(FORTUNE Magazine) – COVER STORY WALL STREET'S SPREADING SCANDAL The web spun by Ivan Boesky threatens to snare more dealmakers and alter takeover rules. Already Congress is talking tough, bankers are turning skittish, deals are coming unstuck, and some raiders are retreating. Still, corporate managers can't breathe easy. LIKE TREMORS signaling great shifts in the earth's strata, the Ivan Boesky insider trading scandal heralds a fundamental change in the takeover game. ) Deals will now be seen in a wholly new light, and the government may change the rules for raiders and traders. To many, the disclosure that arbitrager Boesky was using stolen confidential information from Drexel Burnham Lambert investment banker Dennis Levine proves what was long suspected: that millions in takeover profits have been going to those who rigged the game. Says Chairman James F. Bere of Borg-Warner, itself the target of a recent takeover offer: ''We knew in our own minds that the playing field wasn't level, but if we had told you that, you would have said, 'Show me.' Now we have our proof.'' The takeover surge of the past few years is now suspect. Short of divine omniscience, no one will ever know which deals were tainted and which were clean. But in the aftermath of the Boesky case, proposed takeovers will be scrutinized more closely by financiers and investors. Do they really make economic sense? Or are they the product of too much junk bond borrowing power, greedily and recklessly used? Dealmaking will go right on. Just 11 days after the Boesky newsquake, three fresh bids were unveiled. The Limited, a Columbus, Ohio, retailer, made a joint offer with shopping mall magnate Edward J. DeBartolo Sr. for Carter Hawley Hale Stores. American Brands, a consumer products company, announced that it would try to acquire Chesebrough-Pond's, best known for such products as Vaseline and Ragu spaghetti sauce. A group led by Minneapolis raider Irwin Jacobs proposed to buy Borg-Warner. Many other would-be acquirers are rushing to beat tax law changes that take effect on January 1 (FORTUNE, December 8). The pace of takeovers and financial restructuring will nevertheless slow, though not nearly enough to comfort chiefs of target companies. The leading characters in the scandal will be hauled before Congress and bathed in a glare of publicity not seen since J. P. Morgan Jr. got photographed with a midget in his lap in 1933. This time the pictures will be live, in color, and on your evening news. Any investment bank caught with an in-house crook will be slapped with lawsuits that could wipe out the firm. The downfall of America's most flamboyant arbitrager came when that Wall Street wonder kid Dennis Levine began singing last spring. It appears from SEC documents that he disclosed how he curried favor with Boesky by tipping him off in advance of takeover announcements -- gratis at first. Ultimately Levine and Boesky struck a more formal deal: Levine would feed valuable insider information to Boesky in exchange for up to 5% of the profits Boesky collected on the basis of that information. Boesky, who has agreed to pay a fine of $50 million and return another $50 million in illegal profits to any company, or investor, that can demonstrate it lost money from Boesky's moves, is also cooperating with the continuing SEC investigation. For weeks before the announcement that he had admitted wrongdoing, Boesky is said to have allowed investigators to tap his office telephone. The SEC will not comment on the most persistent rumor: that at least one prominent investment banker has been implicated and is plea- bargaining with the government. WHERE THE SEC'S probe will lead, no one knows. ''When we start one,'' says SEC Chairman John Shad, ''we pursue it down all the avenues it takes us. This doesn't mean that all the people we have subpoenaed have done something wrong, but they may lead us to someone who has.'' The SEC has already subpoenaed Drexel Burnham, the leading underwriter of junk bonds that was also Boesky's investment banker and an investor in one of his limited partnerships (see following story). Among the individuals said to have been subpoenaed are Michael Milken, who runs the firm's big junk bond trading operation in Beverly Hills; Martin Siegel, a managing director in Drexel's mergers and acquisitions department; and Carl Icahn, a big-time raider and Drexel client. Though Boesky will plead guilty to a criminal charge that could put him in prison for five years, some Wall Streeters say he got off easy. The most bitter reaction was from other arbitragers, who lost hundreds of millions when takeover stocks they held fell sharply immediately after the SEC's announcement. In possession of the all-time hottest piece of inside information -- that the regulators planned to go public with his case -- Boesky sold off blocks of those same takeover stocks before they dropped. Says one angry arbitrager: ''That son of a bitch is outrageous.'' While the prices of many takeover stocks recovered some of their lost ground, three major deals fell apart, all because of the new climate of uncertainty. First Wickes Cos. disclosed it couldn't come up with ''satisfactory financing'' of its $1.7-billion offer for Lear Siegler. Then Anglo-French financier Sir James Goldsmith abruptly called off his $49-a-share offer for Goodyear Tire & Rubber, partly because of what he called ''this ghastly Boesky affair.'' Finally Ronald Perelman, who won Revlon last year in a bitter + struggle, dropped his hostile $4.1-billion bid to take over Gillette Co. In an unusual twist to that truce, Perelman's investment banker, Drexel, agreed not to finance the acquisition of Gillette stock for three years. The stocks of all three companies, already down, slipped further after these announcements. Not coincidentally, all three deals depended, directly or indirectly, on high-yield debt securities -- that is, junk bonds. While the current interest rate on long-term government bonds is around 7.5%, recent junk bond issues have sold at yields of 12.5% or more. Risky though the bonds are, Drexel and its king of junk, Michael Milken, convinced a broad clientele of institutional investors that many of them represented greater value than their ratings suggested. Investors, salivating over the promise of fat yields even as interest rates on most other securities were falling, loaded up. Starting in 1984, Drexel pioneered the use of junk bonds to help finance takeovers, especially the unfriendly kind that commercial banks and blue-blood investment firms had tended to shy away from. With Drexel providing advice along with the financing, the raiders came to seem invincible. Now Drexel is ''a bleeding shark,'' says J. P. Guerin, a California investor who heads PSA, the West Coast airline. Drexel's close relationship with Boesky suggests that the firm or some of its employees could become implicated in the affair. Neither Drexel nor any of its employees have been charged with any wrongdoing. But the Boesky news shook the junk bond market for a few days before prices firmed. What if key Drexel players, such as Milken, are implicated in the Boesky episode? Most experts agree with Asher Edelman, a takeover artist now pursuing an unfriendly $1.9-billion bid for Lucky Stores. ''Listen,'' he says, ''Mike Milken is absolutely brilliant, but nobody is irreplaceable.'' If Drexel's role in the junk bond market should diminish, the market would shrink until eager competitors filled the void. Such a shrinkage could also reduce other kinds of credit for a time. In many cases leveraged buyouts or stock raids are financed only in part by junk bonds, which supplement other types of debt. These include commercial bank loans made on the expectation that the borrower will quickly pay back by selling assets of the target company -- with such second-stage sell-offs often financed by junk bonds. If the supply of junk bond credit declines, bankers are likely to be stingier with their own loans. One Chicago banker says he intends to postpone commitments for leveraged-buyout deals until the dust settles. With Drexel crippled, takeover entrepreneurs say, the heaviest impact would be on the biggest deals. ''No one has come close to demonstrating Drexel's capacity to raise big money,'' notes Joseph Rice, president of the New York leveraged-buyout firm of Clayton & Dubilier. Says William Farley, a Drexel client who acquired Chicago-based Northwest Industries two years ago and is now trying to take part of it public: ''The market for megadeals could be severely crimped.'' Some lesser deals could also come unstuck. Investors in junk bonds presumably would demand an even higher yield to make up for the market's lesser liquidity. The portfolio manager of a major university endowment fund says that even slightly higher borrowing costs would have torpedoed many of the deals he has seen over the past year -- especially those that, in his words, ''required an act of faith.'' The broad reappraisal now under way brings into question the role arbitragers, or arbs, play in takeover battles. This role is not always fully understood. Arbs, who manage portfolios for institutions and trade for investment banking houses, are heavily concentrated in New York. Honest arbs fulfill a useful function. They make the financial markets more efficient by ironing out discrepancies in the prices of stocks, options, futures, and interest rates. For example, when a stock option price gets out of line with the underlying stock, the arbs buy the undervalued security and sell the overvalued one, and prices tend to converge again. ARBS PLAY a different role in takeovers. Once an offer is made, or sometimes when it is merely rumored, they bet on the outcome. If they buy the target company's stock, they assume the risk of getting stuck with a loss if the deal falls apart. Meanwhile, they have added to the market's liquidity by enabling itchy stockholders uncomfortable with uncertainty to bail out at a higher price. Many risk arbitragers have been unusually good at sniffing out takeovers. Boesky was too good -- because he was being tipped off. For instance, the day before InterNorth announced a bid to acquire Houston Natural Gas, Boesky's ''crystal ball'' told him to buy 300,000 shares of HNG. Two weeks later he had banked a cool $4.1 million in profits. The new chairman of the Senate Banking Committee, Senator William Proxmire, wants to rein in the arbs. He is considering a proposal that in effect would redefine when a shareholder becomes a full-fledged shareholder. In the event of an unfriendly tender offer, only those who owned the stock at least 30 days before the formal offer would be entitled to have their shares counted. Says Proxmire: ''There's no reason to let the arbs vote in a takeover battle.'' Proxmire, who pushed a similar idea last session without success, also believes hostile bids ought to require the approval of two-thirds of all shares rather than a simple majority. While his proposal will get a better hearing in the new Democrat-controlled Congress, it will be a tough sell. Many will argue that all shareholders should be treated equally. What's more, writing legislation affecting takeovers is extremely complex and is not made easier by the divided stances of various business lobbies. The Reagan Administration has opposed takeover curbs until now, but this could change. After the Boesky news, the White House decided to reappraise its position on insider trading and takeovers. Even if no law passes, the arbs -- indeed, everyone speculating on takeover stocks -- are bound to be more circumspect from now on. Many who relied on Boesky's coattails may exit the risk arbitrage business. As one who plans to stay in puts it, ''The slimiest arbs are getting squeezed out.'' Harold Simmons, who joined the ranks of the big-league raiders with his recent takeover of NL Industries, a chemical and oil services company, would be happy with no arbs at all. ''They force prices to go higher than they otherwise would,'' he says. Another prominent raider, who asks not to be identified, has a different view: ''Arbs grease the skids. They make the target company a little more nervous. You'll still do the deal without them, but it will be slower going.'' Even before the Boesky affair made headlines, the SEC was leaning toward taking one modest advantage away from the raiders: the sneak attack. Under present rules investors have to file notice with the SEC as soon as they accumulate more than 5% of a company's shares. The catch is that they have a ten-day grace period before the filing is due. In the meantime, of course, a raider, or any other investor, can go on secretively building up his position. By the time he files he may actually own 10% or more. He must report significant further changes in his holdings -- again, after ten days. Meanwhile, risk arbitragers, perhaps recognizing the trading footprints of a ; takeover in the making, may start buying shares in the same company. By the time the startled management of a company knows who is buying its stock -- or why -- it may be too late to mount a defense. Some merger experts regard the ten-day grace period as an anachronism. Today's most rudimentary technology enables an acquirer to file the minute he crosses the 5% threshold. If Congress requires that such filings be made within two days, as the SEC hopes, the impact will be felt most by raiders out to greenmail a company, not buy it. That's because an important chunk of their profits from a raid depends on being able to buy a lot of stock cheaply, before other investors bid the price up to reflect the possibility of a takeover. Through publicity alone Congress will keep Wall Street under the spotlight for months. The Senate Banking Committee, and possibly other congressional panels, will be holding hearings. An expected deluge of lawsuits will make more headlines. FMC Corp., the large machinery manufacturer and defense contractor, is studying the possibility of suing Boesky and Goldman Sachs, which advised the company in a recent recapitalization plan involving a buyback of stock. SEC documents say that David Brown, a former Goldman Sachs investment banker who pleaded guilty to insider trading violations earlier this year, passed word about FMC's confidential recapitalization plan to Ira Sokolow of Shearson Lehman Brothers, who passed it to Dennis Levine. He passed it to Boesky, who turned a quick profit by buying FMC shares -- thereby kicking up the price -- before the company announced its plan. Winning such lawsuits could be difficult. To have a good chance of winning, the plaintiff must show that the investment bank breached its fiduciary duty and benefited from doing so. But the mere threat of huge fines -- and the criminal convictions already received by Levine and his youthful confederates -- will have a powerful impact on future dealmaking. Says Sam Zell, a Chicago raider who has acquired three New York Stock Exchange companies this year: ''You get market discipline for many reasons. But the most important is fear. Now there is fear, and there will be discipline.'' THE RAIDERS, roundly condemning Ivan Boesky and his ilk, insist that they will keep doing what they have been doing. Says T. Boone Pickens Jr., the chairman of Mesa Petroleum who made runs at several giant oil companies: ''The main event -- the restructuring of corporate America -- will go on.'' While the scandal has greatly discredited the takeover craze, the key players are far from sated, and the investment banks are tripping over themselves in pursuit of business. Shortly after Boesky's fall Simmons disclosed, ''Just yesterday I got calls from two investment bankers saying that if Drexel goes down, they'd sure like to have my business.'' Most important, the investors whose money has made merger mania possible, many of them the pension and profit-sharing funds of major U.S. corporations, seem in no mood to trade junk bonds for high-grade bonds that yield less. Though deals will be fewer, the quality seems bound to improve. Salomon Brothers' chief economist Henry Kaufman, no friend of raiders, has long predicted that unrestrained takeovers could eventually bring serious trouble for the economy. But recently he told a group of international bankers and finance ministers, ''There will continue to be more mergers, more consolidation.'' If the suppliers of the capital behind those transactions act more judiciously, as Kaufman believes they will after Boesky, future deals will be ''more worthy than some that have been consummated in the recent past.''