WALL STREET is predicting that 2005 will be a year of corporate marriages and initial public offerings of common stocks, and the Street is rejoicing. No doubt for Wall Street, resumption of both kinds of crapshooting will be good. Moneybags will rake in fees on mergers and acquisitions and amass fast bucks on hot new issues. But both activities are signs of a juiced-up market. So here's a warning to local investors: before getting seduced into such dice-rolling, bone up on San Diego's sorry history in the merger/acquisition and initial public offerings, or new issues, games.
As the San Diego experience attests, investors will be the losers. Before every proposed merger, suckers will be told that two plus two equals five. They'll be told that after two companies merge, each will be stronger. But in merger madness, two plus two often equals three. Both entities are likely to end up worse.
Similarly, an initial public offering is an insider's racket. Wall Street gets rich on investment banking fees and in the marketing and manipulation of the stock. Venture capitalists and founders buy their shares for pennies apiece, then unload them for one million percent profits. Ordinary investors, unless they get lucky, are left holding the bag.
A swarm of mergers and new issue offerings is an essential element of a stock market bubble, as was seen in the 1990s. In 1999, the average new issue zoomed 75 percent the first day, a certain omen the bubble would burst, as it did in 2000.
Last month was the hottest December ever for mergers. And in 2004, there were as many new issues as there had been the previous three years combined. So if 2005 is to be a year of mergers and new issues, stocks, selectively, may do well as a bubble expands, but beware: at some point the air begins leaking, slowly or rapidly.
All this means that if you are in the stock market, Wall Street touts will try to get you to buy shares of companies on the acquisition trail or companies that might be bought out for a fat premium. Your broker will try to woo you into a new issue, telling you how rapidly it will soar.
Tell the touts to go to hell. You live in a city that has been hell on earth for innocent lambs who got sucked into these rackets. The following history is revealing for another reason. National news articles on the city's current financial shenanigans repeat the myth that the San Diego business establishment is staid and conservative, that it was known for its cleanliness until recent problems emerged. 'Taint so.
Merger madness has cropped up throughout the history of capitalism, but the insanity peaked in the 1960s. Wall Street would bankroll a company, then tout its stock to the heavens. The company would use the inflated stock, as well as cash generated by massive borrowing, to gobble up doggy, disparate enterprises, then cook the books to make it appear that earnings were soaring.
Conglomeration was a mirage, and suitably enough, the semi-desert of San Diego produced two of the most rattlesnake-infested conglomerates: U.S. Financial and C. Arnholt Smith's Westgate-California.
U.S. Financial began business providing short-term loans to companies. In 1964, it went public at $4.62. Two years later, it acquired the businesses of Robert H. Walter and then installed him as chief executive. One of his businesses was SWAN Constructors. Walter boasted that the acronym stood for "Started Without a Nickel." He also boasted that he "would make housing happen."
Instead, he and colleagues made egregious book-juggling happen. U.S. Financial appeared to have booming sales and earnings because, among many things, it was selling products to itself. These shenanigans were exposed by New York accounting professor Abraham Briloff in articles in Barron's and, in 1972, in his book Unaccountable Accounting: Games Accountants Play.
The stock hit $62 in 1971. Assets were purportedly $311 million. There were 80 subsidiaries and more than 70 joint venture partnerships around the country. Management called it "the Sears Roebuck of the development industry." But in reality, U.S. Financial was like the proverbial 400-pound Texan who is given an enema and shrinks to the size of a Barbie doll.
"It was a conglomerate based on real estate, but it got into insurance companies and things like that," recalls San Diegan Dennis Schmucker, who was bankruptcy trustee and coauthor of a major report on the company's self-inflated bubble. U.S. Financial played two main games. "First, they were front-ending real estate." The company would sell out a development before it opened, such as 939 Coast Boulevard, a high-rise condo in La Jolla, and then book future revenue. Then it would estimate future expenses. "They were substantially understating expenses and therefore overstating profits. They would report profits on projects they really had losses on."
Secondly, "They would develop or acquire a property in Entity A and turn around and sell it to Entity B and book the profits, when Entity B was actually one of their own entities," recalls Schmucker. And sometimes, "Entity B was an outside shill."
There is no evidence that the company ever made any honest money, says Schmucker. "They created phony earnings and used the inflated stock to acquire other properties." Thus, the company was among the first to master the 1960s conglomeration scam.
But all balloons burst. As news clippings from the era related, U.S. Financial became one of the nation's largest Chapter 11 bankruptcies ever, in July 23, 1973. Stockholders got creamed. That was my first day as the new financial editor of the San Diego Union. For several months before arriving, I had been reading in national media about the calamities at U.S. Financial and C. Arnholt Smith's Westgate-California. Thus, the day after the bankruptcy, I was horrified to hear a top editorial executive of Copley Newspapers declare, "These are respectable people in San Diego." Respectable? Didn't anyone read the national financial press?
Walter, the chief executive at U.S. Financial, pleaded no contest in federal court to charges of conspiracy and filing a false report with the Securities and Exchange Commission. He got three years in prison, according to press reports at the time. Two other top executives got prison time on financial fraud charges. Five others got lighter sentences or stiff fines, as reported in local media. The company's accounting firm paid huge sums in civil suits and was censured by the Securities and Exchange Commission.
There was another, darker side to U.S. Financial. It borrowed money from a questionable, small Swiss institution, the Cosmos Bank. As a 1974 article in Business Week and a 1978 article in Forbes pointed out, this bank, which failed in the mid-1970s, had made deals to fund some very shady operations. One was Los Angeles-based Equity Funding, called "the fraud of the century" in one of three hot-selling books about the company published in the 1970s. Another was the Paradise Island Bridge, which connects a controversial gambling casino to Nassau, Bahamas. Another company getting money from Cosmos was Westec, considered one of the major auditing failures of the 1960s. Said Forbes, "Cosmos also made a concealed loan of $800,000 to Peñasquitos Corp., a [San Diego] land developer, which also received $100 million in loans from the much-investigated Teamsters Union Central States Pension Fund. The owner-operator of Peñasquitos, [San Diego's] Irvin J. Kahn, who died in September 1973, was involved in numerous deals with principals related to organized crime." (Full disclosure: as a staff member, I provided reams of information on the Cosmos Bank to Business Week. Also, I was a major contributor to the 1978 Forbes article.)
Investigative author Dan E. Moldea in his book Interference says that former president Richard Nixon stashed $35.9 million in the Cosmos Bank in 1971 and 1972. According to the Business Week story, "the Senate Watergate Committee and the special prosecutor's office looked into Cosmos Bank, among others, to learn whether it was a conduit for illegal Republican campaign contributions."
Like U.S. Financial, C. Arnholt Smith, who controlled Westgate-California and United States National Bank, had questionable associations. Owner of the Padres, Smith was beloved of the San Diego establishment. The downtown Rotary Club named him "Mr. San Diego," and a San Diego Union writer called him "Mr. San Diego of the Century." He was a close friend of the Copley newspaper clan -- as I soon learned in 1973 -- a lion of society, and the leader of the business establishment. But another longtime Smith associate was John Alessio, who ran a bookmaking operation in Mexico and went to prison in 1971 for tax evasion. Alessio boasted in a Union-Tribune article that he was one of the biggest shareholders in Smith enterprises. In the late 1960s, the two tried unsuccessfully to get the Del Mar Racetrack license and move it to their Oceanside track, San Luis Rey Downs, according to the North County Times.
In 1933, Smith and his brother had bought the ailing United States National Bank, and in ensuing decades, they acquired other banks.
Smith launched Westgate-California in 1960 and through rapid acquisitions created a hodgepodge: Yellow Cab operations in 13 California cities, a tuna fleet, the Westgate Plaza Hotel, regional airline Air California, Airport Limousine and Trucking Services, diversified manufacturer Golconda Corp., and scattered raw land.
In the mid-1960s, some Las Vegas entrepreneurs decided to build a posh resort in North County, named La Costa. The leader was Morris "Moe" Dalitz, a charter member during Prohibition of Cleveland's Mayfield Road Mob. In the 1950s, when Senator Estes Kefauver was investigating organized crime, Dalitz, asked about rum-running, snapped famously, "If you people wouldn't have drunk it, I wouldn't have bootlegged it."
U.S. National made the interim loans on La Costa, according to James Mulvaney, later the government-installed president of the bank. Then the Teamsters' funds would assume the U.S. National loans, explains Mulvaney. Teamster head Frank Fitzsimmons, "who had taken over for Jimmy Hoffa, used to come down to the ballpark regularly when the Padres were a minor-league team, and also when they were in the majors," says Mulvaney.
According to federal banking and securities regulators, the Smith-controlled bank would dole out money far in excess of legal insider-lending limits to the Smith-controlled conglomerate Westgate-California and also to Smith's cronies, such as Alessio, La Costa developers, and owners of farm acreage.
"Smith used the bank as his cash register," says Dave Stutz, who probed Smith and John Alessio for a combined federal and state organized-crime strike force. Stutz, who retired last year from the district attorney's office, says Smith made sure that the majority of bank officials "were in his pocket; they would approve anything -- gave him a cash cow to build his empire and fund his friends," such as Alessio and Dalitz.
The strike force was investigating alleged hoodlums that hung around La Costa, says Stutz. Despite bad national publicity about La Costa, U.S. National didn't stop shelling out construction loans; it kept funding the Vegas entrepreneurs, particularly for purchasing surrounding real estate. "I saw all the loan reports generated internally within the bank for La Costa," says Stutz. Dalitz and his pals would routinely request loans of $50,000 and $100,000 and get them. "The bank carried the La Costa loans on the books; they were rolled over but not always paid."
As the bank headed for insolvency in the early 1970s, phantom transactions appeared, says Stutz. Smith and bank officials "set up 80 or so different corporations that were just on paper. There was no corporation. They would roll the loans over into these entities."
In the early 1970s, the Securities and Exchange Commission accused Smith of fraud. Trading in Westgate stock was halted. In a settlement, Smith was removed from office. Federal banking authorities shut down the bank in 1973 -- at the time, it was the largest bank failure in U.S. history. Almost 40 percent of the loans were to Smith companies or cronies. Comptroller of the Currency James E. Smith called the bank's unkempt operations the result of "total fraud." The Smith financing machine was "self-dealing run riot." Initially, stockholders of both the bank and the conglomerate got clobbered.
Smith eventually pleaded no contest to federal felony bank fraud. The government showed that when his bank was shoveling money to his pals, some of it was going into his pocket, pointed out press articles of the time. But Smith was given probation. The public howled. The district attorney nailed him for embezzlement of almost $9 million. In 1984, he was incarcerated, sort of -- he tended flowers for eight months at a work furlough center in Southeast San Diego. He died in 1996.
And he died penniless, says Mulvaney. Most white-collar criminals stash loot offshore and have plenty left after serving time. Not Smith. Shortly before he died, Smith called Mulvaney. Smith groaned that he didn't have anything to eat. "He asked if I would send $150," recalls Mulvaney. "I thought he had stashed money away somewhere. But he didn't have a frigging nickel."
He had built so much -- indeed, the Westgate hotel had resulted from a conversation with former President Dwight Eisenhower. The two had been drinking in the old El Cortez hotel. Schmucker remembers this conversation with Smith: "He said Ike asked if this was the best hotel in San Diego. Smith was so embarrassed for San Diego that he built the Executive Hotel and from there built the Westgate."
But Smith, in fact, was not all that bright. Mulvaney puts it gently: "He was a gambler. He couldn't stop buying. He was a good acquirer but paid little or no attention to ongoing operations."
Says Norman Roberts, longtime San Diego investment banker, "Arnie was hardly an intellectual giant, but Alessio, actually, was pretty smart."
The 1960s and 1970s produced other conglomerate dillies. Harvard Law graduate Walter Wencke ran unsuccessfully for Congress in 1960 as a Democrat -- with Republican Smith's blessings. Then Wencke concentrated on building a conglomerate, winding up with 178 corporations and 46 partnerships in trucking, agriculture, bookkeeping, hotels, and real estate, including half ownership of a Holiday Inn in San Francisco's financial district. He also managed to stash money in offshore tax havens and even tried to set up a bank in the Cayman Islands pirate cove, according to articles in the San Diego Union.
But in 1978, he was convicted of mail fraud and filing false statements with the government. He was scheduled to go to the slammer in October 1979, but he fled and hasn't been seen since. It's assumed he joined his money offshore.
In 1962, Norman Roberts's brokerage firm sold an initial public offering of a company that invested in emerging enterprises. In 1968, Charles "Red" Scott, an effervescent horse trader who hired only confirmed optimists, got control of the company and later changed its name to Intermark, recalls Roberts.
Scott's Intermark owned grimy industrial companies. It also got into consumer enterprises. But two of Intermark's biggest San Diego investments, Nurseryland and Liquor Barn, tanked. For a while, Scott controlled the big specialty retailer Pier I. He controlled half of San Diego's Mission West Properties. And he managed to get more than 25 percent of the stock of Fuqua, an Atlanta conglomerate.
But Intermark and a companion company were unable to service their debt. In 1992, they went into bankruptcy.
Scott went to Atlanta to head Fuqua, where he began feuding with management, according to a detailed 1993 article in Forbes. Soon, he left. However, the loquacious entrepreneur's cornball aphorisms are still quoted in collections of maudlin business sayings. For example, the Horatio Alger Association quotes Scott opining, " 'I will' beats 'IQ' every time."
A rapid-fire acquirer of the era was Richard L. Burns. He moved his R.L. Burns Corp. from San Bernardino to San Diego in 1977. He bought one of La Jolla's most opulent mansions and gave lavishly to charity, as San Diego Union articles of the time attested. His company bought Texas oil wells, a dangerous game for a non-Texan. Mark Twain once defined a gold mine as "a hole in the ground with a liar on the top." Burns didn't realize that Twain's wisdom applied in spades to Texas oil wells, recalls Roberts. The company failed ignominiously.
Undeterred, Richard L. Burns bought control of Nucorp Energy and went on another acquisition spree, buying oil field equipment with stock that had zoomed more than 2000 percent in two years, according to press articles of the day. But no company can sustain such an acquisition binge. The acquirer inevitably buys dogs. Nucorp plunged into bankruptcy in 1982, and the Securities and Exchange Commission charged Burns with doing what San Diego's Peregrine Systems did many years later: booking a sale long before the product had been made and delivered legitimately.
Peregrine Systems, a software company headquartered east of Del Mar, was a case of accounting fraud that facilitated a planned acquisition binge -- all tied in with massive insider trading. Eleven people have been criminally indicted for allegedly helping to inflate the company's revenue by 40 percent between 1999 and late 2001. Among many things, insiders are charged with using techniques such as giving kickbacks to customers to get them to commit to buying products and then ringing up a sale even though the products weren't sold.
Former Peregrine chairman and majority Padres owner John Moores unloaded $487 million of stock during the fraud period and $650 million worth overall. Although he spent much of his time at the company, where he had an office, and essentially controlled the company, according to civil suits, he and some self-purported "outside" directors have not yet been charged. The investigation is ongoing.
As the books were being cooked and insiders were bailing out, the stock ran up almost to $80. The higher stock price would be used as currency to make acquisitions, according to civil suits against former directors and managers. "The higher the price of Peregrine stock, the fewer the number of shares Peregrine would have to issue for each acquisition," says one civil suit filed in federal court here. Because one acquisition was expected to depress Peregrine stock temporarily, directors were told not to sell their shares, according to the civil suits. But they unloaded them anyway. The company went through bankruptcy and is now trying to recover.
During the 1990s, FPA Medical Management, a Wall Street darling headquartered in La Jolla, bragged that it could be a middleman between insurers and physicians -- promising doctors that it could relieve them of clerical costs by handling payments to health insurers. As the stock soared, FPA bought out the practices of many doctors all across the United States. The company reported steadily growing profits until it suddenly filed for bankruptcy in 1998.
Through phony accounting, the company had made it appear that operating cash flow was soaring. It wasn't, as Department of Justice investigators found. With the collapse, more than 1600 doctors owed $60 million to insurers. Those physicians who had sold their practices in exchange for FPA's inflated stock were wiped out. In March of last year, the former chief financial officer, Steven M. Lash, was sentenced to 51 months in prison for mail and wire fraud, as well as defrauding a lender.
Other San Diego acquirers suffered from bad judgment, bad timing, and bad luck and sometimes drew the attention of regulators, but they weren't quite so egregious as the ones that commanded national attention.
Wickes Companies moved its corporate headquarters to downtown San Diego in the early 1970s. The company was already diversified, owning heavy machinery operations, as well as lumberyards, furniture stores, Builders Emporium hardware outlets, and the like. In 1980, Wickes bought Gamble-Skogmo, a Minnesota mishmash with supermarkets, drugstores, discount stores, and discount catalogs. And a huge pile of debt. Wickes doubled its debt to take on the mess, just as interest rates were soaring. The rapidly rising interest rates hit the housing market and soon walloped Wickes's furniture and lumber businesses. At the same time, Wickes was paying higher rates on some of the debt it inherited from Gamble-Skogmo.
Wickes went into bankruptcy in 1982. Then Sanford Sigoloff, known as Ming the Merciless, moved the company to Santa Monica and started paring it down ruthlessly. But after Wickes emerged from bankruptcy in 1985, Sigoloff got mixed up with junk bond king (and later jailbird) Michael Milken. Sigoloff took on more debt and started making acquisitions again. But the acquired companies ran into trouble. In 1988, a troubled Wickes was bought out, as several San Diego Union articles revealed.
For years after its founding in 1983, Sunrise Medical was a successful acquirer of home medical-equipment makers. Sunrise was famous for such products as its Quickie, Breezy, and Guardian wheelchairs, and oxygen and sleep therapy devices with the DeVilbiss name. It moved to Carlsbad from Torrance in 1994 and the next year was already in trouble. It revealed in Securities and Exchange Commission filings that it was investigating suspicious accounting at some of its subsidiaries.
The company had an aggressive bonus program that rewarded spectacular divisional results. But some division executives produced those results with a pencil and eraser, the company learned from its own probe. Sunrise paid $20 million to settle class-action suits. Then in 1999, the Securities and Exchange Commission charged it with keeping falsified books, issuing false financial statements, and failing to maintain adequate internal accounting controls. In 2000, the company was bought for one-third the price its stock had once achieved.
Inland Entertainment had a prosperous business as a consultant to the Barona casino. But in 1998, it got bitten by the dot-com bug. It renamed itself Venture Catalyst and began investing in start-ups with titillating names such as clickNsettle.com, Companyfinance.com, Spun.com, and Idealab. The stock soared above $20. But the dot-com bubble burst in 2000, and shortly, Venture Catalyst wasn't getting money from Barona either, for unrelated reasons. The stock cratered, along with the company, as Union-Tribune articles pointed out.
In the 1990s, Steakhouse Partners, which started in San Diego in 1967 as the Jolly Ox, thought it could revive some ailing restaurant chains that had been snapped up in an acquisition spree. But Steakhouse Partners, with its Hungry Hunter, Hunter Steakhouse, Mountain Jack's, and Carvers, had too much debt and too many restaurants serving cholesterol-sated food. It filed for Chapter 11 bankruptcy in 2002.
Many studies, such as those by Wall Street's Sanford R. Bernstein, have shown that the acquisition route is the very worst for corporate growth. Indeed, most mergers and acquisitions don't work well, as the San Diego experience demonstrates. But the game is rolling again. Why? Corporate managers, running a larger enterprise, can justify higher salaries for themselves. Wall Street rakes in big fees and makes money while the stocks plunge and soar.
There's another game that's bad for investors but great for Wall Street and insiders. It's the initial public offering, or new issues, racket. When markets are sober and corporations and their financiers are sincerely trying to raise money, the market for new issues of stock is a legitimate keystone of capitalism. But when markets are high on giggle juice, as in the late 1990s, the new issues market can be abusive.
The initial public offering gets its imprimatur of respectability from the legendary inventors who launch a company in a garage, with some money provided by a venture capitalist. By the time the company goes public, the founders and financiers have shares for a penny apiece. After the company goes public, the insiders sell for huge profits. That is legitimate -- sometimes a Horatio Alger story. But flimflammers see this as a route to a fast buck: forming a company, giving founders and early investors stock for almost nothing, going public whether or not there is hope for business success, and dumping as many shares as legally possible before the hot-air balloon pops.
In a giddy market, the shares are manipulated. Demand is hyped while supply of stock is squeezed. When that happens, it's often clear that insiders are more interested in making a fast buck than raising funds for the company. Actually, if a new issue leaps from $10 to $20 the first day, a company truly interested in raising capital would fire the underwriters for not pricing the stock at $20 so the company would reap the full benefits.
During the 1990s, Wall Street was "laddering" new issues. The underwriters would tell one big brokerage that it could have 100,000 shares of a hot new issue if it would commit to buying the shares and paying $11. The next had to pay $11.75, the next $12.50, the next $13.30 -- and on up the ladder. Small investors noted the rising prices and jumped in. When the price got high, the insiders sold. When a little penny stock promoter gets caught in such obvious manipulation, he goes to jail. But these were Wall Street's biggest, richest, most politically connected firms. They got off with wrist slaps.
San Diego was loaded with hot new offerings in the madcap 1990s. New issues of biotech, telecom, and tech stocks came out by the bushel. On opening day, new issues of software companies Websense and JNI doubled, while biotech Diversa and online music maker MP3.com tripled. Almost all of the local 1990s new issues employed dedicated scientists and engineers trying to build a company. But some of the top executives had a history of getting rich quick in new stock offerings and then selling out and going on to the next bonanza.
Illumina, a University City-based biotech that produces tools for analyzing genetic variations and functions, went public July 28, 2000. The issue was priced at $16. The first trade was at $29.88, and it closed the first day at $39.17. It then rocketed to $51.62. It's now under $10. The company continues to lose money, although the red ink isn't flowing as profusely as earlier. Insiders aren't complaining; they paid between one cent and nine cents for each of their shares, according to filings with the Securities and Exchange Commission. There was a lot of selling during December 2004, filings show.
Eastgate Mall-based Wireless Facilities, which does network design and management for the wireless communications industry, went public November 5, 1999, at $15. The first trade was at $37.50, and the stock quadrupled the first day, closing at $62. Then, riding the telecom bubble, it soared to $163.50. The company lost bundles of money in 2001 and 2002 and made a modest profit in 2003. Last August, it announced it would restate its profits downward for the previous four years. The stock plummeted 18 percent that day. Now it's selling under $10. The founders got their stock for between one-third of a penny and 2.3 cents, and some of that stock has been sold. Venture capitalist board members got shares for 93 cents to $1.58 each and have also been dumping, corporate records reveal.
Another biotech, Immune Response Corp., went public in 1990 below $10 a share. Before long, the stock had shot up to $60. At the time, it was based in La Jolla, and its main claim to fame was its cofounder, Dr. Jonas Salk, renowned developer of the polio vaccine. The company wanted to develop a therapeutic AIDS vaccine using a technique similar to Salk's approach to polio.
Salk (who died in 1995) and other insiders received shares for one-fourth of one cent each. Insiders began selling from the get-go. But the company, now based in Carlsbad, continues to report big losses on minuscule revenues and has a stunning $323.5 million cumulative deficit, according to official records. The stock sells for below $1.40.
Large profits from new issues seldom hit the news. But one hot new issue was big news in San Diego in 1999. The company was Neon Systems, a software developer based in Texas. It was controlled by John Moores, who at the time was trying to wangle a ballpark from the San Diego City Council. Moores cut councilmember Valerie Stallings in on the "friends and family list," meaning she got shares at the initial price. Few get this kind of privilege. The stock rocketed up 67 percent the first day. Stallings held on for only 26 days and dumped her shares for a 267 percent profit.
Immediately after consulting with Moores, Stallings sold her stock at $49.15, within $1.10 of the stock's all-time high. But the then-U.S. attorney insisted that Moores had no inside information on where the stock was going. She made a killing. He got a ballpark. She got a wrist slap.