TOM SMITH AND MICHAEL MILKEN

 

            TOM SMITH AND HIS INCREDIBLE BREAD MACHINE was written around 1970, two decades before Michael Milken of the Drexel organization rose to prominence in the late ‘80s. But the similarity between these two stories is striking.  Both men created innovative engines of wealth creation – and both were excoriated for their troubles.

            Smith and Milken were ruined not because of what they had done wrong, but because of what they had done right.  They both became wealthy, arousing envy and resentment, but more important they had both incurred the wrath of the established business community:

 

                   But then Tom found to his dismay

                   That certain businessmen would say

                   “The people now should realize

                   It’s time to cut Smith down to size,

                   For he’s betrayed his public trust

       (And taken all that bread from us!”)

 

            Earlier in his career Milken had focused on the financing of promising start-ups.  No problem.  But when he started financing the hostile takeover of established companies, he stepped into a hornets nest of indignation.

            The hostile takeover is the attempt by outsiders to supplant what they regarded as under-performing or complacent corporate management. T. Boone Pickens had been bothered by this problem for years, and he didn’t much care for what he saw:

 

After getting to know the Good Ol’ Boys, I realized that only a few had ever made any money on their own.  In fact, most of them hadn’t made much money for their stockholders, either; they just weren’t moneymakers.  They were bureaucrats, caretakers.  They had learned to move up through the bureaucracy with a minimum of personal risk.  It was a special talent, and not one I wanted.  ¹

 

            The goal of the takeover was to re-allocate under-utilized resources to more productive and more profitable use, but it is hardly surprising that targeted executives were less than enthusiastic.  The prospect of being booted out of their plush offices by a bunch of outsiders was infuriating.  After the hostile takeover of Revlon, the aristocratic former chairman Michel Bergerac described the Drexel-financed raiders with contempt:

 

I’ll never forget those twenty or thirty guys getting off the elevators.,  All short, bald, with big cigars!  It was incredible. If central casting had to produce thirty guys like that, they couldn’t do it.  They looked like they were in a grade-D movie that took place in Mississippi or Louisiana, about guys fixing elections in a back room. ²

 

            One of the participants described the aggressive Drexel style with a bitterness bordering on paranoia:

 

And we have to have detectives in to make sure our rooms aren’t bugged and our phone lines aren’t tapped, and that they aren’t sending electronic beams into our offices, and have to look for hidden cameras when we to into and out of meetings.  They have ruined my life.  You feel like you’re in the gutter, like they’re piling shit on you and you have to keep struggling to get up from it, and it’s all been made possible by Drexel.  Without Drexel, none of it could have happened. ³

 

            The contempt was mutual. Milken and his crew, who regularly worked 16-hour days, looked upon the Wall Street fraternity as Ivy League types whose only real talent was the two-hour lunch.  One writer described an emerging new culture in which “sharp elbows and a working knowledge of computer spreadsheets suddenly counted for more than a nose for dry sherry or membership in Skull and Bones.”

 

Stephen Weinroth, managing director of Drexel, evaluated the culture clash this way:

 

I think the principles are right, and the fact that some of our players are venal or self-interested or unpleasant is almost beside the point.  There is a greater machine going, and these guys [the present managers] don’t make a go of it then somebody else will buy the stock, and the ownership will reside very close to the helm.  And Drexel had more to do with it than anyone else. ⁴

 

            The perceptive Weinroth made an important point: Even if Milken and his associates were every bit as grasping, arrogant and ruthless as their detractors insisted, they were still performing an important economic function by exposing corporate complacency, and by forcing the re-allocation of resources to more productive use.

 

            Did the takeover binge go too far? Maybe it did; economic cycles often do.  But consider this: while some of the takeovers were ill-conceived and failed, more were successful as people gradually learned how to manage this potent new financing vehicle.  That’s how the marketplace sorts things out.  And on balance the great wave of restructuring was right for the times.  Prof. Michael Jensen of Harvard Business School has noted that between l976 and 1990 the market value of these restructured firms increased by around $650 billion.

However, some very important turf was invaded, and this upset a lot of influential people – and they made their displeasure known to the SEC and the Justice Department, and anyone else who would listen.  Influential banker Felix Rohatyn had an article in the WALL STREET JOURNAL, the title of which told it all: “The Junk Bond and Other Securities Swill.” ⁵  When all is said and done, fear and loathing from within the corporate establishment was a major factor in Milken’s ultimate downfall.

 

            In her influential  book THE PREDATORS BALL,  Connie Bruck summarized the Milken case this way:

 

Any one of the [above charges] by itself, might seem an offense which, if proven, could be plea-bargained away without severe sanction.  But seen in concert – and in concert is how they must be seen if any true sensed of Milken’s machine is to be grasped – these individual acts take on different dimensions  Their gravity becomes inescapable.  Indeed, it seems plain to this writer that if the above or some similar assortment of Milken’s and, by extension, Drexel’s actions are not worth prosecution, then the securities laws were not worth passing.  Assuming these actins occurred, it is difficult for this writer to imagine a manipulation of the securities markets that is more broad, more powerful or more frightening. ⁶

 

But Bruck and Rohatyn and the others were standing reality on its head.  Milken brought his product to the marketplace and, like Tom Smith, dealt with others entirely in accordance with the non-coercive “rules of the game.” This is the market process!  The threat to the marketplace did not come from Milken; it came from the SEC and the Justice Department!

            Certainly, the ‘80s had its share of venality and irresponsibility, all exhaustively chronicled in the popular press. But if Milken really was as sleazy as his detractors claimed, new competition, which were already entering the market, would gradually have displaced him with a better product, That’s how the marketplace take its revenge on shady operators – if permitted to do so.

 

            But whether Milken really was the dark prince of sleaze as described by a clueless media, is irrelevant anyway.  Milken was not indicted for “sleaze” or “greed” or for being “unfair”; he was indicted for securities fraud. And as is evident in the plea bargain itself, (see below) the charges against him were “crimes” only because government prosecutors said so – and this is not a good enough reason.  In their zeal to buttress a shaky but highly-publicized case, they repeatedly elevated innocuous acts into criminal offenses simply by placing before them the magic words “unlawfully, willfully and knowingly.”  But when it came to explaining what was misrepresented, or who was actually defrauded, the original indictment as well as the final plea bargain were mute.  Where were the victims? When Judge Kimba Wood referred to crimes that were “particularly hard to detect,” she gave the game away: it was a tacit admission that no actual victims were to be found!  On the contrary, those who dealt with Milken invariably came away wealthier for the experience.

            Moreover, how could insider trading be charged in the initial indictment when the SEC’s own chief economist has acknowledged that it has no effect whatever on the other party? And how could stock parking be prosecuted as a criminal offense when the acts occurred before  parking was elevated from a civil to a criminal matter in 1986? What can one say in defense of “laws” such as these which are created not by Congress, or even by the courts, but merely by the boundless ingenuity of bureaucrats?  Judge Alex Kozinski of the Ninth Circuit put it this way:

 

…Prosecutors are a zealous lot. They will take any statute whatsoever and target beyond its logical extreme.  They will file on counts, they will plead indictments, bring indictments every conceivable way; they’ll use conspiracy, they’ll use vicarious liability.  Whatever tools they think they can get away with they will. That’s their job; they are paid to prosecute.  And whenever we unleash the criminal law as a tool for social control we are really unleashing a very serious force. And I think…this is a good time for us to assess the degree to which we want to let the government, in particular government prosecutors and criminal law be the force that governs a large portion of our existence…I don’t think that there is anybody in this room that is immune from the possibility of a criminal or civil prosecution under any of these laws.  ⁷

 

            Not defined by any actual harm to any actual victim, the “law” is whatever the ambitious regulator says it is.  Neither the original indictment of Milken nor the final plea bargain presented actions which most people would regard as criminal in any ethical sense. These were ideological crimes; offenses not against real  people but against bureaucracy’s abstract notions of “fairness,” “the level playing field,” “sleaze,” or whatever.  But when these illusive and ill-defined rules can destroy anybody at any time, they are a menace not only to our civil rights, but to the values on which economic progress and economic justice depend.  Securities regulation has become the most capricious  body of law on the books today. The question, then, is not simply whether Milken “broke the law, but whether these ever-shifting rules and regulations are defensible to begin with.

            However, the most destructive aspect of ideological law is not its incoherence, but its ready misuse by established interests as a means of punishing the upstart.  Like Tom Smith, Milken was pursued not because of what he had done wrong, but because of what he had done right: He had developed a highly innovative engine of capital formation which has now earned a significant place in the American economic system. But in the process he invaded some important corporate turf, he antagonized a lot of influential people, and he stepped on a lot of toes.  In a word, Milken annoyed the established order.

            And this was his real undoing.

 

 

EIGHT CURIOUS MYTHS

            Al Capone had a better press than did Michael Milken.  The conventional wisdom of Milken can be summarized in terms of “Eight Curious Myths.”

 

1)”Junk bonds contributed to the collapse of the S&L industry.”  In fact, only about 5.3% of all S&Ls held any junk bonds at all, comprising only about 1% of all S&L assets.  The S&Ls failed primarily because of a collapse in real estate prices.

 

2) “Junk bonds were a Ponzi scheme which led to huge losses.”  Junk bonds took a hit in 1989-90, but soon rebounded, with more new issues appearing in 1992 than in any previous year. Junk bonds continue to be solid investments, and an important source of investment capital for new and expanding businesses.

 

3) “Milken engaged in widespread fraud.”  In fact, no “victim” of Milken has ever been discovered.   Those individuals and institutions which dealt with him came away richer rather than poorer.

 

4) ”Milken-backed junk bonds generally ended in default.”  According to Salomon Bros. Figures, the default rate on high yield securities issued by Drexel between 1977 and 1990 was a modest 9.6%, compared to 19.3% for Merrill Lynch, 43.1% for Paine Weber, etc.                                                                                                              
5)  “Hostile Takeovers, LBOs, mergers, etc., were a creation primarily of junk bond financing.”  In fact, only about 10% of these restructurings were financed by junk bonds, with around 73% coming from banks.  In any event, Prof. Michael Jensen of Harvard Business School estimates that between 1976 and 1990 these restructured companies increased in stock value by around $650 billion.

6)  “Junk bonds led the economy into an ocean of debt.”  In fact, according to GAO figures, high yield bonds accounted for only about 9% of total corporate debt in the late ‘80s, up from 1% a decade earlier.

7)  “Junk bonds led to widespread business failures.”  In fact, economist Glen Yago notes that companies which went into bankruptcy or default constituted “only about 10% of the junk bond market at its peak in 1990 and less than 4%  for the decade.”  (See Glen Yago’s “The Regulatory Reign of Terror,” WALL STREET JOURNAL editorial page, March 4, 1992.

8)  “Junk bond activity contributed little to the economy.”     In fact, junk bond financing raised over $200 billion in new capital during the ‘80s, much of which went to new and expanding companies. Yago reports that between 1980 and 1986 these issues accounted for around 82% of ob growth among those public companies which report employment. George Gilder writ, “More important still was the critical role of junk bonds in financing such crucial American businesses as fiber optics, telecommunications and television.  Drexel managed multibillion dollar issues for Turner Broadcasting, MCI, TeleCommunications, Inc., McCaw Cellular, and many other companies without firm collateral – companies that could not possible have raised comparable sums anywhere else.  These firms, backed by Milken, have been critical to U.S. competitiveness…”  (See George Gilder’s “The War Against Wealth,” WALL STREET JOURNAL, editorial page, Sept. 27, 1990.)

 

            But if Milken’s activities were essentially productive and legitimate, why did he end up in prison?  There were three underlying factors – and they had nothing to do with criminal conduct: hostility from within the corporate community, an unfriendly media, and a body of business law based on ideology rather than objective standards and actual victims.


THE PLEA BARGAIN

            The six counts of the final plea bargain are summarized below:

 

Count #1:  Investor Victor Posner was seeking control of the Fischbach company, but had entered into a “standstill agreement” with the management, agreeing to limit his purchases to 24.9% unless another party were to acquire 10%. To get around this restriction Milken himself (according to the original indictment) bought Fischbach stock and then sold it to Boesky, bringing Boesky’s holdings over the 10% threshold. Boesky filed a 13D disclosure as required, but according to the indictment it “fraudulently concealed that the Boesky purchases were made on behalf of the Drexel Enterprise and the Fischbach Shareholders.” The final plea bargain focused of the fact that Boesky had not reported to the SEC that Milken had promised to reimburse him for any losses he might incur in the purchase of this stock.

            To the Justice Department Milken, Boesky and Posner were all “co-conspirators” and these actions wre “fraudulent.” But why? Would it have made a particle of difference if Milken had announced in full page ads that he was buying these shares and turning them over to Boesky? Suppose Boesky had purchased the shares in the maket instead of getting them from Milken? Suppose Milken’s wife had purchased the 10% block of stock? Clearly, the standstill agreement could have been deactivated in a hundred entirely legitimate ways, with no difference whatever to the outcome.

 

 

Count #2:  Milken client Steve Wynn, chairman of the Golden Nugget, had abandoned his plan to acquire MCA, and wanted to get rid of his 4.9% stake without depressing the market.  According to the original indictment Milken arranged for Boesky to buy the shares and then parcel them out slowly. In addition, Milken agree to reimburse Boesky for any losses. That’s it.

            What on earth, one may well ask, is wrong with this? Milken went out of his way to assist a client in selling a large block of stock with as little disruption to the marketplace as possible.  This is a crime? According to the government prosecutors it

was, for they charged that Milken “unlawfully, willfully and knowingly committed fraud…by enabling Golden Nugget to conceal that it was selling its MCA common stock.”  The final plea bargain concerned the fact that Milken’s agreement to reimburse Boesky was not recorded on the Drexel books. Anything for a charge.

 

Count #3:  This count pertained to an offense called “parking” which refers to the temporary placement of stock with an associate for the purpose of disguising ownership.  The stock is reclaimed later at the original price regardless of any change in the market price.  Because the “beneficial ownership” has really not changed, the government regards such a transaction as spurious. One purpose of stock parking might be to get around capitalization requirements: by having cash in hand rather than the sequestered stock, net capitalization could be overstated.

            Boesky parked stock with Drexel in order to be able to overstate his net capital to the SEC. Milken probably did not initiate these transactions, but he did accommodate them.  It would seem the Boesky was the more guilty party here, but Milken pled guilty to “aiding and abetting” Boesky in his compulsive wheeling and dealing.

            It should be noted, however, that no one made or lost a nickel in this transaction. No one was defrauded.  There was no victim.  And if there is no victim, there is no crime.  A civil offense, perhaps, but not a criminal offense.  In fact, prior to 1986 parking was treated simply as a minor civil transgression to be resolved perhaps by an injunction and a fine.  Parking was not regarded as a criminal matter until Boesky’s own plea bargain in 1986.  Accordingly parking was suddenly elevated to a criminal matter not because Congress or the courts said so, but simply because zealous government prosecutors said so!

 

Count #4:  This count concerned the Finsbury Fund, a fund for purchasers of high-yield bonds. The Drexel office in New York paid its salesmen a 1% commission to sell to Finsbury and then, to Milken’s annoyance, charged the commission to Milken’s department in Los Angeles.  To keep everyone happy Milken and the fund manager, Davis Solomon, arrived at an agreement: Solomon would pay a fraction more for the bonds to make up the difference.  Judge Kimba Wood later calculated that this all came to a piddling $318,000, for the adjusted price was still within the bid-ask-range.  To the Justice Department, however, this was “fraud” because the fund customers did not know they were paying this slightly higher price. The hooker was that the invoice which failed to disclose this fact was sent by mail, and this made it mail fraud.  Of course, the person who really failed to disclose was not Milken, but Solomon.  But why quibble. Anything for a charge.

 

Count #5:  In 1985 David Solomon asked Milken to arrange some trades in which he could lock in losses for tax purposes, and Milken obliged. Such trades are absolutely commonplace and have been for years.  Significantly, Solomon was not charged here, nor were his tax returns challenged.  If there is an egregious loophole here, it is for Congress to close it.  Again, Milken derived no profit from this.

 

Count #6:  This count alleged a conspiracy linking all the other counts.                                                                                                                                                                                                                   

LOOKING BACK

            Milken was sentenced in November, 1990 to ten years in prison.  He served about 22 months. With benefit of hindsight, it’s now pretty clear that he was railroaded on grotesquely trumped-up charges.  And yet it must be conceded that to some extent he brought  it on himself.

            The Greeks had a word for it: “hubris”-  the excessive pride or over-confidence or arrogance which invites retribution.

            Milken’s goal was never wealth for its own sake; let’s give him that.  His desire was to build something new and great. And it had to be the biggest and the best. And it was, and he knew it, and at times he overreached, and at times he was not fastidious about some of those with whom he did business.  But when all is said and done, his offense was hubris, not criminality.

            Yet, it is obsessed and creative people like Milken (and Tom Smith!)  who are among the most important assets a society has, for it is they (not prosecutors or journalists or politicians), who create the new ideas, the new products and new companies and new jobs.  To denounce them for their alleged “greed,” to belittle their accomplishments, to harass them with mindless regulation, to send them to prison – these are the responses of envy and ignorance.  To the extent that these efforts are successful, all of us are diminished.

 

 

Raiders, invaders, and insider traders,
And things that go bump in the night!
With grabbing and jabbing and all that back-stabbing
We’ve had a most terrible fright!
But we needn’t fear, for our government, dear,
Has accomplished a glorious goal:
With Milken and Drexel, the market, and all,
Now under its total control!

 

***

 

 

Footnotes:

 

T. Boone Pickens, BOONE, (Houghton Mifflin Company, 1987) p. 126.

Connie Bruck, THE PREDATORS BALL, (The American Lawyer/Simon and Schuster, 1988), p. 222.

3) Ibid. p.230.

4) Ibid. p.333.

5) Felix Rohatyn, “Junk Bonds and Other Securities Swill,” WALL STREET JOURNAL, April 18, 1985, p. 30.

6) Bruck, op. cit., p. 352.

7) Remarks by Judge Alex Kazinski, U.S. Ninth Circuit at a panel discussion on “Crime and Punishment in Business Law,” conducted by The Manhattan Institute, May 8, 1989.