 The Starlight Lounge presents an evening with the Progressive Box. Oh, what a great audience. Let's dim the lights for this next one. Nope, too much. Ah, there it is. Gotta get things just right. Like progressives, name your price tool. Tell us what you want to pay and we help you find coverage options that fit your budget. And now, the mood is right. Wait, the lights are back on again. Trudy, can you? And now it's completely dark. Progressive Casualty Insurance Company and Affiliates Price and Coverage Match Limited by State Law. In defense of financial markets, lecture six. We started this morning, we started our discussion of restructurings and we talked about what they are, why they occurred and why they occurred when they occurred. And some of the forces that are arrayed against the restructurings primarily against the hostile takeovers and the leverage buyouts. Now I'd like to take a brief look at some of the people responsible for these takeovers. What are often referred to as takeover artists. Give me some names of some of these individuals. People like Carl Icahn, Irvin Jacobs, Carl Linda, Victor Posner and probably the most colorful of them are T. Boone Pickens, a real Texan. Now how are these some of these individuals depicted by our media? Let's take Carl Icahn and these are quotes out of a publication called Institutional Investor. These people supposedly who know what they're talking about. Carl Icahn, a notorious corporate opportunist, a racketeer, an unprincipled predator who will stop at nothing in his search for a quick buck, or Victor Posner. His goal was to prey upon and defraud stockholders of a carefully chosen series of corporations by means of a corruptly conceived and maliciously executed strategy of corporate warfare. That's in the Wall Street Journal. So our media presented these people as vultures, as predators. Supposedly they would take over corporations that had lots of cash, you remember the free cash idea. They take all that cash for themselves and leave the corporation. They'd also sell off the assets and fire as many people as they could. Now, if you look at the companies that actually took over, if you actually do some case studies and look at what happened, none of these claims have any foundation at all. The claim that they took the cash and consumed it as salaries and perks is completely unfounded. So what is it that they did do? They would take over a company. They would usually fire the upper management of that company and either take that role for themselves or bring in experts who they believe could do a better job. They usually streamlined the company to make it as efficient as possible. There's often involved layoffs. They sold off the corporate jets, the penthouses, the summer homes. And then they broke, many times they broke these conglomerates, these diversified companies. They broke them up by selling the unrelated assets to other firms who could put those, that capital, those productive resources to better use. And often once they'd restructured all of this, they would sell the company. They would either sell it back to the public through an initial public offering or sell it to other investors. Or in cases where the company was still public, that is there were still many shareholders, they would just sell their own shares on the market. And they would make very nice profits. This is why they did it. Their goals were not altruistic. They did this to make money. What they achieved was that once shareholders of these companies made a lot of money. They created hundreds of millions of dollars for these shareholders. And then these shadows took this money that they received and did what with it? They reinvested it. They reinvested in what they believed were the best, most productive uses for that capital. In addition, they put corporate assets to their most productive use. They increased efficiency, increased productivity. I believe that one of the reasons the U.S. economy and U.S. corporations today are competitive in world markets is because of the reallocations of capital that these individuals were responsible for during the 1980s. That is U.S. business went through a necessary healthy restructuring that resulted in companies in the 1980s being more efficient, more productive, increasing the productivity of labor to the point where in many industries where we were lagging, we are doing better than the Japanese and the Germans. Or I've caught up with the Japanese and the Germans at least to some extent, for example, in automobiles. So in summary of this section on corporate restructuring, regulations, government intervention that prohibits the most qualified, the most able investors to take part in the management of U.S. businesses created serious problems for those businesses, created the problems associated with the separation of ownership and control. Remember that the origin of that problem are in the fact that the most able, most qualified investors cannot invest in these companies, cannot sits on the board of directors, cannot get involved in the management. Therefore, management is truly separated from its shareholders. The 1980s, for various reasons we've talked about, were a time of realignment. A day of reckoning, if you will, for the management of these corporations. The market, the financial market asserted itself as a disciplinary force on managers. Now, not only did new managers enter businesses where takeovers and LBOs occurred, but all managers were affected by this. Because if you weren't taken over, you were living under the threat of being taken over. So you realized if I do a bad job, my share price will go down, I'll be taken over and I'll be out of a job. So I better shape up. I better improve my performance. And you see a lot of voluntary restructuring during the 80s to address this exact point. So a lot of companies initiated restructuring and selling off a lot of their assets and laying off some people and taking on maybe a little bit more debt than they had in the past. In order to avert a takeover. So they became more efficient, better managers to prevent a takeover. Yet again, as we've seen, this phenomena of takeovers was vilified, demonized by the press, the politicians and many businessmen themselves. Now let's take a look at the people who financed these takeovers. So we're now on part E, I think that's F, okay. On part F, let's look at the people who financed, who made the financing possible. Now as I told you, debt was heavily used in these transactions. A lot of debt was used in order to buy up the shares when a company was taken over. Somebody like Carl Icahn or T. Boone Pickens would contact a bank, an insurance company, a pension fund that will lend him the money. So that's debt and he would go on and buy the stock. One particular form that was used in order to raise the money for these takeovers were junk bonds. What are called junk bonds? Now what are junk bonds? We've covered this a little bit, but junk bonds are high-yield bonds. They're bonds that pay a high interest payment. Does everybody know what a bond is? I don't know. It's well clear what I want to know. A bond is a contract that specifies that over a given period of time, certain payments will be made, say once a month or once every six months or once a year. And that is the interest payments. And then at the end of the period, the principal will be returned. So if it's a face value, the bond has a face value of $1,000, its principal is $1,000. At the end of the period you get the $1,000 and in the some period you get the interest payments. And you can purchase this. So you might pay $1,000 for this bond now and then you get 10% payments for 10 years and then you get the $1,000 back 10 years from it. A junk bond is just a bond like this that pays a very high interest payment. Now why does it have to pay a very high interest payment? Because it is usually issued by very risky companies. Companies where either the likelihood of bankruptcy is high or just uncertainty is very great. It's a new industry. These are firms that have low ratings. You know, they're companies that rate firms in terms of their safety. California Adventure Park. Bring your super family and your friends and come celebrate Friendship and Beyond at Pixar Fest before it ends September 3rd only at Disneyland Resort. Attractions and entertainment subject to change without notice. Stop by any of the 133 Los Angeles area O'Reilly Auto Parts stores where you'll find everyday low prices on the parts you need to keep your vehicle at its best. Our guaranteed low prices ensure you're always getting our best deal. In fact, we'll match any auto parts store's price on any like item. O'Reilly Auto Parts. Better parts. Better prices. Every day. Now junk bonds were first issued. The first issuance of junk bonds. That is the first issuance of high yield bonds where company went to the markets and said, yeah, we realize we're risky. We realize there's a problem here. So we're going to pay you a higher interest rate. Was made in 1977 by Lehman Brothers and Goldman Sachs. Previous to this, the only high yield bonds were bonds of companies that were okay. There were good companies that had deteriorated. That is the company had deteriorated. Approached bankruptcy and then these bonds dropped in a quality because suddenly they were bonds of a company in financial distress. Now junk bonds turned out to be a primary tool for takeover artists. The first use of junk bonds was in the early 1980s. T. Boone Pickens used junk bonds in his attempt to restructure the oil industry. He went after three oil companies, one after the other. City Services, General American and Gulf. Now none of those names are probably familiar because they don't exist anymore. They've all been broken up, merged into other companies. These three deals enriched the shareholders of those companies by $9 billion. As the premium he paid on their stock was worth $9 billion. These deals were financed, that is these junk bonds were issued by a relatively small investment banking firm. There was relatively unknown to both the public and even on Wall Street. And that was Drexel and Michael Milken. So this was the first time that junk bonds had been used explicitly to finance a takeover. This was the very early 1980s. Now one way in which junk bonds and debt in general was used was in leverage buyouts. Now what are leverage buyouts? A leverage buyout is when in order to buy back the shares from shareholders, debt is almost exclusively used. So you land up after the takeover with a company that has let's say 90% debt and 10% equity. So only 10% of the capital of the firm is from shareholders. 90% is debt. It actually has gotten up during the late 80s to 98% would be debt and 2% equity. So think about it, you could take RJ on Ibisco private. You could take over RJ on Ibisco with an investment of a few million dollars and $24 billion worth of debt. Now LBOs in one form or another have always existed. Think about buying a house. I got 90% of my mortgage, my ownership of the house, I've got 10% equity and 90% debt. So in a sense a mortgage on a house is like an LBO. You're financing the purchase of an asset with almost all debt. In the case of buying a house the interest payments I make on the mortgage are tax deductible. That's one of the things that makes it attractive to take out such large mortgages. The same thing when you purchase a company. The interest payments that you make to bondholders are tax deductible. One of the reasons these are relatively attractive transactions. Now, leverage buyouts were occurring throughout the 60s. Primarily in the purchase of medium-sized family-owned businesses to new owners. So a new owner wanted to buy a family business, a private business. They would take out something like a mortgage, a 90% loan from the bank, 10% equity and they would buy it. But this had never been done for a large publicly-owned corporation. The first was in 1978, but the first really big one, the first mega deal, was in 1984. It was a company called Metro Media. At the time, I think it's John Kluge. Kluge, you pronounce it? K-L-U-G-E-S. Owned 26% of the company. But he was very dissatisfied with the way it was being run. It had turned into a conglomerate with lots and lots of different assets. The company at the time had $550 million in debt. Kluge, by taking on more debt, landed up owning 76% of this company in a very, very complex deal, put together for him by Michael Milken and his team at Drexel. As a result of this takeover or this change in control, Kluge sold off many of the assets of the company, focused the company on the media industry. And today, if you look at the Forbes 500 richest man in the world, or at least in America, he's in the top 10. He's worth something like $6 or $7 billion. This was the first big deal, but there were many big deals to follow, culminating with the largest LBO in history, the Arjean-Abisco deal, in 1988. Now, let's look a little closer at Drexel and Michael Milken, who were at the center of all this activity. Drexel was financing many, if not most, of the takeover deals during the mid-to-late 1980s. And Michael Milken was the brains behind this. Now, I'm not going to talk a lot about Michael Milken primarily because you're going to see a trial of Michael Milken, in which I think many of the details are going to come out, Dr. Locke's lecture next week. So I'm going to just touch on a few key things that are relevant to the story. Drexel became a dominant player in the junk bond market. In a sense, Michael Milken created this market in the mid-70s. He discovered that these high-yield bonds, these risky investments, actually paid a good return. And he believed at the time, and there's empirical evidence to suggest this, that they were actually undervalued. This is an example where these were out of favor. Investors were not paying attention to this segment of the market. And an entrepreneur comes along and says, hey, there's a profit opportunity here. And he started managing money for Drexel, investing that money in junk bonds, and was making a lot of money for Drexel. Now, originally all he did was invest in junk bonds of companies that existed. However, after the first initial public offering of junk bonds, the first issuance of actually high-yield bonds, Drexel became the dominant player in issuing junk bonds, not just in trading in them, but it actually issued them for company. The first billion-dollar issue that is over billion dollars of high-yield bond that were issued for a new company, a relatively new company, was in 1982 for MCI. Now, MCI, what was MCI doing at the time? What did they need the money for? Build what kind of infrastructure? What are they laying in the ground? Fiber optics cables. MCI had the vision. To compete with AT&T, they would have to put in a system that was better than AT&T. They needed large amounts of capital. They went to the investment banking community and said, listen, we'd like to sell stock. We'd like to sell stock, raise the money, and put out down the cable. Most of the investment community says, you guys are crazy. You can't compete with AT&T. We're too big. We will not underwrite decision. They went to the bond market trying to raise using bonds. Nobody would provide them with financing, not banks, not insurance companies, not investment banks. Finally, they approached Drexel. And Drexel agreed to underwrite this bond issue, which turned out, of course, to be a brilliant move. Drexel made a lot of money, and we all benefit from a much superior telecommunication system, an industry, as a result. After this issuance, during the early and mid 1980s, Drexel becomes a dominant player in this market. Every deal, or most deals that involve junk bonds, that involve takeovers, that involve leverage buyouts, go through Drexel. Michael Milken manages to create a network of capital providers, from SNLs to pension funds, a network of takeover artists, and he is the one who puts these deals together. When you want to take over a company, you go to Michael Milken, and he will arrange the financing. It was to a point where, if you go back to the early 80s, when you wanted to take over a company, you had to show that you had the money ready available with you to make the purchase. In the mid to late 1980s, all you needed was a letter from Michael Milken saying that he would raise the capital, even if you didn't have a single cent in the bank. His letter was worth gold. Now, Drexel became linked in people's minds with hostile takeovers and LBOs. Joe Pirella, a takeover specialist at First Boston, referred to Drexel as the private pool of predatory capital. So the predators, i.e. the takeover artists, this is where they got their capital. It was a private little bank or institution. Michael Milken understood the new financial environment. He understood what deregulation had done to the SNL business. He had seen what was occurring to the insurance companies. Insurance industry was going through a revolution. Inflation has caused them to modernize, to change the kind of instruments they were offering their customers, to invest in different types of investments. And so Michael Milken managed to arrange capital from SNLs, insurance companies, first executive being one of his primary sources. We'll get back to first executive later. Wealthy individuals like the Bass Brothers, trust departments of banks, pension funds, and even corporate treasuries. He realized where the capital was, and he networked that capital like nobody else could, like nobody else did. This was the man who created the junk bond business. Now, originally he got very little publicity. One of the reasons was that in the late 1970s, Michael Milken went to the top bass in Drexel and said, we're moving to LA. My unit is moving to LA. And he, of course, laughed at him and said, he can't do business from LA. Nobody's ever done Wall Street business in California. That's ridiculous. You have to be here. You can't make money. He said, I'm moving. They couldn't argue because he was the best they had. And he moved everything to Los Angeles. Nobody really paid attention to him. Until the mid-80s when it was obvious what he was achieving and what he was doing. In a 1986 Business Week article, a Harvard Business School professor has quoted as saying, the only figure comparable to Milken who comes to mind is J.P. Morgan. So he was compared directly. And I think this comparison is valid to the greatest banker in US history, J.P. Morgan. So the mid-80s, huge volumes of transactions. Michael Milken and Drexel heavily involved in these transactions, making lots of money. 1986, Michael Milken makes $500 million of selling. Now, it's interesting. He made this money off of a contract that he signed in the mid-70s which specified how he would be compensated in the future. He basically would get a percentage of all the deals he closed. The $500 million he got was under the same contract he had worked for for over 10 years. You can imagine the magnitude of the deals that went through Drexel and that Michael Milken was involved in in 1986. 1988, he made $120 million. Okay. Now, as we've seen, big business, labor unions, politicians, the media, everybody was against what was going on. Everybody thought what was going on was destructive, was bad for American business. And very early on, very early in the 1980s, a battle began. A battle that's aim was to destroy the takeover market. So there was a concentrated effort to destroy the takeover market. And it was fought, if you will, on a number of different fronts. The first of those fronts was an attempt to destroy the financiers. If we don't want takeovers, let's make sure the takeover artist can't get the financing. So if we destroy the providers of capital, if we destroy their ability to provide capital to finance these deals, these deals will die as well. And the first target or the major target of this attack was Drexel and Michael Milken. Now, a lot of this was driven by envy from other investment bankers. Drexel in the 1970s was a little unknown investment bank. Without the tradition of the older, more established, more prestigious investment banks on the street. This was a company that could not get the business of most of the companies that it was now helping to take over. And irony, the businessmen or the managers did not appreciate it. So if it had gone to some of these companies and asked, can we underwrite your stock, underwrite your bonds, they would have shut the door in their faces. Now, these same companies wanted a thread of a takeover from people being financed by Michael Milken and Drexel. So the list of people who want them destroyed was very long. It included the business round table for the reasons we saw earlier, established investment bankers, and I would name one in particular, because he plays a role throughout this story, and that is Nicholas Brady, who in 1988 becomes Treasury Secretary of the United States, a role which obviously gave him a lot of power to achieve his goal. Of course, Rudolph Giuliani, the district attorney for the Southern District of New York. Giuliani had given up his position as a deputy secretary, I think, in the Department of Justice because he realized that that was a dead end in terms of his political ambitions. Moving to New York, the Southern District of New York is the district that covers Wall Street, provided him with lots of opportunities for visibility, lots of opportunities for political ambition. There's no accident that today he is the mayor of New York, and much of his campaign was financed by some of the old line investment banks that wanted Drexel originally destroyed, so he got paid back for what he did. Giuliani set out on what some authors have called the reign of terror. He systematically went after various financiers, some who were probably truly corrupt, like Boski. Ivan Boski, who was indicted for insider trading, who actually stole information, broke into people's offices and had people do it for him. Others who were not and did nothing. But Giuliani was responsible for the rest and prosecution of dozens of financiers, of people who worked within the financial markets, as I said before, many of whom were later released, who had just dropped because there was nothing there. In addition, during this time Giuliani, and the politicians in Congress, made every effort to criminalize offenses that had previously been only civil offenses. So for example, something like stock parking, where you ask somebody else to buy the stock for you in their name in order to avoid certain SEC regulations, had always been a civil offense, which you would get fined for, a slap on the hand, a fine, that you might be prohibited from being in finance for a while, but it was not involved a jail sentence. Giuliani and others managed to criminalize this, so people went to jail for doing this. By the way, this is what Michael Milken ultimately pleaded guilty for. Michael Milken never pleaded guilty to insider trading claims, and he countered to what, again, the popular press says. Now this is a quote from a book describing what Giuliani was really after, all these arrests. You know, he went into Goldman and had two investment bankers handcuffed at their desk, handcuffed at their desks, let out of the building with reporters everywhere. Giuliani was also very good at leaking exactly what was going on. The press somehow was always there to take his photo making their arrest. He was a master at manipulating the press, or working with the press, whichever way you want to look at it. This is what Robert Sobel, S-O-B-E-L, in a book called Dangerous Dreamers, a book I recommend, it's a good book, it has some flaws in it, but overall it's a very good description of what was going on in terms of the takeover market, it has a lot of interesting statistics, it has some history about some of the stuff that was going on in the 50s and the 60s. So it's called Dangerous Dreamers, referring to financiers, dangerous dreamers, by Robert Sobel, S-O-B-E-L, and it was published in 1983. He writes, all who had been indicted so far were pawns as far as Giuliani was concerned. Few even knew who they were. Michael Milken was Giuliani's ultimate target. He would be the end of the line, and Giuliani vowed there would be no deal. Milken's trial and conviction would enhance Giuliani's image as a fearless prosecutor. All along, the goal that aimed was Michael Milken. All along Giuliani, from about the mid-80s, Giuliani started leaking all kind of information about Milken out to the press. And for about two years, Milken's arrest was imminent in terms of the newspapers. So even while he couldn't charge Milken, he was distorting Milken's reputation, was causing people to view Milken as a criminal even before any charges were made. In addition, Giuliani went after Drexel, and he went after Drexel with the RICO Act, causing Drexel to completely have to restructure in 1988, weakening Drexel, also forcing them to sell Michael Milken out. Drexel explicitly sold Milken out. They agreed to completely cooperate with the prosecutor's office in the investigation of Michael Milken. They agreed to fire Michael Milken. So he was no longer with Drexel. They agreed to pay, I think it was a $500 million fine to the government. And to, in general, lay low. That does not perform any of some of these activities. What if you have an opinion of the legality of what the prosecutors are doing here? Some of this RICO stuff strikes me as just upright black man. I think it is, but I'm not a... I don't know anything about the legal aspect. This is pure black man. Drexel had done nothing wrong to that point. What the district attorney was doing was using RICO in order to force Drexel. RICO allows them to take your assets before the trial. So RICO allowed them basically to close down Drexel, take everybody's personal assets without even bringing them to trial. That is the trial would be laid. So it would have destroyed Drexel. But they used it in order to blackmail them. I don't think anything that was done there was particularly legal, but I don't know of any appeals or any lawsuits that are being filed. There were all sorts of deals cut in the background so that individuals would not be prosecuted in order for these things to go through. Drexel's chairman at the time, not only sold out Michael Milken, gave a very, very weak excuse of a defense of what Drexel was doing, but he was never prosecuted and wonders what was done in the background. On February 12, 1990, Drexel was forced into bankruptcy by the Federal Reserve and the Treasury Department. Basically, the CEO received a phone call the evening before saying, you either file for bankruptcy voluntarily or we're coming in in the morning. The Wall Street Journal that day wrote, Rudolph Giuliani's legacy now includes the collapse of a major security firm and its 5,000 employees. Now someone from the Justice Department needs to explain what it was that Milken allegedly did to justify the punishment being inflicted on the capital markets. On March 29, 1990, the district attorney brought a 98-count indictment against Michael Milken. In the month that followed, Michael Milken was put under all kinds of pressures that I'll leave to Dr. Locke to describe and if you want more details, read Payback, in which he was, I would say, blackmailed to plead guilty. If not, they said they were gaffed as brother. They were actually interviewing his 1998-year-old grandfather. They were putting a lot of pressure on Michael Milken's family. He decided at that point that it was easier. They made more sense for him to plead guilty and he pleaded guilty to six felony charges, none of which included insider trader, by the way. All of them were technical violations. All of them, most of them were based on Boski's testimony. Remember the Boski that they originally got? One of the reasons they got him was so he could testify later on about Milken. Now, for these six felony charges, the judge sentenced Michael Milken in a statement, sent a scene, she said that she doesn't know whether history will judge him to be a great man or a bad man, but he is to be an example to all. And she sentenced him to 10 years in prison for six technical violations, which it is doubtful that he even did, but that he admitted. Kimberwood of Nanny Gate fame, I think. Later on the sentence was reduced. However, today Michael Milken, his parole was supposed to have expired a few months ago. He is one of the conditions of his sentencing was that he must never do any financial dealings, that he was banned from his career. A few months ago there was the big deal between Turner and Warner Brothers. And Michael Milken was the one who financed Ted Turner, financed CNN, created in a sense the cable industry, he also financed TCI. Michael Milken provided the financing for the cable industry in general. We have cable today to a large extent due to Michael Milken, not only MCI, in terms of phone services, but also the cable industry, TCI and Turner. So Turner and Michael Milken have had a business relationship that goes back at least 15, 20 years. And Ted Turner had asked Michael Milken to advise him about this deal. Now he did not serve as a financial advisor, but as a business consultant. Yet the SEC now is investigating Michael Milken for violation of parole, and have extended his parole now for the second six month period. So he should have been let go six months ago, he's still under parole because he's still under investigation. Now in destroying Drexel and Michael Milken, remember that the bigger plan is to destroy the takeover market. And to do that, the junk bond market had to be destroyed. Now you take a big step in destroying the junk bond market by destroying Drexel and Milken. The dominant players in this market, the people who provided this market with liquidity, the people who put together most of the deals that relate to this market. So they destroyed Michael Milken and Drexel. In addition, in 1989, Congress passed FIRA, that's F-I-R-R-E-A, which was legislation that was aimed at saving the SNL industry. That was its purpose. One of the provisions of FIRA was that SNLs could not hold junk bonds in their asset portfolio. That is on their portfolio as investments. Junk bonds were deemed too risky for SNLs. And in order to save their SNLs, they demanded, government demanded that their SNLs sell off their junk bond portfolio. Now what do you think happens? When the government forces a large player in a given market to sell into that market all of its holdings. The market collapses. A number of SNLs went bankrupt because they sold into a collapsing market. Their junk bond portfolio. They sold at huge losses, which caused them to go bankrupt. The whole purpose of legislation, remember, was to prevent them from going bankrupt. Between 1989 and 1991, the junk bond market completely collapsed. If you look at the, what do you call it? The handout that I originally gave you in the first class in the back. There is a table that shows new issues of junk bonds between 1980 and 1994. You can see what happened in 1990 and 1991. 1990, 1991, there was hardly any business in this market. You can see what happened in 1992. So this was not a permanent event. But during that period, the junk bond market almost disappeared. Now there were two reasons for this. One is all these SNLs selling into this market. The second is the one financial institution that could probably have coped with this sell-off. They could have probably provided enough liquidity to keep the market afloat was Drexel. Drexel was now either dead or dying. Now this was not enough for the regulators. They destroyed Drexel, destroyed the junk bond market. They went after other users of junk bonds. And again, this is out of payback. One of the most innovative insurance companies in the 1980s, one of the most successful and innovative companies, was a company called First Executive. First Executive from about the mid-1980s. Now First Executive held a large portfolio of junk bonds. From about the middle 80s, First Executive was hounded by state regulators, both in New York and California, where it did most of its business. Hounded for using junk bonds and for various other things. As far as I can tell, First Executive did nothing wrong. Yet, its business was systematically destroyed. Regulators kept making different types of products the First Executive was selling. They would make them illegal for them to sell. And finally, in April 11, 1991, regulators seized the assets of First Executive. For example, in one stage they forced them to get rid of their junk bond portfolio. Now, as just a side story, regulators seized the assets of First Executive and they seized among those assets a large portfolio of junk bonds. This is 1991, the junk bond market is bottom. And they did an auction to try and sell these junk bonds off. They landed up selling them to a man called Leon Black, who was an ex-Drexel employee, who bought this portfolio for pennies on the doll. And his sense made an unbelievable profit on it. The regulator in California, the head of the insurance agency, that was responsible for this actually lost his job as a consequence of the scandal. He basically gave it away. Billions and billions of dollars worth were given away. Leon Black today is a very, very wealthy man as a result of this action. So that portfolio, if it had been continued, if First Executive had been allowed to continue holding that portfolio, would have recovered in 1992 and made them nice profits. The fact that Leon Black ultimately made a lot of profits off the same portfolio, and First Executive was told they couldn't hold because it was too risky for them as an insurance company. In addition, I mean this campaign was all over the place, the Federal Reserve under Alan Greenspan, restricted bank lending in general, made bank lending very difficult, and particular restricted bank financing of LBOs and other highly leveraged transactions, that is other transactions that involved a lot of debt. And even commercial banks were affected. Now, if you remember, I don't know if you remember this, but 1990, 1991, 1992 are considered a period of a credit crunch. It was very, very difficult for businesses to raise capital. This is why, at least partially. What else happened in 1991, 1992? Economy-wide, what did we go through? A recession. Do not be surprised if these events were an important cause of that recession. There are a number of economists who would pinpoint the cause as being this. The fact that companies started going bankrupt in the 1990s was a direct consequence of the fact that Milken wasn't there to provide them with new financing. Those bankruptcies led to unemployment, to their suppliers going bankrupt can lead, you can see how that can lead to an economy-wide recession if these companies are big enough. There were a lot of bankruptcies in 1991, 1982. A lot of them were LBOs, these companies that had large amounts of debt. These were companies that needed Michael Milken there, that needed his ability to raise capital and renegotiate and restructure deals, and he was not there. In addition, on the legislative front, Delaware courts were turning more and more pro-management, anti-takeovers, anti-stockholders. There were a number of deals, Time Warner being one of the biggest, the merge of Time Warner, where the Delaware courts ruled in what seems to be an obvious anti-shareholder pro-management way. So takeovers were becoming more difficult because lawsuits filed against the takeovers in courts helped them out. In 1987, I told you a story about Congress trying to pass legislation. What did big business at that point do? What did the business around the table do when their attempt to regulate takeovers failed in Congress? They moved to state legislatures. More than 21 states today in the country have anti-takeover legislation that prohibits companies from taking over companies that are incorporated in that state. Pennsylvania has one of the most stringent anti-takeover legislations. It has become an incredibly difficult task to take over a company today. The financing is not available. It is legally a nightmare. And in many cases and in many states it is simply impossible because of the legislation. The fact that we see less and less takeovers these days except, I might add, in banking, which is a completely different story, but in other industries the reason we see very, very few takeovers these days is not because the restructuring of American corporations has ended and somehow we've achieved complete efficiency. It is because they can't happen. They're too costly. The barriers have become too high, too difficult to overcome. And I've noticed over the last year or so there have been a number of attempts at takeovers. There were two toy companies where one toy company made a hostile bid on another company and three weeks later they withdrew the offer. The reason they withdrew the offer is they realized that if the company being taken over did not want to be taken over it was almost impossible to force them into doing so. In the 1980s there would have not been a problem. Companies like General Motors, who I think are incredibly inefficient and require an urgent takeover, cannot be taken over in this environment and we're not taken over in the 1980s because of their size. I mean, if Argyan and Bisco were larger, 25 billion, we're talking about GM, I think, well over 100 billion dollars. However, I believe that if Michael Milken and Drexel would have been allowed to survive a takeover of that nature, it would have been feasible. There's no reason why not, but that's not going to happen. Now, we're again running out of time, but I'd like to run through a few of the fictitious claims that are made against takeovers and leverage bias. What are they? Why don't you ask me after class, just because that's technical and it's another way in which management can protect itself against takeovers. So these are some of the myths and my response to them. The first one is, debt levels reached in the 1980s while outrageous. The prediction is that they will bring massive bankruptcies, quoting Robert Reich from his article in The New York Times in 1989. The Brookings Institute's computer simulation revealed that with the levels of debt prevailing in the late 1980s, one in ten American companies would succumb to bankruptcy. Fact is, while some companies did go bankrupt, there was nowhere near one in ten American companies. During a recession that the Democrats during the 1992 campaign claimed was the worst since the Great Depression. It's a really bad recession that Robert Reich would admit was a really bad recession. Nowhere near, I don't have exact number, but nowhere near one in ten companies went bankrupt. In addition, the whole notion that debt levels increased in the 1980s is false. While the amount of dollars of bonds, of debt increased, so did the value of equity. Do you know what leverage, how do you tell what the leverage is? It is the ratio of debt to equity. You divide the amount of debt the company has by the amount of equity. Now if the value of the equity is rising and the value of the debt, the amount of debt is rising, then the ratio could stay constant, right? And if you look at the ratio of debt to equity in the U.S., among all U.S. companies during the 1980s, it was about the same as it was at the beginning of the decade. Furthermore, in 1988, debt levels in the United States, which were at their peak at about 45%, were significantly lower than the two countries that were being hailed at the time as the model of industry, Japan and Germany. While the U.S. had about 45% debt equity levels, Japan had a 67% equity level and Germany 56%. Debt is a tool used much more often by these countries than it is in the U.S. Now, going back to bankruptcy point, I would say that many of the bankruptcies that occurred would not have occurred if Drexel and Michael Milken were still around. So if you're looking for a cause for these 1 in 10, it's not the debt levels, it's the fact that you've taken out the major players that could have prevented these bankruptcies from occurring to begin with. The recession itself, as I said, was probably a result of their disappearance. So I think what they've done is they've reversed cause and effect here. The second myth, managers have to worry about paying interest on debt instead of running of the business. So all the money coming in has to pay out the debt, so they worry about that all the time. And again, to quote Reich, corporate debt in the 1980s has reached alarming proportions. 25 years ago, the average American corporation paid 16 cents of every dollar of pre-tax earning in interest on its debt. In the 70s, it was 33%. Since 1980s, it has been more than 50%. Now, that's true, corporations were paying more and more in debt payments. The question is, in interest payments, is this good or is this bad? Now, I would claim that debt has an important role, not only is it cheaper capital for tax reasons, but it is an important role in forcing managers to focus on their primary function. It is like putting a gun against their head. Because if they don't do a good job, it takes very little to force them into bankruptcy. The more debt you have, the easier it is to put you into bankruptcy. Debt serves a function of motivating or forcing managers to do their best to keep the company solvent, to keep the company running well. The nation's best network? I feel better already. Now you can focus on how you're spending your summer. Discover the total wireless stores and get total confidence. The latest phones. The best network. All at great prices. Now open in Los Angeles. Refer to the latest terms and conditions of service at TotalWireless.com. It depends on the industry. I would not, for example, use a lot of debt in those companies, but more so in high-tech companies. I don't think Intel should take on a lot of debt. Why? Because they've got really good uses for that cash. But for a cigarette company that has cash streaming in with nothing to invest in, one way to force it out of the hands of management, make sure that they don't make stupid investments, is to force them to pay it out as interest payments. So it makes sure that they don't spend a lot of it on perks because they don't have enough of it to spend on perks, make sure that they don't diversify because it's all gone. Now what do the people who get it as interest do with that money? They reinvest it. So it all flows back into productive uses instead of into consumption by the managers. The third, that all this is structuring would make U.S. companies less competitive. Again, let me quote quickly from Reich. Only the public relations of offices of the United States Chambers of Commerce would contend that the American companies have stayed competitive with those of Japan, Germany and South Korea. And other places around the globe where incidentally hostile takeovers and leverage buyouts rarely have ever existed. All for a Fortune magazine article, while internists and strife hogged attention at home, the U.S. are treated in far more important war of global competition. The biggest winner, Japan, where companies stay in fighting trim shape without having to listen for predators' footsteps. So we were losing ground to everybody else. Now, I don't have much time, but if you look at the charts, productivity was going up during the 80s. And the fact is that U.S. became more competitive, not less competitive as compared to Japan and Germany. Japan and Germany today over the last four or five years have been in deep economic trouble. Japan has gone, has come very, very close to a depression. Germany's cost of labor is astronomical and they are not in a position to compete today with the U.S. because the Europeans are actually complaining about the U.S. the same complaint that we are complaining against Asians. That is our cost of labor is too low. We're not being fair. We're paying our employees too little as compared to the Europeans, what the Europeans are getting. Okay, fourth one, takeovers are done for short-term gain only. This is the short-term versus the long-term. Remember from our previous discussions that this is a false dichotomy. Capital markets explicitly look at the long-term. We're talking about the present value of future cash flows. The other answer to this is if managers are doing poorly now, why would you think they do better in the future? Think of the speeches and other people's money for those of you who've seen it. If Gregory Peck talks about this and this is maybe going to happen in the future, well if you can't manage it right now, why do we assume that you'll be a better manager in the future? Why do you assume that these events somehow your projections from now to the future are better than your projections from five years ago into the future? Five, takeovers bust up companies with the implication that they destroy companies. Well, it is true takeovers did bust up companies. Divisions that didn't fit into the main business were sold. These assets were put to better, more productive use by other companies, by other individuals. Six, takeovers and restructuring put people out of work. They cause unemployment. Now yeah, among top management. Among the people who deserve to be laid off. But if you look at it, if you look at employment numbers, employment was declining throughout, unemployment was declining throughout the 80s. And it's today relative to the mixed economy that we have today is low. Unemployment is low. So that the facts do again not match the claims. And of course what is the alternative? Lifetime employment. Do we want to wait until these companies go bankrupt and then let these people go off? So the alternatives, as the Europeans know, because they do have lifetime employment and very high salaries, are disastrous. They would cause our industries to become less competitive. Finally, they accuse takeovers and LBOs for reducing R&D expenditures and capital expenditures. Again, this idea of sacrificing the long term for the short term. That is companies who had takeovers and LBOs underwent these events, cut their R&D expenses and cut their capital expenditures. And again, I'll refer you to those little graphs that I handed out. And you'll see that during this whole decade, R&D spending went up dramatically. Capital expenditures continued going up. And the places where these were cut. The industries in which R&D and capital spending were cut. Were those industries that didn't need R&D and capital expenditures? And where did that capital go? The money that they were now not spending on R&D and capital expenditures? They probably ultimately landed up in Silicon Valley, fueling the growth of real companies that need money for R&D and capital expenditures. So if anything, this facilitated the movement of capital from mature declining industries into high growth R&D intensive industries, who needed the capital from MCI to Turner to TCI to Intel to Silicon Valley. So in summarizing almost everything that was said about takeovers and LBOs in the 1980s turns out to be false. The facts just don't match their theories. Their predictions turned out to be false. However, even given all the positives, all the good things that these events, given all the increase in productivity, the improvement in efficiencies, the takeover market allowed or made possible, this is a market that was destroyed. And it was destroyed systematically. I don't know if there was one guiding hand, but lots of guiding hands. Managed to destroy the one tool that we saw was still available in order to correct mistakes by managers because the others are blocked. We still, banks are not allowed to own any stocking companies and so on. Tomorrow we will talk about how we defend against these kind of things. I'll see you tomorrow morning. This concludes with lecture 7.