Turmoil At Salomon

It was another day in the remarkable decline of Wall Street's premier trading house. At a grim managing directors' meeting on the morning of Apr. 18, Salomon Brothers Inc. reshuffled its top management and created a new operating committee and management board. The firm was also forced to amend a controversial compensation system that had led to the departure of some of its most talented traders and investment bankers. That same day, some six managing directors left the firm, bringing the total since December to 15, including three members of Salomon's executive committee, Richard J. Barrett, Martin L. Leibowitz, and Shigeru Myojin. These developments followed reports of horrendous trading losses, multimillion-dollar accounting snafus, and a potential credit-rating downgrade. The firm conceded that its 1994 results were "awful."

Sure, other Wall Street firms have done poorly lately, thanks to weak markets and sharply lower trading and underwriting activity. These conditions followed three fat years, when unusually lush profits papered over deeper problems. Now, the entire securities industry is gripped by a severe shakeout because of overcapacity.

Yet nowhere is the turmoil worse than at Solly. Former employees, current employees, and Salomon watchers say the firm is going through a crisis as serious as the one that followed the government bond scandal in August, 1991--bleak days when Salomon admitted submitting false bids in U.S. Treasury securities auctions. The latest upheaval isn't life-threatening. But one recent defector says: "This is the second time in this decade we had to experience this wrenching change. People have that same sick feeling every day" reading about the problems in the papers. Salomon denies there's a crisis but says the company is undergoing a difficult and stressful transition.

Just what is ailing Salomon? The most visible symptom is the firm's huge losses. Even during the Treasury bond scandal and the two years that followed, Salomon remained quite profitable, earning $550 million in 1992 and $827 million in 1993. But its return on equity lagged behind the rest of the Street, and in 1994, it lost $399 million, mostly from trading (chart, page 147). First-quarter results will be out on Apr. 25, and analysts are bearish. Judging by its underwriting rankings in the first quarter of 1995, Salomon's investment-banking status is slipping. In debt and equity underwritings, it fell from fifth place to seventh, compared with the same period last year.

By many accounts, though, the underlying problem is management. Salomon's point man is Chief Executive Deryck C. Maughan, 47, who runs Salomon Brothers, the big broker-dealer arm of Salomon Inc. The other chief player is Warren E. Buffett, the legendary investor and Salomon director who owns over 20% of the firm's voting rights and has been deeply involved in many of its major decisions, including the compensation plan.

It was Buffett who chose Maughan to replace longtime Salomon boss John H. Gutfreund, who resigned in the wake of the Treasury bond affair in 1991. That was a curious choice. Although Salomon is a trading firm, Maughan has no trading experience. And Buffett selected Robert E. Denham, 49, Buffett's attorney for 17 years and a man with no Wall Street experience at all, to be Maughan's nominal boss as head of parent Salomon Inc. Denham has only a minor role in day-to-day decision-making at Salomon Brothers. Buffett declined to comment for this story.

WAGGING TONGUES. Within Salomon, there is a widespread feeling that Maughan isn't up to the task of running the firm, according to many interviews by BUSINESS WEEK. "Deryck has taken a phenomenally successful franchise and turned it into a mediocrity in a remarkably short time," says one ex-Salomon veteran. Like most of the former employees interviewed by BUSINESS WEEK, this individual left of his own volition, retains strong, positive feelings toward the firm, and is upset about the way it's being run. Many current Salomon execs expressed similar feelings during interviews. Nearly all of the people who talked to BUSINESS WEEK declined to be quoted. The firm says it totally supports Maughan.

Certainly, Salomon Brothers still has superb franchises. It is a leading buyer and seller of bonds for customers and has a strong Tokyo operation. Some observers think Salomon will regain its former eminence. "I think the firm is going to whip itself into shape," says Michael Flanagan, an analyst with Lipper Analytical Securities Corp. and a lonely Salomon bull. "This will result in some short-term pain. Long-term, I see tremendous potential and earnings power in Salomon's franchise and balance sheet."

But the prevailing view is that Solly is losing its edge and that Maughan is in over his head, partly because of his lack of trading and risk-management experience. Maughan, who spent 10 years as a British Treasury bureaucrat and four years at Goldman, Sachs & Co. in London, rose at Solly as a sales manager and an administrator. From 1986 to 1991, he ran Salomon's Tokyo office. Its success won him a promotion to co-head of investment banking in 1991.

Yet judging from the 1994 losses, Maughan has proven a poor risk manager, which involves overseeing a $172 billion balance sheet with complicated trading positions. In August, 1994, Maughan stepped down as chairman of the risk-management committee, a possible sign he wasn't doing well.

Maughan, say former Salomon employees, also erred when he decided not to rehire John W. Meriwether, a popular and hugely profitable trader and risk manager. Meriwether left Salomon shortly after the Treasury bond episode but in 1992 sought to rejoin Salomon. But Maughan strongly discouraged Meriwether from returning, say three sources with knowledge of the situation, because Maughan felt threatened by Meriwether's power at the firm.

In doing so, Maughan ultimately cost Solly about a dozen of its top traders--colleagues of Meriwether's who left to join his new firm. Indeed, some believe Salomon's top traders in Japan and London--Shigeru Myojin and Stephen J.D. Posford, both of whom are leaving--may end up working with Meriwether, a close friend of both men. Meriwether declined to comment. Solly says Meriwether couldn't have come back without running the firm and that it has no regrets about his departure.

Another sign of poor management has been Maughan's clumsy handling of the new compensation plan introduced last October. Its purpose is laudable: to ban excessively generous bonuses and link compensation directly to the firm's performance--a goal dear to Buffett. In the past, Salomon had been guilty of overpaying employees: Its return on equity has lagged (chart) because its compensation and benefit costs are rising faster than net revenues, says analyst Flanagan.

But the plan's implementation has been poor. Its many inequities and inconsistencies pit employee against employee. And in 1995, it may leave some star employees making, say, $400,000 when they could make perhaps $2 million at another broker. Ironically, the plan could end up hurting shareholders. "Any person who is any good is thinking of leaving," says New York headhunter Alan Johnson. "It's a disaster."

Maughan acknowledged in last year's annual report that the pay plan would cause a "radical shift in our culture" and could hurt earnings in the short run because "we shall lose a number of our most productive professionals." Yet he said he believed that, longer-term, it would create a firm that is built around shareholder value.

On Apr. 17, Maughan had to backpedal on the plan, making it more "flexible" so that it could reward "outstanding individual performance." This was a necessary move to respond to widespread discontent. But it may be too little, too late.

Maughan also presided over two embarrassing accounting mistakes. Last November, Salomon announced it had an accounting problem with "unreconciled balances" that would be "insignificant." Then, in early February, Salomon announced that it would take a $140 million aftertax charge for sloppy bookkeeping for trades as far back as 1988. Denham said the firm's bookkeeping problems were definitely "resolved." But on Feb. 27, Salomon sheepishly said it would have to take an additional fourth-quarter 1994 aftertax charge of $35 million for an unreconciled balance from a 1988 derivatives trade. Denham said that the firm has implemented better financial and control procedures.

Many current and former employees also question whether Maughan has the people skills to manage a place such as Salomon. To many, he seems better suited to a large blue-chip corporation, with his focus on process and organization charts, than Wall Street's most rough-and-tumble trading firm, where managing talented people with big egos and difficult personalities comes with the territory.

Many Salomon employees portray Maughan as a man who isolates himself in his office, who seldom walks around their nerve center--the huge equity- and debt-trading floors--or the investment-banking floors. That is in distinct contrast with Gutfreund, who was a highly visible presence in the trading rooms. The firm takes issue with this. It insists that Maughan walks the trading floors two or three times a week and that he maintains an open-door policy. But the press of clients, regulators, and other visitors, as well as visits to foreign branches, prevents him from circulating more, the firm says.

"COMING UNGLUED." Finally, despite Salomon's vulnerable strategic position in the global investment-banking race, there is a sense among many insiders that Maughan lacks a clear vision for Salomon's future. "The things of the past are coming unglued. There's a recognition that Salomon very substantially has to change, yet a transition to what is not clear," says one recent departee. The firm says its vision is to be a first-class global investment bank, including sales and trading for clients, combined with a first-class proprietary-trading capability.

In essence, Maughan has dismantled the old macho Salomon culture without yet putting anything in its place. Although it had many excesses, the old culture fostered a sense of pride and innovation, of being part of the best trading firm in the world. Employees are not leaving just because of the pay plan. Many don't feel they are part of a firm that is striving to be the best, knows where it is going, or appreciates their various contributions. "You have traders making tens of millions who are unhappy, when in the old days, they would be grateful for an opportunity to work at Salomon Brothers," says another defector. Employees no longer feel positive, and "when you lose that, you are managing mercenaries," he says.

The weight of troubles seems to be visibly weighing Maughan down. He looks haggard and overwhelmed, according to those who have seen him recently. And the firm seems to be confirming Maughan's shortcomings. It is searching for a chief administrative officer to reduce Maughan's burden of overseeing the financial, operations, technology, and regional administrators. Salomon says that it was Maughan's idea to add a new executive.

The role of Maughan's boss at Salomon Inc., Denham, is to help make strategic as well as compliance decisions but to leave the operating decisions to Maughan. Thus, Denham would be in on a decision, say, to exit equity trading in Europe, but was not involved in Maughan's recent move to set up a new operating committee. A mild-mannered Californian and close friend of Buffett's, Denham started out thinking the parent-company CEO job could be part-time but quickly realized it was a full-time assignment. He remains an enigma to Salomon employees and has stayed in the background except for restructuring Salomon's Philbro Energy division.

Exacerbating Salomon's identity crisis is the complicated role of Buffett. While Buffett rescued Salomon during the bond scandal by taking over as CEO for nine months, his ongoing role as a still powerful, behind-the-scenes activist shareholder gets mixed reviews. Salomon shareholders are thrilled that he has such a big stake, but many employees wonder why Buffett chose Maughan and still supports him.

For all of Maughan's weaknesses, Buffett is expected to stand by him. The Apr. 17 reorganization is viewed internally as a reaffirmation of Buffett's and Denham's support of Maughan. Buffett is known to be extremely loyal and has too much personally invested in Maughan and Denham to withdraw his backing. "Warren thinks both of them are terrific," says Jack Byrne, chairman of Fund American Enterprises in Norwich, Vt.

Yet some shareholders worry that Buffett might scale back his stake in Salomon. His biggest positive influence has been to bolster Salomon's ailing stock. The shares, which currently trade around 34, flirted with highs of 52 in 1994 and would undoubtedly be much lower without the halo effect of Buffett's ownership. In October, though, he must start redeeming a $140 million chunk of his $700 million in preferred shares for cash or stock. If the stock is trading for less than 38, he would have an incentive to take cash. That would depress the stock further, costing Solly a nice chunk of capital.

Curiously, Solly's descending fortunes and Buffett's ascending influence both stem from a muggy August day in 1991, when Salomon's Treasury bond bid-rigging scandal broke. Tarnished, Gutfreund and President Thomas W. Strauss resigned. So did Meriwether, despite Buffett's support. Meriwether later was suspended from the securities industry for three months because of his role in the Treasury bond episode and fined $50,000.

In less than 24 hours, Buffett drafted Maughan out of a group of Salomon executives to run Salomon Brothers. The decision was "the most important hire of my life," Buffett recently told a group of business school students. The superinvestor said he was looking for someone with the right character to run the firm: "Essentially, I was very lucky, because I found that individual, a fellow named Deryck Maughan." Buffett installed Denham as CEO of Salomon Inc. to oversee Salomon Brothers and Phibro.

By December, 1992, Meriwether was ready to return to the firm, where he would have rejoined a dozen traders who had remained intensely loyal to him. But in a move that upset Meriwether's followers, Maughan offered him a job that would have made him a distant No.2, with fewer responsibilities than he had when he left after the scandal. Meriwether rejected the offer.

What followed was the first wave of a dramatic talent drain. Furious at Maughan, Eric Rosenfeld, Lawrence Hilibrand, Merton Scholes, and Richard Leahy in 1993 joined Meriwether in Greenwich, Conn., at "Salomon North," as his firm, Long-Term Capital Management, is known. Cumulatively, the former Salomon employees who joined Meriwether generated the bulk of Salomon's profits. By 1995, even more top Salomon traders had signed on, including foreign-exchange trader Hans Hufshmid.

BIG BONUSES. Maughan's other big mistake has been to make a muddle of the firm's compensation plan, long a source of strife. The problem: how to fairly reward proprietary traders who rack up huge profits? The firm not only had generous pay arrangements with the proprietary traders but also extended generous deals to many of Solly's other business units.

By 1994, the system became too much for shareholders to bear. Despite the fact that 1994 was Salomon's worst year in history, it paid some phenomenal bonuses. Indeed, Solly paid more in compensation and benefits, $1.5 billion, than the $1.4 billion it earned in net revenues, says Lipper's Flanagan. The crowning blow was when a few traders in the proprietary bond-arbitrage group got pay packages worth an incredible $35 million each, even though the proprietary-trading group lost $49 million last year. In 1994, Posford, head of London proprietary trading, made about $25 million, even though London proprietary trading lost $400 million. Posford and the firm declined comment.

In response, Salomon announced a new compensation system last October to link pay directly to performance. The plan sharply segregates the firm into two parts: the proprietary-trading business, which is allocated $2 billion of the firm's $4 billion in equity; and the customer-driven businesses, which have the other $2 billion behind them. The latter is a partnership of 125 managing directors, including investment bankers, research analysts, and traders who execute trades for customers.

TWO-TIER SYSTEM. One problem with the new pay plan is that it treats the 6,800 employees in the customer-driven businesses shabbily compared with the 100 proprietary traders. First, if 6,800 people have $2 billion to use, they will likely make far less than 100 people using $2 billion. Thus, the managing directors in the partnership, even in a good year, can earn a only small fraction of what Salomon's proprietary traders can earn. Further, no allowance is made for the fact that there is far less risk in the customer businesses than in proprietary trading.

As for the customer-driven businesses, employees are paid based on the total results of all the customer businesses. These employees receive a minimum salary of $400,000, $600,000, or $800,000. If the firm earns a 7% return in 1995 or less, they earn only the minimum. Whatever the firm earns over this hurdle, 40% goes to employees and 60% goes to the firm.

The trouble is, even if a managing director in, say, European investment banking does a terrific job, he has little chance of influencing the total, and thus his own pay. Some employees figure their efforts won't trickle down to them.

There are more inconsistencies. The plan even violates Buffett's own philosophy, as articulated in his Berkshire Hathaway Inc. annual report. In a section on compensation, he writes: "In setting compensation, we like to hold out the promise of large carrots, but make sure their delivery is tied directly to results in the area that a manager controls," instead of firm-wide results. This inconsistency hasn't escaped employees' notice: These pages are posted on the wall of the partners' gym.

The Apr. 18 modification generated such a hue and cry that Maughan set up a $20 million fund to "recognize outstanding individual performance even if the client-driven business as a whole does not meet its targeted returns." An additional $25 million will be spent on new hires.

It's unlikely the new pay plan will stem the defections. If all managing directors in the customer businesses earn just their minimums, the firm will spend a total of $80 million. That's down from $220 million in 1994. What Maughan has done is add $20 million to be divided among the group. "That won't go very far," says one glum managing director.

If Maughan can't get Salomon back on track, he will face tough and somewhat unpalatable strategic choices on Salomon's direction. One possibility may be to shrink and end up looking like Bear, Stearns & Co., a smaller trading house that is a niche player in investment banking. Salomon would give up its ambitions of being a global, top-tier powerhouse. A more radical plan would be to turn the clock back to the 1970s, when Salomon was strictly a fixed-income trader, with little emphasis on equity, research, and investment banking. Finally, Salomon could try to compete with the Merrill Lynch & Cos. of the world by merging or being acquired by a domestic or foreign commercial bank, an idea being discussed by employees. This could improve Salomon's credit rating and its competitive position, but it would mean surrendering its proud heritage.

The most favorable option may now be out of reach: the Salomon of the 1980s that was close to joining Wall Street's top tier of Merrill Lynch, Morgan Stanley, and Goldman Sachs. For better or worse, the Salomon of the 1990s faces a much more modest future.

What's Ailing Salomon

-- Weak leadership by CEO Deryck Maughan

-- Below-par financial results, including $399 million deficit in 1994 from trading losses

-- Lack of a clear vision for Salomon's future

-- Controversial pay plan that benefits shareholders but is causing continuing exodus of best employees

-- $15 billion of Salomon debt under review by Moody's for possible ratings downgrade

-- Uncertainty over Buffett's stake--if Salomon stock doesn't rebound by October, he might start cashing in preferred shares

-- Market-share decline in underwriting rankings


Before it's here, it's on the Bloomberg Terminal.