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Salomon and the Treasury Securities Auction: 1992 Update
In early July, the S.E.C. and the Justice Department issued a subpoena for Salomon's trading documents for the May 1991 2-year note auction. In response, Salomon asked Wachtell, Lipton, its outside counsel, to investigate the May auction. After several weeks, Wachtell, Lipton informed Salomon that they had found problems in four auctions dating back to December 1990. !" !" In the December 27, 1990 4-year note auction, Salomon submitted a $1 billion bid for "Warburg" without S.G. Warburg's knowledge. In the February 21, 1991 2-year note auction, Salomon fabricated bids for Warburg and Quantum Fund, another client. Salomon ended up with 57% of the notes after proration of its own bid and the two fake bids. In the April 25, 1991 5-year note auction, Salomon submitted a $2.5 billion bid on behalf of Tudor Jones, $1 billion more than the client's authorized bid. After the auction, Salomon purchased $600 million of the $2.1 billion in notes awarded to Tudor Jones. In the May 22, 1991 2-year note auction, Salomon ordered $2 billion in notes for Tiger Investment, $500 million more than Tiger's authorized bid. After the auction, Salomon purchased the $500 million in extra notes from Tiger.

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After hearing the outside counsel's report, Chairman John Gutfreund and President Tom Strauss telephoned the S.E.C., the Treasury, and the Federal Reserve Bank on August 9, 1991 and disclosed the violations that had been uncovered. A press release on the same day announced the problem to the investing public. Senior mangers also suspended Paul Mozer, Thomas Murphy, and two trading desk employees while the violations were under investigation. At a special board meeting on August 18, 1991, Salomon Inc's board of directors called for and received the resignations of Chairman John Gutfreund and President Thomas Strauss. At the same time, the board accepted Warren Buffett's offer to act as interim chairman of Salomon Inc and its subsidiary Salomon Brothers. The board also fired Paul Mozer, Thomas Murphy, and the two trading desk employees involved in the scandal. The next day, Warren Buffett accepted John Meriwether's unsolicited resignation.
Charles M. Williams Fellow Patrick Moreton prepared this update to "Salomon and the Treasury Securities Auction," HBS Case No. 292-114, from public sources under the supervision of Professor Dwight Crane as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright © 1992 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School.

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293-057

Salomon and the Treasury Securities Auction: 1992 Update

On August 19, 1991, Treasury Secretary Brady banned Salomon from the Treasury auction. After discussing the changes instituted at Salomon with new chairman Warren Buffett, Brady agreed to let the firm buy securities in the auction for its own account but not for other customers. In the subsequent weeks, several important customers temporarily severed relations with Salomon pending the resolution of the ongoing investigation. Shareholders and Treasury market investors named Salomon as the defendant in several class action suits.

Warren Buffett's Rescue
At a news conference on Monday, August 19, 1991, Buffett announced that Deryck Maughan, the co-head of investment banking, would be Salomon's chief operating officer. At the end of the week, Chief Legal Counsel Donald Feuerstein resigned and was replaced by a Warren Buffett choice, Robert E. Denham, a Wall Street outsider from Los Angeles. At the end of the month, Wachtell, Lipton stepped down as outside counsel. On September 5, 1991, Warren Buffett assured the Senate Subcommittee on Banking that Salomon would cooperate fully with all investigations. He also described Salomon's new compliance procedures, including the designation of Buffett himself as the chief compliance officer. At the urging of the subcommittee, Buffett severed all relations with the employees involved in the scandal, refusing to help with their legal expenses and cutting all severance arrangements. On September 25, 1991, Salomon senior managers met with customers to assure them that the firm's troubles were behind it, and that there was no risk of a collapse on the order of either Drexel Burnham's or E.F. Hutton's, both of which failed to survive criminal indictments in the 1980s. As part of an existing contingency plan, Salomon shrank its balance sheet from $134 billion on June 30, 1991 to $97 billion on September 30, 1991, thus reducing its reliance on short term debt, which had been downgraded to below investment grade. Salomon's common stock fell from $36e on August 8, 1991 to 21: on September 21, 1991. On October 30, 1991, Warren Buffet published a full page newspaper advertisement announcing several changes at Salomon. In the advertisement, Buffett characterized the scandal as follows: "A few Salomon employees behaved egregiously . . . but the misconduct and misjudgments were limited to those few. In short, I believe that we had an extremely serious problem but not a pervasive one." Buffett vowed to cooperate fully in all investigations and announced a $200 million reserve to cover the cost of all legal proceedings and fines. Buffett also announced a $110 million reduction in compensation, reflecting the firm's lower earnings and a restructuring of the its approach to compensation. Buffett noted that Salomon's "share-the-wealth" approach to compensation, left over from its days as a private partnership, was inappropriate for a "publicly-owned company depending on shareholder capital." Buffett summarized Salomon's new compensation philosophy as follows: "It is appropriate that the excess earnings of exceptional performers—that is, what they generate beyond what they are justly paid—go to the firm's shareholders." On November 6, 1991, Salomon Brothers announced the formation of a new executive committee. The committee, headed by COO Deryck Maughan, replaced the previous board of directors of the Salomon Brothers subsidiary. Stanley Shopkorn, the head of the equities department, and Jay Higgins, the head of Salomon's M&A department, two of the four Salomon Brothers board members who were not appointed to the new management committee, subsequently left the firm. At year end, a substantial number of equity department "stars" left the firm citing the departure of Stanley Shopkorn, the poor bonuses handed out, and a perceived reduction in the attention given to the equities and investment banking sides of the business. Salomon's share of new issue underwriting dropped from 10.1% for the first half of 1991 to 6.6% for the second half.1 By February 1992, Salomon had reversed its scale-back in compensation to stem the flow of talent out of the firm.

1. Leah Spiro, "Rescuing Salomon Was One Thing, but Running it . . .," Business Week, February 17, 1992, p. 120.

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Salomon and the Treasury Securities Auction: 1992 Update

293-057

On May 20, 1992 the S.E.C. announced a $290 million settlement with Salomon Brothers. The agreement, made up of $190 million in civil penalties and a $100 million fund for the payment of private claims (unclaimed amounts reverted to the Treasury), allowed Salomon to avoid criminal indictment. The settlement was second only to Drexel Burnham's $650 million fine in 1989 and was considered excessive by many on the street in comparison to the $3 million to $5 million in illegal profits Salomon was estimated to have made. Salomon announced a $185 million pre-tax chargeoff to cover the settlement's cost in excess of the previous $200 million in funds reserved. The firm still faced approximately 50 lawsuits from investors and other dealers. News of the settlement sent Salomon's stock up $2f to $332. With the settlement in hand, Warren Buffett resigned as chairman of Salomon Brothers on May 28, 1991 and appointed Deryck Maughan to the position of chairman and CEO of the Salomon Brothers subsidiary. Two weeks later Buffett resigned as chairman of Salomon Inc, the holding company, and selected Robert Denham, Salomon Brothers's chief legal counsel, to succeed him. The move caught most of Wall Street by surprise and represented the first time that a lawyer had headed a leading firm. For the first half of 1992, Salomon Inc earned a record $836 million pre-tax ($1.02 billion before the special charges related to the settlement), up from the previous record of $815 million in the first half of 1991. However, third quarter earnings plummeted to only $6 million, down 93% from the $85 million earned in the third quarter of 1991, as a result of a slump in trading profits. On December 2, 1992, the S.E.C. named Paul Mozer and Thomas Murphy as defendants in a civil suit accusing them of securities fraud and creating false records and books. The S.E.C. also alleged that Mozer violated insider trading rules when he sold his Salomon stock in August 1991 and engaged in illegal trades in 1986 to help Salomon evade taxes. Criminal investigations of Mozer and Murphy continued. On December 3, 1992, John Gutfreund, Thomas Strauss, and John Meriwether all settled civil suits with the S.E.C. Criminal investigation against the three were stopped and the S.E.C. apportioned management responsibility for Mozer's violations to the three executives based on their seniority and the efforts they made to address the problems. Gutfreund received a fine of $100,000 and a lifetime suspension from the securities industry. Thomas Strauss was fined $75,000 and suspended for six months. The S.E.C. concluded that Meriwether acted reasonably by immediately reporting the Mozer's violations, but still fined him $50,000 and suspended him for three months for failing to ensure that his superiors reported the illegal bidding to the government.

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