When Bankers Started Playing With Other People's Money

On the afternoon of May 22, 1969, Dan Lufkin, the 36-year-old cofounder of the small research-focused investment-banking and brokerage firm Donaldson, Lufkin & Jenrette, or DLJ, walked into his first board of governors meeting at the august New York Stock Exchange, then, as now, located at the corner of Broad and Wall Streets, carrying with him a copy of a document that he had filed two hours earlier with the Securities and Exchange Commission (SEC). It was the first step in the process that would transform DLJ from a 10-year-old private partnership, with its stock owned by the firm’s partners and their friends, into a public company with shares that could be bought or sold by anyone willing to do so. It also would allow DLJ to get greater access to more affordable and badly needed capital than its partners would otherwise be able to provide.

DLJ “is the first member corporation of the New York Stock Exchange (NYSE) to offer its equity securities to the public,” the firm proclaimed on the cover of its prospectus. DLJ’s decision to sell a portion of its equity to the public—it was hoping to raise $24 million—was a direct challenge to a nearly 200-year-old NYSE rule that prohibited member firms from selling stock to the public because the NYSE had to approve all stockholders of a member firm. Obviously, with a public company’s stock being bought and sold nearly every hour of every day, the NYSE would no longer be able to approve, or not, the DLJ stockholders.

Wall Street would never be the same. And not necessarily for the better.

That was just fine with the brash and aggressive founders of DLJ, who were eager to challenge the status quo on Wall Street and everything that it meant to be a Wall Street securities firm. Ever since the three founders met at Harvard Business School and decided to start a brokerage firm together with around $500,000 in cash, they always hoped to attract permanent capital by turning to the public as investors. DLJ was a small but very profitable firm, as the document Lufkin had with him attested—revenue in 1969 was $30.4 million and pretax income was nearly $14 million, a 46-percent profit margin—and the three partners knew that to continue growing and to take advantage of the myriad business opportunities available to them, they needed more capital. (For instance, DLJ had just bought Louis Harris and Associates, the polling firm, for 80,000 shares of stock.) They had always wanted to go public, and this was their chance, especially because Lufkin had grown tired of the years the NYSE spent studying the issue, without making any progress. Lufkin knew that going public was against the NYSE rules and that DLJ could be kicked out of the NYSE club, which, of course, had the potential to damage materially its future profitability. The firm hoped that the board of governors would somehow see the situation its way and allow it to remain an NYSE member and also to go public, especially in light of another burgeoning crisis—the so-called “back-office crisis,” when many brokerage firms could not process their paperwork fast enough and then failed—that was exposing how woefully Wall Street was undercapitalized. “However,” the firm said in the prospectus, “DLJ’s ability to avail itself of opportunities for continued growth is a more important consideration. Capital additions can be effectively utilized immediately and are essential to the maintenance and improvement of its competitive position.” To try to see if he could ease a path forward for DLJ’s IPO, Lufkin had dinner the night before the board of governors’ meeting with his close friend Bunny Lasker, the NYSE board chairman, at Lasker’s Park Avenue apartment. Lufkin told Lasker about the plan for the DLJ IPO, which until then had been a carefully guarded secret. This is how Lufkin remembers the exchange, 30 years later:

“You’re crazy,” Lasker told him.

“I hope not,” Lufkin replied. “Well, Bunny, we’ve been studying this thing for five years and nothing’s getting done, so nothing is changing about that conclusion, but it’s time we get something done.”

Lasker replied, “Well, I can’t support you. If it comes up at the meeting tomorrow, I’m just going to say, ‘We’re fortunate to have Dan Lufkin, who will be able to explain this.’ That’s all I’m doing.”

The next day, a very nervous Lufkin distributed the IPO documents to the assembled governors. They asked the requisite questions about what could possibly have possessed Lufkin and his partners to make such a rash decision. He explained how DLJ needed a permanent source of capital to grow, to make acquisitions, to redeem the stock of partners looking to leave the business, and to be able to attract new partners. It all made sense, but it was absolute heresy.

The leaders of the NYSE, while appalled by DLJ’s gambit, had little choice but to follow the NYSE’s bylaws for amending its constitution. They knew, deep down, that in order to continue financing the growth of the country’s great businesses, Wall Street needed more capital. The easiest and cheapest way for Wall Street to get the capital it needed was from the public, just as Wall Street’s corporate clients had been doing for more than a century. Soon after DLJ filed its IPO prospectus with the SEC, Lufkin proposed amendments to the NYSE’s constitution that would allow member firms to go public, as, of course, nearly any other corporation could do, with Wall Street’s help. DLJ was simply trying to do for itself what Wall Street had been doing for other American businesses for nearly two centuries: helping them to raise the capital they needed to grow their businesses from the people who had capital they wanted to invest. And for many of the same reasons: DLJ needed the capital, which was more plentiful and cheaper than private capital, to grow its business, to hire more people, and to consider getting into new business lines.

On April 10, 1970, nearly a year after first filing its IPO prospectus with the SEC, DLJ pulled it off, raising $12 million from the public and as a result fundamentally altering how Wall Street has functioned ever since. “Going public changed Wall Street permanently and forever,” Richard Jenrette (the J in DLJ) told the Times. “If Wall Street had remained in a private mode, it would have acted like a club and been so vastly undercapitalized that someone would have taken it over long ago. There would have been no alternative but to have let the [commercial] banks take over”—something that the Glass-Steagall law, of course, had made illegal. The truth was going public made perfect sense for DLJ and the many Wall Street firms—nearly every one—that followed its lead.

The problem is that the country is still dealing with the unintended consequences of the DLJ IPO to this day. And, of course, back in 1970, very few people, if any, were paying attention to what a small private partnership on Wall Street was trying to do to change the system. And honestly, the importance of the DLJ IPO has still not been fully appreciated. But it was a seminal event.

Whereas for more than 150 years Wall Street firms had relied on the prudent use of their partners’ capital to take risks—which nonetheless occasionally went awry—and to run their businesses, knowing full well that a single mistake could spell the end for their firms, as well as threaten whatever fortunes they had personally built up over the years, the move by DLJ was destined to change the whole calculus of Wall Street. If DLJ were successful, if the public’s capital could be substituted for partners’ capital, if the public’s legal liability for mistakes could be substituted for the partners’ legal liability for mistakes, there would be no telling what the consequences would be both for Wall Street and for everybody who relied on Wall Street to raise capital, to provide liquidity in the buying and selling of stocks and bonds, and to help individuals manage and grow their wealth. Although it was unlikely the founders of DLJ could have anticipated all of what its IPO would unleash over the next nearly 50 years, they must have had some inkling that by substituting a bonus culture—where bankers, traders, and executives demanded to be paid for the revenue they generated in their various product lines—for the long-standing partnership culture—where the individual partners of the firm collaborated to make sure only prudent risks were taken in order to ensure there would be annual pretax profits for them to divide—Wall Street would never be the same.

And the behavior of Wall Street bankers, traders, and executives since 1970 as one firm after another followed DLJ’s lead, has proved unequivocally that neither Wall Street nor much of the world’s economy would be left unchanged. People are pretty simple; they do what they are rewarded to do. Thanks to the DLJ IPO, bankers and traders were being rewarded to take outsized risks with other people’s money and with very little financial accountability when things went wrong, as happens with far more frequency and severity than anyone cares to acknowledge. Before the DLJ IPO, mistakes made by partners at individual firms could be personally devastating for them, causing one existential crisis after another, if not causing the firm to go out of business.

After the DLJ IPO, the stakes were very different. Firms had much easier access to capital—in the forms of both debt and equity—and that capital largely came from outside investors, often leaving the original partners of the firm very wealthy and with little of their own capital left at risk in the firm. The idea of essentially playing with the house’s money and being rewarded for it would lead Wall Street’s numerous critics to refer to it as a casino, where the house always finds ways to win. It forever altered the reward system that had been so carefully calibrated over the centuries to encourage prudence over wanton risk taking and to emphasize long-term profitability over short-term greed.

Ultimately, the unintended consequences of the DLJ IPO would be devastating. In October 1970, Weeden & Co. followed DLJ’s lead and went public. Then the floodgates opened. In December 1970, a small firm Pressman, Frohlich & Frost, went public by merging with another, already public financial firm. Its chairman, Stanton Pressman, told The New York Times that the times they were a-changing, and fast. “Without major public capital,” he said, “I think member firms are going to find themselves very hard-pressed to compete. The little grocery store in this business is just not going to make it. You’ve got to have the ability to do much more.”

Pressman was right (although his firm is long defunct). In April 1971, Merrill Lynch, the largest brokerage firm on Wall Street, announced its plans for a $120 million IPO. The New York Times called it a “milestone” that would “set the standard” for other Wall Street firms to go public. The news was on the front page of the paper, its lead story of the day. In September 1971, Bache & Co., the nation’s second-largest brokerage, announced plans for its own IPO, in part to be able to compete better with Merrill Lynch, which had increased its capital by nearly 50 percent with its successful IPO. Suddenly the remaining private partnerships found themselves at a significant competitive disadvantage, having to compete against their better-capitalized peers. What had been for nearly two hundred years an industry of small, poorly capitalized private partnerships was being rapidly transformed into a group of bigger, more powerful public firms with easy access to cheap capital. The existential question for the firms that remained private was whether they intended to try to compete with their public peers or to remain small and focused.

But, truthfully, there was very little choice, especially if firms wanted to compete in the underwriting or trading businesses which required tremendous amounts of capital. In 1981, Salomon Brothers, the big bond house, merged with Phibro Corporation, a publicly traded commodities dealer, and eventually became Salomon Inc., a public company. Also in 1981, American Express bought Shearson Loeb Rhoades, a brokerage firm, and Prudential Insurance bought Bache & Co. In 1984, American Express added Lehman Brothers to its stable. In 1985, Bear Stearns & Co. went public. Morgan Stanley went public in 1986. In 1994, American Express spun off the combined Lehman and Shearson to the public. After years of internal debate, which had begun to take on the feel of a Shakespearean drama, Goldman Sachs, the most profitable and envied Wall Street firm, decided to go public in May 1999, making the partners lucky enough to be there on that day extremely rich. Even Lazard Fréres & Co., which prided itself on its quirkiness and iconoclasm—and its intense privacy—went public in May 2006. The partnership culture that had dominated and molded Wall Street behavior for nearly 200 years was over. Wall Street would never be the same, nor for that matter would the American economy it supposedly served.

It would take a decade or so, but by the late 1980s Wall Street had been utterly transformed from a series of relatively small, undercapitalized private partnerships, where the partners of the firm supplied the sparse capital needed and faced the risk of losing it every day, to a group of fast-growing publicly traded companies, where capital was relatively cheap and relatively abundant and where there was a distinct disconnect between the people who supplied the capital—the shareholders and creditors—and the people who managed and worked at the firms. The fundamental link between capital, risk taking, and accountability had been severed, never to return—or not yet anyway.

As a result, the culture of Wall Street was forever transformed from small, intimate petri dishes of greed and caution, where prudent risk taking was celebrated in hopes of generating sufficient pretax profits on an annual basis that could then be distributed to the partners, into a Darwinian free-for-all, where bankers, traders, and executives were rewarded for taking big risks with other people’s money in the hope of being able to justify to a division manager that they deserved—indeed must have—multimillion-dollar annual bonuses. In short order, Wall Street’s incentive system—what people got rewarded to do every day—went from being focused on a sense of collective benefit, where the partners risked on a daily basis nearly everything they had worked for in their lives, to one where, despite corporate window dressing to the contrary, each individual’s annual bonus discussion was based largely on how much revenue had been generated in the previous year. It was a relatively simple calculus: Those bankers, traders, and executives who had generated the most revenue were rewarded with the biggest bonuses, the amount of which always managed to seep out for everyone to know. Those who had not produced the revenue were given small bonuses or fired. The new culture on Wall Street was one that encouraged swinging for the fences—taking big risks with other people’s money—in hope of getting a big annual bonus. The message was clear: Either produce or you’re out. And everyone knows where that has led.

This article has been adapted from William D. Cohan’s book, Why Wall Street Matters.