Let's Make a Deal

By John Greenwald

Christmas was just around the corner, but the videotaped tidings that Frederick Joseph handed out to the TV networks last Wednesday evening were not exactly festive. Looking tired and tense, the silver-haired chief executive officer of Drexel Burnham Lambert discussed the settlement that Drexel had reached that day with federal prosecutors to end the largest probe ever of a U.S. securities firm. Declaring that the long-awaited agreement "makes sense from a business and human point of view," Joseph, 51, tried to be upbeat. The deal, he said, would leave the firm "in a very strong financial position, and allows us to refocus our energies on running the business successfully."

In fact, the agreement was a stunning about-face by the most influential, go-go investment-banking house of the 1980s. After maintaining for two years that Drexel had done nothing wrong, a shaken board of directors voted 16 to 6 to accept the stiff terms proposed by Rudolph Giuliani, U.S. Attorney for the Southern District of New York. The deal calls for Drexel to plead guilty to six felony counts involving mail, wire and securities fraud and to pay a record $650 million in penalties. Some $300 million of the fine would go to the Government, which has spent an estimated $10 million prosecuting the case so far, and $350 million would be set aside to compensate the victims of Drexel's wrongdoing.

In return, Giuliani agreed to drop his stated plan to bring racketeering charges that could have crippled Drexel, the fifth largest U.S. securities firm. Before the deal can be completed, however, Giuliani stipulated, a 184- page civil complaint that the Securities and Exchange Commission brought against Drexel in September must be settled by Jan. 10. The SEC could conceivably ask for a larger pool of money to compensate alleged victims, who range from ordinary stockholders to Drexel's clients. Even so, Giuliani declared Drexel's fines and concessions "appropriate punishment." He added, "You do not put corporations in prison."

But Giuliani is expected to try to put at least one Drexel employee behind bars. In perhaps its most humiliating cave-in, Drexel agreed to cooperate with the Government investigation of Michael Milken, the financial wizard who created the market for high-yielding junk bonds (total now held: $180 billion) and who remains the ultimate target of Giuliani's probe. Milken, who was not represented in the settlement talks, is expected to be indicted in Manhattan sometime in January.

A senior officer at Drexel, Milken was the chief architect of the firm's rise from a lackluster, second-tier brokerage into a feared and envied powerhouse. By developing the use of junk bonds to stake such corporate raiders as Saul Steinberg and T. Boone Pickens, Milken presided over the radical reshaping of American industry in the past ten years. Along the way, dozens of Drexel executives became multimillionaires.

But Drexel's very success led to its comeuppance. As in a Greek tragedy, the company seemed to suffer from an overabundance of hubris that concealed a fatal flaw. In Drexel's case, it was Milken's growing appetite for power and control. The turning point came in November 1986 when Ivan Boesky, a notorious Wall Street speculator, pleaded guilty to a single count of securities fraud and agreed to pay $100 million to settle SEC charges that he had used insider information to buy and sell stock. Boesky, who is serving a three-year term in a minimum-security prison in Lompoc, Calif., agreed to identify others who had joined his schemes. The trail led to Drexel and its wunderkind, who allegedly used a complex network of contacts to manipulate securities prices.

During the nearly two years that the Government spent preparing its case, Drexel defiantly declared its innocence and launched a major advertising campaign extolling the civic virtues of its junk bonds. Joseph claims that the two-year federal probe cost Drexel $1.5 billion in lost revenues and an additional $175 million in legal and advertising fees. Since November, the firm has bargained for an agreement that, as chairman Robert Linton put it, "would not make us look like a bunch of thieves."

Negotiations appeared to collapse last Monday, when Drexel's board of directors voted against a settlement. Joseph boasted that his staff had sifted through 1.5 million Drexel documents without finding any incriminating evidence. A former lightweight boxing champion at Harvard, Joseph insisted that the best defense against a heavy punch is "to come back at your opponent smiling."

But the blows kept furiously raining down, and Joseph's smile began to fade. When the board voted that Monday, Giuliani had already turned three close Milken associates into Government witnesses by granting them immunity from prosecution. The knockout power of an indictment under the 1970 Racketeer ! Influenced and Corrupt Organizations Act was also greatly feared. Charges under RICO, developed to prosecute the Mafia and other organized criminals, would allow Giuliani to tie up much of Drexel's $2.3 billion of capital -- including the fortunes of the firm's 1,700 employee stockholders -- throughout a lengthy trial.

Meanwhile, a fierce struggle raged inside the firm. On one side stood Milken's supporters, many of them younger executives who worked in the Beverly Hills office where Milken has been based since 1978. The leading loyalists included Leon Black, Drexel's mergers-and-acquisitions chief who works in New York, and Peter Ackerman, Milken's top assistant. Arguing that the California group was responsible for 90% of Drexel's profits over the past decade, both threatened to leave the company if it reached a settlement that might harm Milken's defense. They were opposed by older executives, mostly in Manhattan, who feared losing the firm's accumulated net worth if RICO charges were brought.

The hawks on the board held sway over the doves until Giuliani gave an ultimatum. Following the directors' rejection of a settlement on Dec. 19, Giuliani phoned Joseph the next day and promised that unless the board swiftly came to terms, the firm would be indicted at 4 p.m. Wednesday, Dec. 21. That took some of the remaining fight out of Joseph, who had taken to sporting a lapel button emblazoned with the word STRESS. After holding late-night talks between Giuliani and Drexel attorneys in which the proposed criminal penalty was pared from $700 million to $650 million, Joseph called the board back into session at 2:30 p.m. Wednesday. By 4:30 p.m., the board agreed to Giuliani's terms.

The Government consented to limit the plea agreement to less severe and fewer offenses than those detailed in the SEC case against the investment house, which described a pervasive pattern of illicit practices in Drexel's junk-bond department. As in the SEC case, the criminal charges focused on dealings with Boesky from 1984 to 1986. Included in the SEC litany of complaints were insider trading, "parking" stocks to conceal their true ownership, and schemes to gouge Drexel's own customers.

If the criminal agreement had been broader, Drexel might never have agreed to it out of fear that the guilty pleas would have given Drexel's alleged victims a better chance of winning lawsuits against the firm. Even now, the $350 million that the Government plans to set aside to meet damage claims may barely cover the awards that could arise from the 13 class-action suits already lodged against the company.

For Giuliani, the Drexel settlement was the most heralded part of a dramatic three-way sweep. Hours before the deal was announced, a federal grand jury in Manhattan indicted Paul Bilzerian, 38, a raider who won control of the Singer Co. in a $1 billion buyout last February. If convicted of fraud, conspiracy and other charges that arose from earlier takeover tries, Bilzerian would face a maximum of 60 years in prison and at least $3 million in fines. On the same day, testimony began in the Manhattan trial of GAF Corp., a chemical and building-products company, which is charged with inflating the price of Union Carbide stock that it sold after failing to acquire Carbide in 1986.

But the Government's big prize was Drexel, which must now face life as a confessed felon. Said Congressman Edward Markey, a Massachusetts Democrat who heads a House subcommittee that covers finance: "We now know that the single most financially successful Wall Street firm of the 1980s in large measure built its fortune on the foundation of criminality."

Such broadsides will die down, but it may take Drexel a long time to restore its prestige and competitive position. The firm's share of new junk-bond issues has slipped from nearly 80% in the mid-1980s to some 25% today. That puts Drexel barely ahead of Goldman, Sachs and Morgan Stanley, its main rivals. Drexel may suffer a brain drain as well, losing not only Milken but also his loyalists. Moreover, Milken is so much the mastermind that clients may balk at trusting his understudies who remain.

Yet Drexel still displays its characteristic moxie. The firm is handling a $3.5 billion junk-bond offering as part of the $25 billion leveraged buyout of RJR Nabisco. For its share in financing history's largest takeover, Drexel expects to take in $229 million before expenses. Many clients still profess their allegiance. Says raider and oilman Pickens, who relied on Drexel's financing clout to make bids for Gulf Corp. and Phillips Petroleum: "I have the highest regard for Fred Joseph."

To help burnish its image, Drexel has been courting Howard Baker, the former Senator and White House chief of staff, as a possible new chairman or CEO. Joseph may step aside after the settlement is complete. Without a forceful new leader of unquestioned integrity, the company is in danger of losing morale and momentum -- and something else as well. Mike Milken engendered an innovative spirit at Drexel. If the company is to thrive once again, it must somehow preserve that spirit while at the same time escaping the darker side of his legacy.

With reporting by Frederick Ungeheuer/New York