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Since its incorporation in 1976, Drexel Burnham Lambert Incorporated (reorganized as New Street Capital Inc.), once a little-known, second-tier underwriter, became one of the most widely publicized investment banks in U.S. corporate history. Drexel pioneered the "junk bond" craze of the 1980s and played a leading role in many of the decade's best known corporate takeover bids. At its peak in the early 1980s, Drexel had a firm grip on more than 70 percent of the junk bond market. The company's innovative and aggressive financing strategies made the firm virtually an overnight success, and Drexel became one of Wall Street's most respected, and at times most resented, investment banking houses.
But in 1986, Drexel Burnham Lambert became the center of an investigation by the U.S. Securities and Exchange Commission (SEC) involving insider trading and other illegal trading practices. The firm's role in the scandal took its toll on the company. In the late 1980s, its business declined as quickly as it had been built, and in February of 1990 Drexel declared bankruptcy and liquidated its business. It was the end of an era; the firm emerged from bankruptcy in mid-1992 as New Street Capital Inc.
Drexel Burnham Lambert's roots can be traced back to 1838, when Francis Martin Drexel went into the banking business. His son Anthony took over Drexel and ran it until the 1890s. During the late nineteenth and early twentieth century, Drexel was the Philadelphia arm of J.P. Morgan and Company of New York. The company conducted both commercial and investment banking until 1933, when the Glass-Steagall Act precluded commercial banks from underwriting and dealing in securities. Drexel and Company, like Morgan, followed the commercial banking route.
But in 1940 former Drexel partners Edward Hopkinson, Jr., and Thomas S. Gates, Jr., together with a number of their associates, founded an investment bank. The commercial bank was completely absorbed into the Morgan organization and they acquired the rights to the Drexel name. The new Drexel began with an initial capital investment of $1 million. The firm, although profitable, grew very slowly during its first 15 years, never quite making it to investment banking's first tier. In those days Wall Street played by a strict set of unwritten rules that insured the continued dominance of only a few investment banks. One such practice was "bracketing," which refers to the order of listing participants in the advertisement for an underwriting. The special bracket firms, such as Morgan Stanley, First Boston, and Merrill Lynch, were listed first, then the major bracket firms, then submajors, then regional firms. This hierarchy clearly indicated to issuers and buyers who the most powerful investment banks were. Drexel held close ties to many of the nation's biggest securities issuers, but it ranked one notch below the special firm bracket and was not one of the dominant forces on Wall Street.
In 1965 Drexel merged with Harriman, Ripley and Company to form Drexel Firestone Inc. That arrangement, however, lasted only two years. With its capital dwindling, Drexel Firestone Inc. merged with the very successful, though relatively unknown, Burnham and Company.
Burnham and Company had been built by I. W. "Tubby" Burnham, who founded the company in 1935. Burnham began with $100,000 in capital, $96,000 of which Tubby had borrowed from his grandfather and the founder of I.W. Harper, a Kentucky distillery. Burnham and Company, though very successful, was still a submajor investment bank. By the late 1960s Burnham could see that if he wanted to expand much further he would need to link up with the reputation of a major firm. The ailing Drexel Firestone afforded the opportunity for such a combination. Drexel provided the "white-shoe" image, and Burnham came up with the capital.
Burnham's investment bank had grown substantially over the years, and by 1973 its capital was $44 million--80 percent of the new Drexel Burnham and Company. Tubby Burnham served as chairman of the new company. By focusing on underwriting securities issues of small- and medium-sized companies, Drexel Burnham prospered.
In 1976 Drexel Burnham and Company merged with Lambert Brussels Witter, which was controlled by the Belgian Bank Brussels Lambert. The Lamberts were one of Europe's oldest banking families. Baron Leon Lambert served as a director of the new Drexel Burnham Lambert, Inc., while Tubby Burnham continued as chairman. Burnham's protégé, Robert E. Linton, was president and chief executive officer (CEO).
From the start, Drexel Burnham Lambert concentrated on the leftovers of Wall Street's bigger investment banks, going after smaller companies with less than perfect credit ratings. The company's high-yield (junk) bond department, which would spearhead its climb to the top of the investment banking heap, had the unique talents of Michael Milken. While working on his master's in business administration at Wharton, Milken had discovered that so-called junk bonds--bonds rated BB or lower by Standard and Poor's--had only a slightly higher rate of default than blue chip issues, while their premiums were considerably higher. Milken found that through careful research and selection, a diversified bond portfolio made up of junk bonds would pay interest rates that more than made up for the higher risk. Milken looked at a number of factors that the rating services ignored and paid more attention to a company's future than its past. It was a very successful formula.
In 1978 Milken moved the high-yield bond department to Beverly Hills, a clear indication of his influence inside Drexel as the king of junk bonds. Before 1977 the junk bond market consisted entirely of "fallen angels"--bonds issued by former blue chip companies that had run into financial difficulty and had fallen from grace. In the late 1970s, however, a number of lower credit companies began to issue their own bonds, rated BB or lower. Milken and Drexel Burnham, with their close ties to the institutional investors who liked junk bonds, controlled this rapidly expanding market. Milken's confidence in his ability to distribute high-yield bonds made Drexel actively seek out low-credit issuers. Drexel's first issue was Texas International, followed by Michigan General. As low-credit companies found they could raise capital without having to offer equity shares, the junk bond craze took off. Drexel Burnham Lambert had created a market for first-issue junk bonds.
In the early 1980s Drexel Burnham Lambert continued to tighten its stranglehold on the junk bond market. Investors trusted Milken, who had gathered the most talented group of researchers and traders of any investment bank and paid them well enough to prevent defections. If a company Milken had recommended got into trouble, Milken was on the phone with them getting information and giving advice. Drexel Burnham Lambert was also always willing to make markets for the bonds it underwrote. This built special confidence in the firm, since investors knew they would not get stuck with a bad issue. The policy, combined with Milken's genius for picking winners, made Drexel the hottest investment bank on Wall Street. Although no firm is perfect--Drexel watched the Flight Transportation Company default on a $25 million issue it had underwritten in 1982--Drexel's record was the best of any investment bank.
In 1982 Tubby Burnham stepped down as chairman and was replaced by President and Chief Executive Officer Robert E. Linton. Linton was one of a handful of investment banking executives who had never attended college; he had joined Burnham and Company after his discharge from the Air Force following World War II. Frederick Joseph, formerly head of the company's corporate finance department, took over as president.
Joseph had joined the old Drexel and Burnham in 1974 and had worked closely with Milken assembling an aggressive team in the corporate finance department. Cultivating Drexel's image as an upstart, Joseph once remarked that his firm was loaded with "fat women and ugly men"--not the typical blue-eyed six-footers most people picture as the classic investment banker. Joseph was described as a diplomat in an aggressive business and was seen as the man who could best coordinate Drexel's West Coast and New York offices. In 1983 Drexel underwrote its first $1 billion junk bond issue, for MCI Communications. Drexel's share of the junk bond market peaked at about 75 percent in 1983 and 1984. At that time, other major investment banks, including Merrill Lynch and Morgan Stanley, were lured into these not-quite-respectable but highly lucrative markets. Drexel maintained its overall superiority, but these companies gradually encroached on its market share.
In the early 1980s Drexel also became increasingly active in mergers and acquisitions, specializing in leveraged buyouts financed by junk bonds. A letter from Drexel saying that it was "highly confident" that financing could be arranged was the go-ahead for many hostile bids, and Drexel became associated with the decade's most notorious corporate raiders. It arranged financing for T. Boone Pickens's unsuccessful run at Gulf Oil in 1983; it helped Carl Icahn try to take over Phillips Petroleum; and it financed Saul Steinberg's bid for Disney Studios. One of the largest leveraged buyouts it arranged was Ted Turner's purchase of MGM/UA for a staggering $1.3 billion.
While junk bonds remained its greatest strength, Drexel had been expanding in other areas as well. In 1984 Drexel acquired the Denver firm Kirchner, Moore, and Company, expanding its expertise in municipal bond financing. Drexel also launched a major effort to enter the mortgage-backed securities markets in 1984. By the mid-1980s Drexel Burnham Lambert ranked solidly among Wall Street's top investment banks.
But at this time Drexel and the junk bond market it had created began to draw some criticism. Critics claimed that many companies were overleveraged, while the media dubbed junk bonds "toxic waste." Although default rates were no higher than before, there was speculation that the collective risk was accumulating and that a major default would soon shake the market. In addition, Drexel Burnham Lambert seemed to be making too much money too fast. Competitors--and the federal government--were inclined to take a closer look at the company.
In May of 1986 the Securities and Exchange Commission charged a Drexel Burnham Lambert managing director, Dennis Levine, with insider trading. When Levine pleaded guilty, a wave of insider charges ensued, including those involving corporate raider Ivan Boesky. Slowly, one of the Wall Street scandals of the century unraveled. The SEC investigated Drexel Burnham Lambert for two years before bringing any charges against the firm, while U.S. attorney Rudolph Guiliani targeted Michael Milken himself. The investigation itself may not have been directly responsible for Drexel's estimated 79 percent drop in earnings in 1987, the same year the stock market crashed, but the cloud over Drexel certainly didn't help business. In spite of the negative publicity, Drexel maintained a 49 percent market share of the junk bond market in 1987, down considerably from the early 1980s but still the biggest single slice of the pie, as junk bonds made up about one-fifth of all new bond issues.
In December of 1988, threatened with racketeering charges that would have allowed seizure of certain Drexel assets and effectively put the firm out of business, Drexel pleaded guilty to six felony charges of illegal trading and paid $650 million in fines. In addition, Drexel agreed to withhold Milken's estimated $200 million compensation for 1988 and remove him from his position as head of the high-yield bond operation. Milken challenged the actions in court, but finally left Drexel in March of 1989, after he was formally charged with 98 counts of wrongdoing, including securities fraud, racketeering, and tax fraud. Milken pleaded not guilty; his defense was expected to center on the notion that a $175 billion market was obviously too big to be controlled by one man.
In April of 1989 Drexel announced it was going to sell its retail operation. Many Wall Street firms had been suffering since the October 1987 stock market crash undermined public confidence in the markets, and Drexel's investigation by the federal government was a double blow to the investment bank's business. In an effort to brighten its tarnished image, Drexel brought in former SEC chief John Shad as chairman in 1989. Shad vowed he would be an active chairman rather than a "window dressing," but just how he planned to restore Drexel Burnham Lambert in the wake of one of the broadest securities scandals of the century was uncertain. And indeed Drexel, which had risen from semi-obscurity in the mid-1970s to achieve annual revenues of $4 billion in the mid-1980s, survived barely more than a month of the new decade: Drexel declared bankruptcy on February 13, 1990.
Although Drexel Burnham Lambert reported $800 million in equity at the end of 1989, it could not pay off $100 million in short-term loans due early in 1990. Drexel had become overly dependent on junk bonds to the detriment of cash flow. Its financial problems were compounded by the "crisis of confidence" precipitated by the firm's ruined reputation.
The SEC adopted new regulations as a result of Drexel's failure, requiring firms with more than $20 million in capital or single-customer accounts in excess of $250,000 to file quarterly disclosures with the government agency. In the ensuing three years, Drexel went from being the first Wall Street investment bank to liquidate since the Great Depression to being the first to endure bankruptcy. The reorganization settled more than $30 billion in claims and established several legal precedents under the guidance of an independent board of directors. Most creditors got from 50 cents to 75 cents of every dollar owed them by Drexel. In the wake of the Drexel collapse, some observers felt that Drexel and Milken should have been punished more severely for the inherently bad investments made with shareholder's money. Others lamented the loss of risk-takers who would invest in medium-sized U.S. companies with no other source of large amounts of capital.
The new incarnation of Drexel, called New Street Capital Inc., was formed under a "loophole" in the federal tax code that permitted companies to change their state of incorporation without having to pay income taxes. New Street maintained its headquarters in New York, but was incorporated in Delaware. The transformation was authorized by bankruptcy Judge Milton Pollack, the Justice Department, the SEC, and the Internal Revenue Service.
Led by new Chairman Robert Shapiro and President and CEO John F. Sorte, New Street had only 20 employees, down from a high of 10,000, and a charter that limited the company's business activities. New Street inherited a portfolio of junk bonds from Drexel totaling $450 million and dumped the former entity's checkered past. New Street's whitewashed reputation allowed it more freedom than Drexel's severely limited purview. The bulk of New Street was owned by Drexel's creditors through a post-bankruptcy trust. Former Drexel employees also held warrants amounting to 20 percent of the new firm. Many predicted that New Street would maintain a low profile, then come under new ownership by the end of the twentieth century. Unresolved lawsuits held up any sale in the meantime.