loosen the noose of interest-payment obligations on strangling companies. Milken’s theory was that many companies don’t go broke on the operating-profit line; rather, it is often financial charges that kill them. If there were a way of reducing or removing those charges, these companies might survive and ultimately return to health.
Drexel investment banker Paul Levy, who would come to specialize in this area, stated that its key is the concept of the “flexible balance sheet,” or adapting to a company’s changing needs. If a company is being choked by its interest-payment obligations, why not make those payments in common stock? Or why not just exchange the old debt paper for common stock, and eliminate the charges entirely? In this new-age finance, nothing is written in stone. “People used to issue bonds, and after twenty years they would repay them,” Levy said. “That’s hogwash!”
The bondholders would tend to accept these offers, no matter how displeasing, because they would find themselves between the proverbial rock and a hard place. As Levy explained, these exchange offers are essentially an arbitrage. If a buyer purchased at par a bond which then came to trade at sixty cents on the dollar, he would probably be willing to exchange it for a piece of paper trading at sixty-five cents—especially if he thought his alternative was to be stuck holding the bonds of a bankrupt company.
For these remedies to spell salvation for companies in such dire straits, however, they would have to be completed quickly; there was no time for the months-long process of registering with the SEC. Drexel investment banker James Schneider, in the firm’s San Francisco office, had had workouts on his mind through most of 1981, since ACI was his deal and he had had the responsibility for trying to salvage it. In early 1982, Schneider, who had obtained a law degree before turning to investment banking, claims he realized that the way to achieve these exchange offers with the requisite speed was through the window of Section 3(a)9 of the Securities Act of 1933. That provision allows companies to offer new paper in exchange for old, without having to go through registration. It stipulates, however, that investment bankers are prohibited from accepting fees for selling or promoting unregistered securities, and they may not solicit for the exchange. All the investment banker is allowed to do, then, is advise the company on what kind of exchange is most valuable to the company and most likely to find favor with the bondholders; after that, the solicitation is supposed to be left to the company.
Over the next four years, most other investment-banking firms would shy away from these transactions on the advice of their lawyers. Their attorneys took the position that it would be hard to define what was “promoting” or “soliciting” in these highly complex exchange offers, in which bondholders typically need a lot of explaining and persuading, and that their clients, the investment bankers, would be thrusting themselves into what was at best a gray area. Other investment-banking firms differentiate between the carrot-and-stick exchange offers for troubled companies—in which the bondholder has to be persuaded it is better to accept a less attractive piece of paper than risk default—and exchange offers done often in a defensive buyback, where the offer is so patently attractive that no solicitation would be required.
Commenting on this problem, Drexel’s corporate-finance partner Mary Lou Malanowski said, “The buyers can talk to us—we just can’t solicit them. And since we’re in the aftermarket so much, talking to buyers all the time, we know what they want, they can talk to us, we can tell the company.” Malanowski added that the 3(a)9 for the troubled company has another advantage from Drexel’s point of view, which is that it carries no underwriting liability. Since the securities are unregistered, Drexel’s name does not appear on the prospectus.
Drexel completed its first 3(a)9 in 1981. Over the course of the next five years, it would do about 175 of these exchange offers, the majority for troubled companies, involving a total of $7 billion of junk debt. According to an article by Randall Smith in The Wall Street Journal in September 1986, while other investment-banking firms that aggressively entered the junk-bond market through the eighties tended to expe
rience high rates of default on their underwritings—9, 10, even 17 percent—Drexel with its lion’s share of the market would have a default rate of just under 2 percent.
Drexel’s low default rate was certainly not wholly attributable to its use of the 3(a)9. It had been in this business longer than nearly all its competitors, and its knowledge—reflected in its credit analysis and fashioning of the proper covenants for a given issue—was unrivaled. Still, those 3(a)9s did play a role in keeping Drexel’s record—and, indeed, the record of the whole junk market, since Drexel did not limit its 3(a)9s to issues that it had underwritten—more default-free than it would otherwise have been. According to the Journal article, $2,927,000—or 3.4 percent—of all the public new-issue junk debt underwritten by the top fifteen underwriters from 1980 to September 1986 (totaling $86,043,000) went into default. Drexel’s 3(a)9s were not exclusively for new-issue junk debt, so the comparison is imprecise. Nonetheless, if one assumes most conservatively that without that $7 billion of 3(a)9s another $2–3 billion of new-issue debt would have gone into default, then the dollar amount of defaulted debt noted in the Journal would have roughly doubled.
It seems plausible that a higher default percentage, or a sudden slew of defaults of Drexel-underwritten issues, might have dulled the growing institutional appetite for junk in this country in the early eighties. But if there ever was the possibility of an externally generated braking to Milken’s machine, the 3(a)9 removed it. And with the 1981–82 recession weathered and the problem deals at least temporarily fixed, Milken was ready to move to a new plateau.
