The SEC v. the American shareholder: the Drexel Burnham case.

ON SEPTEMBER 7, 1988, the U.S. Securities and Exchange Commission filed a long-awaited civil lawsuit against the investment-banking firm of Drexel Burnham Lambert. The complaint is a litany of securities violations that includes insider trading as well as various other claims that are quite technical and therefore devoid of news appeal. A criminal indictment also seems likely in the near future.

But Drexel's alleged wrongdoings are not the only tale to tell. Lurking in the Drexel case is a story of questionable government maneuvers against a firm that has played a major role in the modern takeover movement. The heart of the matter is not securities fraud at all; it is government hostility to takeovers and, more generally, government protection of certain firms and individuals from competition.

The events that finally led the SEC to Drexel began at least as early as December 1985, when Bank Leu International, in return for a grant of immunity, gave the SEC records of illegal trading by its client, investment banker Dennis B. Levine. Based on these records, Levine was indicted in May 1986. Harvey Pitt, Bank Leu's counsel at the time, said that the SEC let Bank Leu off the hook because the Commission "was looking . . . for a major player in the investment community."

It first appeared that the "player" was the rapacious arbitrageur, Ivan Boesky. Levine told the SEC that Boesky had paid him for secret information about takeover and restructuring targets and had used this information to make millions in insider-trading profits. In November 1986, Boesky settled insider-trading charges by paying $100 million in profits and penalties. He was barred for life from the U.S. securities industry and is serving time in a minimum-security prison.

For all the $100 million, the Boesky settlement was still so generous that it suggests the SEC was even then looking beyond Boesky to a different target. The settlement left Boesky, a man who admitted to blatant insider trading on a grand scale, free to trade securities in any market outside the United States. Boesky was allowed to keep more than half of his estimated wealth from suspect securities trades.

Most tellingly, the SEC gave Boesky enough advance warning of his prosecution to permit him to sell almost $500 million in securities before the SEC's case against him was made public. (Apparently the SEC is not disturbed by all forms of insider trading.) Even after his settlement, Boesky was given additional time-until April 1988-for an orderly sale of his holdings. While the SEC undoubtedly feared that word of these sales would collapse securities markets, Boesky clearly was the primary beneficiary of the delay.

IF THE SEC had already targeted Drexel, the deal with Boesky gave it what it wanted. And the SEC's complaint against Drexel demonstrates the Commission's heavy reliance on Boesky's testimony. Even so, the SEC could not establish a case against Drexel with Boesky's testimony alone. He is after all a convicted felon and a notorious liar. He portrayed himself as a legitimate businessman in his book Merger Mania. Arbitrage. Wan Street's Best-Kept Money-Making Secret at the same moment that he was secretly buying information from Levine. These and other problems with Boesky's credibility may also account for the U.S. Attorney's delay in seeking a criminal indictment against Drexel. In short, the government's case against Drexel needed more power than it seemed to have.

Realizing the weakness of its case, the SEC apparently decided to try to influence the outcome in advance. Beginning in November 1986, a regular drumbeat of news stories, primarily in the Wall Street Journal, quoted "lawyers familiar with the government's investigation," "people familiar with the government's investigation," "legal sources with knowledge," "sources," and so forth. The most likely explanation for this "inside information" is that SEC sources regularly gave the information to the Wall Street Journal. If this is the case-and the SEC at least knew of the "leaks" even if they were not authorized-the SEC's approach stands in stark contrast to its silence during the Boesky proceedings, when Boesky was allowed to unload his cache of securities unhindered by public scandal.

The anonymous sources, whatever their true identity, announced each turn in the government's investigationsuch as the transactions the government was investigating, that Boesky's allegations were supported by a "paper trail," or that one of Boesky's affiliates gave documents to the SEC. The sources disclosed tbe SEC's "Wells request," a traditionally confidential notification designed to allow a defendant to rebut charges before the Commission files them publicly. And in what might have been a final flourish, the SEC took the unprecedented step of announcing this June that a civil complaint against Drexel had been approved, while it delayed the actual filing of the complaint until September.

This constant stream of innuendo, for almost two years before the filing of a civil complaint, created public antagonism against Drexel and cost Drexel valuable reputation and business. All of this made the SEC's case seem stronger than it was, and may have undermined Drexel's right to a fair trial.

The Commission did this without bringing in a shred of evidence or permitting Drexel to use legal discoverywhich is not available until after a suit is filed-to build a defense. Even after filing its suit the SEC sought by court motions to limit Drexel's discovery. Such are the litigation tactics of the nation's top securities watchdog agency.

These tactics suggest both that the SEC does not feel terribly confident about the case, and that it wants badly to win. The case as it stands now is weak. After two years of investigations and despite hundreds of Drexel deals that provided opportunities for securities fraud, virtually all of the significant charges in the complaint hinge on the credibility of Ivan Boesky. Nineteen of the 21 counts against Drexel, covering 632 of 712 paragraphs and 159 out of 184 pages, turn on a single alleged secret scheme for Boesky to operate on Drexel's behalf. Thus, the principal allegations constitute wrongdoing by Drexel only if Boesky engaged in the transactions for Drexel. But if these transactions were on Boesky's own behalf there is not much of a case against Drexel. The SEC may win, and, of course, it may still bring other charges. But the case as initially filed is very much weaker than two years of damaging quotes and leaks from anonymous sources have suggested.

Not only does the complaint depend heavily on Boesky, but it also fails to live up to its advance billing as part of the SEC's campaign against insider trading. Insider trading figures in only two of the complaint's 23 counts, involving only about fifty of the 712 paragraphs of the complaint. The remainder of the complaint alleges such diverse offenses as manipulation of stock prices to increase the fees paid to Drexel by its clients; failure to disclose beneficial ownership of stock in violation of federal takeover law; and aiding in net capital violations and tax-loss trades by Boesky's investment partnership.

In the light of the SEC's extensive propaganda campaign against Drexel, the length of its investigation, and the nature of the complaint that finally emerged, it seems appropriate to wonder about the SEC's motives. There could be more connection than meets the eye between the SEC's persistent interest in Drexel and Drexel's prominent role in the takeover boom of recent years. This possibility is worth exploring, though it will be necessary first to explain some little-understood aspects of the development of takeovers, as well as Drexel's role in this development.

Put simply, takeovers constitute the key solution to the most serious problem inherent in the operation of publicly held corporations. In an enormously influential book published in 1932, The Modern Corporation and Private Property, Adolf Berle and Gardiner Means argued that managers run large corporations autonomously and in their own self-interest because the shareholders are apathetic about management. Indeed, an owner of a small fraction of the outstanding shares of a public corporation has little to gain from personally monitoring management. Each shareholder will want every other one to do the job, especially since the proportional part of any gain to a small shareholder will rarely justify the cost. It is easier for a dissatisfied shareholder to sell his shares and forget the managers. So the danger remained that managers could and would run corporations for their own, not the shareholders', benefit.

But contrary to Berle and Means's view, the market provided a solution to this problem. The problem of a separation of ownership and control (or "agency costs," as economists now call it) can be adequately neutralized through an active and competitive market for corporate control, especially through the device of takeovers. Takeovers function effectively when a tender-offerer ("raider") secures enough voting shares to replace incumbent managers with others and thereby increase the market price of all shares. The offerer reaps his reward for this service through an increase in the price of the shares he has acquired in the tender offer. Thus, to reduce the risk of being swept out of office, managers are constrained to keep stock prices as high as possible by running their companies efficiently and in the interest of the shareholders.

Over the last twenty years, unsolicited tender offers have emerged as our most important instrument of corporate governance. Any move that lowers the return from bonafide takeovers diminishes the effectiveness of the market for corporate control and the protection of all shareholders.

The financial focus of a tender offer lies in the cash premium paid to target-company shareholders for their shares. In recent years this premium has averaged about 30 per cent over pre-offer market price. Obviously this process of buying huge amounts of shares at premium prices requires large amounts of cash. A few corporations can finance tender offers out of their own retained earnings, but that is relatively uncommon. Similarly, a single commercial bank or investment-banking firm might lend all the money required, but financing a takeover is a large and risky transaction for one firm, and so again this is not too common.

Some kind of sharing or syndication of such loan efforts would therefore seem to be the obvious solution to the risk problem. But syndication raises its own special problem. For if the capital is provided by a number of firms, it is not feasible to maintain the needed secrecy. And if a pending offer becomes known in advance, the price of the target's stock will rise immediately, thus making the takeover more-and often prohibitively-expensive.

This is where Drexel came in. Through Michael Milken, a principal defendant in the SEC suit and a target of the SEC's investigation, Drexel dramatically increased use of high-yield bonds to finance takeovers and developed an extensive network of buyers for these securities as they came on the market. This network permits Drexel to assure a potential acquiring company that Drexel can obtain financing for a proposed takeover without putting the firm's capital on the line or disclosing the bid to others.

High-yield bonds, even apart from Drexel's network, proved especially valuable in takeovers because they allowed the raider to assure investors that the target company's cash flow would largely be paid out rather than reinvested at below-market rates of return. Such wasteful reinvestment is a prominent explanation for takeovers, and the raider needed to assure shareholders that he would not be doing the same thing. This can be especially important where the raider is an individual whose management skills are not well known to the market. This is why the Drexelbacked takeover of Revlon by Mr. Ronald Perelman, then a relative unknown in the field, occasioned such near-panic among threatened managers. This takeover established that, with Drexel's backing, anyone could play the game.

As Professor Michael C. Jensen of Harvard Business School has noted, prior to the takeover threat to oil companies in the mid Eighties, these companies continued to search for oil even though the exploration cost for each barrel of oil discovered was considerably higher than the price of oil on the spot market. T. Boone Pickens and others quickly put a stop to that foolish behavior. But the threat of a takeover may be as effective as the real thing, and among the benefits of this system must be counted the many cases where incumbent managers themselves initiated desirable changes in operations-often using high-yield bonds for financing-in order to forestall a tender offer.

The high-yield bonds Drexel uses so effectively are often called 'Junk," but it is hard to see anything 'Junky" about them. As compared to so-called investment-grade bonds, they involve a different but perfectly rational tradeoff of slightly increased risk for increased return. They act a lot like stock with required rather than discretionary dividends, but they retain the legal, financial, and tax advantages of bonds. And the argument that junk bonds have dangerously leveraged American industry is simply without economic foundation. There have been many periods where the so-called "coverage ratio"-aggregate corporate interest payments as a percentage of cash flow-was higher than it is now.

TAKEOVERS HAVE come to play a strong and occasionally dominant role in the stock market, certainly in recent years when the market has been very strong. Many analysts believe that it was Congress's threat to tax takeover gains heavily that precipitated the market crash of October 19, 1987.

Incumbent managers have not been helpless or idle in the face of takeover threats. As mentioned, many have read the handwriting on the wall and restructured their corporations so as to obviate any need to displace them. Others, either of lesser ability or simply from basic disagreement, feel that there is too much to lose from a takeover. Not surprisingly, then, they have encouraged the development of a bewildering variety of legal and financial tactics for preventing takeovers, many of which will be upheld by courts.

These maneuvers, while costly to shareholders, have still not given threatened managers all the protection they want from unsolicited takeovers. Managers have accordingly opened their fight on new fronts, including state legislatures, where, with considerable lobbying power, they have often secured passage of anti-takeover statutes.

But that is a piecemeal solution. Accordingly, the antitakeover political forces (an unlikely coalition between corporate managers and union leaders who do not want plants moved or closed as part of a restructuring) have brought their lobbying power to the august Congress of the United States. Congress early proved itself to be a willing ally of the anti-takeover forces. In 1967, primarily owing to the tireless (anyone for "public spirited"?) efforts of former Senator Harrison Williams (recently of an Allenwood Penitentiary address), Congress passed the Williams Act. This Act, among many other things, requires anyone who has bought 5 per cent of a company's stock to disclose his takeover plans. And unlike many states' anti-takeover measures, this one is imposed on all public corporations without the need for troublesome or embarrassing shareholder votes.

The disclosure required by the Williams Act greatly increased the prices bidders had to pay for control of target companies; it lengthened the time for which the bidder had to borrow funds (thus increasing the bidder's interest costs); and it increased the likelihood of success of defensive strategies by the target management. Although Congress said that the Williams Act was supposed to "level" the takeover playing field and make it a fairer game for all participants, it had no obvious intent other than to reduce the number of tender offers. The result has been a cost of billions of dollars to shareholders from lost tenderoffer opportunities. Incidentally, anti-takeover forces in Congress now want to tighten the Williams Act as an alleged response to the insider-trading scandals.

The Williams Act did not, of course, succeed in squelching the takeover movement. New devices and techniques were invented almost daily to counteract the increased costs and risks of operating under the Williams Act. For instance, we have seen how Drexel's high-yield-bond financing helped to provide the cash needed for financing postWilliams Act tender offers.

Another device was "risk arbitrage," practiced on a large scale by Ivan Boesky. The "arbs" initially earned money on the spread between the price of a stock after announcement of a tender offer and the tender-offer price itself This spread is essentially a premium for taking the risk that the offer will not succeed-a risk premium that was greatly increased by the Williams Act. Ultimately it became routine for effective control to be acquired by the arbs during the course of tender offers.

That is, the arbs could guarantee the transfer of control -or some specified percentage of shares-of the target to the bidder at a known time and price. Therefore, it is fair to assume that they were operating with at least the tacit approval of the raiders and their investment bankers. The bidders would in fact want the arbs to have "inside information" about their takeover intentions so that the arbs could perform the share-gathering task the Williams Act prevented the raiders from doing themselves. So it is that the very insider-trading evil the SEC claims to be pursuing in the Levine-Boesky-Drexel affair was created by Congress's misguided efforts to regulate the market for corporate control. Harrison Williams, meet your creation, Ivan Boesky!

And Congress still lends itself to the pressure against takeovers. Apparently not satisfied with the SEC's efforts to hobble Drexel, Representative John D. Dingell's subcommittee of the House Energy and Commerce Committee recently held hearings of its own that for sheer posturing and vacuousness have rarely been matched. The subcommittee called Milken and Fred Joseph, Drexel's chief executive, to testify about supposed allotments of new issues of high-yield securities to Drexel employees.

This practice could hardly have justified two days of congressional hearings. These bonds may not even be subject to existing rules regarding so-called "hot issues" of securities, and the hearings could only confuse the ongoing civil and criminal investigations of Drexel and Milken. The hearings degenerated into a charade when Milken was required to appear even after his attorney told the subcommittee that because of the ongoing investigations Milken would have to plead the Fifth Amendment.

What the hearings were really about is revealed in Dingell's opening statement on each of the two days: High-yield bonds, or as they are more commonly known, 'Junk bonds," have played a significant role in the change in corporate America. Companies which existed for decades, which carried the brunt of our national defense through two world wars, which provided employment to the heartland of America, no longer exist. They have been the victims of takeovers financed through the junk-bond market.

The issue never was "hot issues," it was takeovers. And it did not hurt the anti-takeover forces to have Drexel hauled before a congressional committee and have one of its principals made to look like a mobster by being forced to plead the Fifth Amendment.

Congress, of course, pulls the SEC's strings. During its leak-ridden investigation of Drexel, the SEC was seeking millions of dollars more than Congress had initially proposed for it. And Congress can be helpful to the Commission in other ways. For instance, a bill recently passed strengthens the sanctions against insider trading, thereby greatly increasing the SEC's power to obtain highly publicized settlements in insider-trading cases. So it should not surprise anyone to learn that the SEC curries favor with Congress by doing its bidding, in all likelihood including the pursuit of Drexel.

THERE MAY, of course, be reasons for the political pursuit of Drexel besides its role in financing takeovers. For instance, other investment-banking firms have not been able to match Milken's skills and his organization of bond buyers. And they are not without the means, the motive, and the willingness to secure congressional help in their competition with Drexel. While the evidence for this explanation is much weaker than it is for the anti-takeover thesis, only the naive would deny the possibility.

So it is not likely that the SEC's pursuit of Drexel is the high-minded pursuit of an evil-doer. It is at least partly an attempt to humble a company that has threatened the comfortable status quo of managers of big corporations and probably some old-line investment-banking firms as well.

But there is much more at stake than Drexel's welfare. This attack could undermine the very existence of a market for corporate control. This market-which is virtually non-existent in other capitalist countries-gives America a powerful edge in international competition. To destroy this market would seriously weaken the competitiveness of our great corporations and significantly reduce returns on American corporate securities. The ultimate consequences for consumers, workers, and investors could be far more serious than short-sighted politicians and bureaucrats are likely to realize, or to take responsibility for.