The Salomon Shocker: How Bad Will It Get?

Some five months ago, Salomon Brothers Inc. relocated from a pale, stone-faced structure at the foot of Lower Manhattan to a building not far away--the never-occupied corporate headquarters of Drexel Burnham Lambert Inc. It was a savvy move in a depressed real estate market, and, at the time, utterly devoid of symbolism. Yes, Salomon dominates the supercharged world of U. S. government bond trading almost as completely as Drexel dominated junk bonds. But under Chairman and Chief Executive John H. Gutfreund, Solly was the embodiment of aggressiveness without aggression--the clean fist in the velvet glove. When scandals swept the Street, Salomon was untouched, serene.

Today, Salomon Brothers is still the unchallenged king of government bonds. But the storm clouds of wrongdoing that bypassed the firm for so many years have arrived with a thunderclap. On Aug. 9, Salomon issued a gingerly worded statement admitting that it had committed "irregularities and rule violations in connection with its submission of bids in certain auctions of Treasury securities," that two managing directors had been suspended, and that the bond-trading powerhouse was under investigation by the Securities & Exchange Commission and the Antitrust Div. of the Justice Dept. On Aug. 14, Salomon issued an even more detailed mea culpa, in which the firm conceded that it failed to promptly take action when it learned of wrongdoing last April and conceded that it may be subject to civil and criminal sanctions, suspended or barred as a broker, or even dropped as a government-appointed bond dealer.

NO SMALL FRY. The question confronting regulators is daunting. Did Salomon deploy vast amounts of capital to manipulate and "corner" the market for government bonds, thereby maintaining its franchise and making illicit profits at the expense of its customers, smaller firms, and the bond-buying public?

Just as crucial is the question of executive responsibility. John Gutfreund is a veteran trader and a hands-on executive. What, if anything, did he know? And when? Salomon says that management became aware of auction-related misconduct in April--but many Wall Streeters believe it may have been a lot earlier. After all, the two managing directors who are said by Street sources to have been suspended by Salomon--the firm will not confirm their identity--are not small fry. One is Paul Mozer, head of the government securities trading desk, and the other is his No. 2 man, Thomas Murphy. Neither could be reached for comment.

Salomon officials would not discuss--on the record--the investigation or the firm's trading practices. But the Aug. 14 statement provides damning details, although it raises more questions than it answers. According to the statement, before the auction of two-year Treasury notes in May, the firm inadvertently failed to disclose that Salomon already had a $497 million position in two-year notes, which it had purchased in the "when-issued" market--that is, the market for bonds that have not yet begun trading. "I think a box wasn't checked," maintains a Salomon official.

In other admitted transgressions, bids were submitted by Salomon in three earlier auctions, one in December, 1990, and two in February, 1991, on behalf of "persons who had not authorized such bids." Salomon then bought back the notes and wound up with 46% of the December issue and 57% of the five-year February issue in violation of Treasury rules. That's a lot more serious than not checking a box--and smacks of a possible attempt to corner the market. But no, a Salomon official asserts, the unauthorized bids were nothing more than unauthorized acts by employees. The official emphasizes that higher-level executives--Gutfreund included--had no prior knowledge of the unauthorized trades.

'PRACTICAL JOKE.' What would have been the employees' motivation? "I couldn't begin to guess," the official replied on Aug. 12. "How these guys thought they could get away with it is beyond me." But in the statement issued two days later, a motivation is given for one of the two February auctions: A managing director was playing a "practical joke on a Salomon employee. The plan went awry, and the bid which was not intended to be submitted was in fact submitted in the name of a customer."

Well, traders and rival bond dealers say that corners are no "practical joke," but rather a commonplace occurrence in the Treasury market, and that Salomon has committed them in the past--which the firm denies.

But they are divided over the notion that Solly higher-ups would condone a scheme to corner the market. One high official of a rival brokerage fervently believes top management is innocent of wrongdoing. "John Gutfreund and Salomon President Tom Strauss and Salomon Vice-Chairman John Meriwether had no idea what was going on," he asserts. "I would bet my life on it." Apparently, however, the three top Solly honchos weren't too anxious to do anything when they found out what was going on. The Aug. 14 statement says that Gutfreund, Strauss, and Meriwether were told of one of the unauthorized February bids in April but failed to report it to the government "due to lack of sufficient attention to the matter."

One of the reasons for the disbelief expressed on the Street is the clumsiness of the machinations confessed by Salomon. "Just a silly thing to do," says Steve Modzelewski, a former Salomon trader. "Ethics aside, it's embarrassing to do something so simple-minded. . . . if you were going to break the law, you could be more clever."

And sure enough, some traders maintain that Salomon was, indeed, "more clever" for a considerable period of time. They assert that the firm cornered--or "couped" in trading lingo--a number of auctions in a manner that will not be so easy for regulators to prove. "It's been our view for years they've taken the auction down," says one rival trader. "This time they did it more blatantly." Thus the effort to portray top management as a victim of errant employees, and negligent at worst, carries little weight with some Wall Streeters and regulators. One senior government official, who requested anonymity, maintains that it is "pretty amazing that top management hasn't resigned over something so blatant happening in a central part of the operation that they pride themselves on." Suspensions, in his view, might not be enough: "Strong punishment is appropriate here."

The specter of Salomon profiting by abusing Treasury auctions will continue to send shock waves through the Street and Washington. By its willingness to commit huge chunks of capital to the auctions, Salomon provides the liquidity that's vital for the Treasury in its constant replenishment of the government's cash needs. Moreover, the probes are being watched with rapt attention by the thousands of firms throughout the world, large and small, that do business with Salomon. Those firms include virtually every large pension fund, mutual fund, and major financial institution in the country.

Also watching closely are Salomon's rivals in the bond business. Salomon is the most active of the 40 U. S.-authorized primary dealers in government bonds--the brokerages and banks that are the hub of the government securities market. Primary dealers must put in bids at every Treasury auction and either keep the securities or resell them to institutional investors and the public. Among the other large primary dealers are Merrill Lynch and Lehman Brothers, with Goldman Sachs, Morgan Stanley, and First Boston trailing behind. But none can match Salomon in the amount of capital committed to bonds.

LEGAL HEADACHES. Bond trading and bond-sale commissions, largely stemming from its dominance of the government market, are Salomon's main source of profits. So far, Salomon is apparently not losing business as a result of the probe. "Over the years, they have built up a lot of goodwill, and now people will have to wait and see how it happened" before considering a move from Solly, says one money manager in London. But that wait-and-see attitude could vanish if the legal agony mounts. A shareholder class-action suit was filed on Aug. 12, and lawsuits--from bond traders in particular--are but one potential legal headache. A major dealer is actively considering a lawsuit, and a source at his firm says company officials are looking through records to assess what its losses were in the May auction.

But the damage to Salomon's reputation alone may be enough to send customers to the competition, thereby seriously eroding Salomon's franchise and revenue base. "We expect our markets to be on the up-and-up," says Mark S. Venezia, a bond-portfolio manager at the Eaton Vance Management Inc. mutual-fund group. "We have a lot to lose if one premier broker-dealer is guilty of wrongdoing." In foreign markets, where Salomon has long-established operations, customers are taking a similarly hard look at their relationship with the firm--even if, for now, they are not cutting ties. At Axa, a major French insurance company, international equities manager Jean-Patrick Dubrun is concerned: "It's bothersome when someone thinks that because he's powerful, he doesn't have to obey the rules."

On Wall Street, however, powerful market players have a way of making their own rules--or bending the government's. Traders maintain that the market for Treasury notes has been cornered periodically, but only in recent months have they gone public with tales of supposed market-cornering transgressions by Salomon. The brouhaha began in June, when traders publicly complained that Salomon had cornered the May 22 auction of $12.3 billion in two-year notes (BW--July 1).

In theory, at least, the mechanics of gaining a corner on the market are not terribly sophisticated (chart). The idea is to overcome Treasury rules that set the maximum amount any one bidder can purchase in an auction--35% of a bond or note offering. The head trader at one large bond dealer points out that the first step is to look at the when-issued market.

By bidding just three- to four-hundredths of a percentage point above the price of bonds in the when-issued market, a dealer can be fairly confident that the bid will be accepted. Cornering the market is not a solitary pursuit, but rather a collegial, group enterprise, requiring the cooperation of friendly customers. After all, 35%--the Treasury-imposed limit per firm--does not a corner make. Compliant customers agree to buy the issue at the auction, and the general practice, traders say, is to immediately sell their notes or bonds, at cost, to the dealer. "It's the equivalent of stock-parking," notes an official of one Japanese-owned brokerage.

RIPPLE EFFECT. Cornering the market in this manner is quite different from the transgressions and "practical joke" admitted by Salomon. Under the scenario set forth by traders familiar with the practice, customers are not victims--they are friendly, active participants. "They Salomon talk accounts into going along with them," says one trader. "This time, they couldn't get customers to go along with them, so they made them up."

The dangers of cornering a bond or short-term note issue are clear. Corners artificially influence the yield curve--the relationship between long- and short-term interest rates. "How the Treasury yield curve goes affects all bonds, all loans, and in some respects, the stock market and the U. S. dollar, too. So anything that happens to the Treasury yield curve ripples through every bond in this country," notes Ron Ryan, president of Ryan Labs, a bond boutique. A more direct effect is that a corner penalizes firms that need to buy the issue--such as dealers who must go short (that is, sell bonds they do not own) in the ordinary course of business. Bonds that are sold short must eventually be replaced--and if one dealer dominates the market, it can dictate the price. Indeed, that raises the price for every bond buyer.For the dealer, however, a corner makes good sense when certain issues of notes are in short supply. And sure enough, notes Roger Portnoy, an investment strategist with Thomson Financial Networks, some of the securities that have been in shortest supply are two-year notes--which traders insisted had been deliberately cornered by Salomon.

Salomon concedes that the potential legal consequences could be dire indeed. True, the firm's status as the top primary dealer is valued by officials of the Treasury and Federal Reserve, who bear the onerous responsibility of financing the government on a continuing basis. And some officials say that, as a result, the two agencies will argue against Salomon being severely punished, perhaps by depriving the firm of dealer status.

But the Justice Dept. and the SEC are likely to take a tougher stance. And the regulators have ample legal tools at their disposal. Although the Securities Act of 1934 does exempt government securities from market manipulation laws, the SEC could pursue charges under Section 10b-5 of the act, its antifraud statute, that covers all kinds of misrepresentation. Salomon could also run afoul of record-keeping statutes or be cited for failure to supervise.

BIGGEST CASUALTY. So far, however, Salomon has only begun to feel the pain. Its customers have remained, but the lawsuits have begun. Market participants who lost money in April and May two-year-note auctions are planning to take legal action against Salomon. And if the SEC and Justice Dept. throw the book at Solly by forcing it to disgorge its profits and pay additional damages, the total tab could wind up at $200 million to $500 million in fines and penalties, estimates the lawyer for a potential litigant.

But the biggest casualty may well be Salomon's corporate culture. Despite inroads made in the more genteel investment banking business, Solly is at bottom a bond house run by and for traders. Paying traders a percentage of what they earned for the firm gives them an incentive to push the limits, competitors maintain. "The compensation system and greed might have pushed them outside the rules," says a trader at a competing firm. And the result, notes the top bond trader at another firm, with a touch of hyperbole, is that "every government agency in the world is after them--all at the same time." A sad omen indeed for the firm that replaced Drexel in an office building but never dreamed of taking on the firm's final role--target.

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