When THE SNOWBALL: WARREN BUFFETT AND THE BUSINESS OF LIFE (BANTAM) was originally published in fall 2008, Alice Schroeder's intimate account of the man known as "The Oracle of Omaha" made national headlines. The book's publication also happened to coincide with the depression of the global economy and the collapse of America's banking system. In this seven-part series, Schroeder details Buffett's reaction to the economic crisis, the November presidential race and election of Barack Obama, as well as the decline of Berkshire Hathaway's stock from Triple-A status.
On October 23, 2006, Berkshire Hathaway became the first American stock to trade above $100,000 per share. By the end of 2007, BRK reached $149,200, which gave Berkshire a market value of more than $200 billion. Berkshire was the world's most respected company, according to a Barron's survey. Buffett's personal fortune exceeded $60 billion, and only a few months earlier, the Dow had reached its all-time high of 14,164.53.2 Businesses were posting record earnings; the market, as a discounting machine, built into stock prices the expectation that an even greater and growing stream of money could be coaxed from consumers' pockets.
Buffett dampened his own shareholders' expectations of Berkshire, yet showed no signs of giving up control or competing any less aggressively than before. Even so, a few of Berkshire's longtime shareholders began to sell stock. Some were donating appreciated shares to charity at a recently run-up price. Others cited Buffett's age; he was approaching seventy-eight. And inevitably, the $149,200 price tag for a single share of BRK drew in the sort of new investors who always buy in at the top.
As reflected in Berkshire's stock price, Buffett had been enjoying a period of almost unbroken success since the end of the Internet bubble. Only one episode of any significance marred the record of these six years. This was a legal threat to Buffett and to Berkshire that, at least initially, was as serious as Buffett's earlier encounter with the SEC over Blue Chip, and Salomon's near brush with death. It had to do with General Re, Buffett's onetime problem-child investment, which had--at least financially--undergone a remarkable recovery.
By 2007, the company had become the most successful of Berkshire's long string of insurance turnarounds. After $2.3 billion of cumulative losses related to insurance and reinsurance sold in prior years, and $412 million of charges for the runoff of Gen Re Securities, the company's derivatives unit, General Re was reporting the most profitable results in its history, with $2.2 billion of pretax operating earnings.3 It had earned back the losses and restored its balance sheet to a better condition than when Buffett bought it; it was operating with nearly one-third fewer employees and the company had been transformed.
General Re had escaped the fate of Salomon and overcome the stigma of its Scarlet Letter. Buffett was finally able to praise it and its senior managers, Joe Brandon and Tad Montross, in some depth in his 2007 shareholder letter, saying "the luster of the company has been restored" by "doing first-class business in a first-class way."
But at the beginning of 2008, four employees of General Re and one employee of AIG were put on trial in Hartford, Connecticut, on charges of federal criminal conspiracy. For those on trial, the next few months would bring to a climax the years of hell that white-collar criminal investigations impose on their subjects. For Buffett, the trial would mean the beginning of the end to this particularly golden chapter of his life.
The trial came about as a consequence of General Re's last act of ignominy before its change of management in 2001. General Re had created a Salomontype scandal of its own in which it broke Buffett's rule of not "losing reputation for the firm." This was the event that had, as it unfolded, adjusted Buffett's perception of the new legal-enforcement environment, in which showing extreme contrition and cooperation produced no advantage in how a company was treated by prosecutors. Extreme contrition and cooperation were now the expected minimum standard--in part because of Salomon. Anything short of that--for a company to defend itself or its employees, for example--could be considered grounds for indictment. Trying to exceed the minimum threshold for extreme contrition and cooperation, as Buffett was always inclined to do when confessing any sort of mistake or flaw, could even be a disadvantage now, attracting more attention to a company at a time when the fairness of certain state and federal criminal procedures was being questioned.
General Re had first become entangled in legal and regulatory problems when New York Attorney General Eliot Spitzer started investigating the insurance industry over "finite" reinsurance in 2004. "Finite" reinsurance has been defined in many ways, but, put simply, it is a type of reinsurance used by the client mainly for financial or accounting reasons--either to bolster its capital or to improve the amount or timing of its earnings. While usually legal and sometimes legitimate, finite reinsurance had been subject to such widespread abuse that accounting rulemakers have spent decades trying to rein it in.
In 2003, both General Re and Ajit Jain's Berkshire Re were condemned in a special investigation for selling finite reinsurance that allegedly contributed to the 2001 collapse of an Australian insurer, HIH. Two years later, General Re was accused by insurance regulators and policyholders of having sold fraudulent reinsurance in the 1990s in connection with the failure of a Virginia medical malpractice insurer, the Reciprocal of America. Though the Department of Justice investigated the allegations extensively, no charges were brought against Gen Re or any of its employees.8 That same year, Eliot Spitzer's investigation of the insurance industry prompted an additional investigation that concluded that six General Re employees had conspired with one AIG employee to aid and abet an accounting fraud for AIG. Before long, the New York State investigation was joined by the SEC and the Department of Justice.
In June 2005, two of the conspirators, Richard Napier and John Houlds - worth, plea-bargained and agreed to testify for the prosecution against General Re's former CEO, Ronald Ferguson; its former chief financial officer, Elizabeth Monrad; its head of finite reinsurance, Christopher Garand; and its general counsel, Robert Graham; as well as Christian Milton, head of reinsurance at AIG, all of whom were indicted on federal conspiracy and fraud charges. At the same time, the SEC and the Department of Justice began pursuing a settlement of some sort with Berkshire Hathaway.
The defendants were tried together as conspirators in a case that began in federal court in Hartford in January 2008 and lasted for several weeks. It was noteworthy for the prosecution's use of numerous e-mails and taped telephone conversations in which several of the defendants had repeatedly discussed the matter in colorful terms. The fraud had been executed through a reinsurance transaction designed to deceive investors and Wall Street analysts by transferring $500 million in reserves to AIG to window-dress AIG's balance sheet. This made AIG appear to have more claim reserves than it actually had, which soothed analysts' worries that AIG might be overstating its earnings by failing to record sufficient expenses for claims. In fact, AIG was doing just that.Spitzer, joined by the SEC and the Department of Justice, had investigated this question, and Munger, Tolles & Olson, led by partner Ron Olson, who sat on Berkshire's board, had conducted a massive internal investigation at Berkshire Hathaway. The investigation, which subsequently expanded to include the AIG deal, focused mainly on General Re and its employees. Munger, Tolles was required to, in effect, act as an arm of the prosecution, and worked with the handicap of representing Berkshire Hathaway, General Re, and Buffett personally as its clients. The conflicts posed by this set of relationships were unusual, although not unheard of in the legal profession. Ordinarily Buffett would not tolerate, much less create, such a conflict-riddled situation, but the investigation terrified him and threatened his deeply ingrained desire for privacy.
Buffett thought of himself and Berkshire as indistinguishable. He had fought like a Rottweiler earlier in his career to escape being named in the consent decree to the Blue Chip fraud case. He was far more invested in his gargantuan reputation now, both psychologically and from a business standpoint. During the months in 2005 and 2006 that the investigation was at full boil, the threat to his reputation from the case obsessed him.
Buffett was put through an awkward investigative process by Munger, Tolles and interviewed by the government, but Spitzer was quick to clear him. In April 2005 (five months after he entered the race for governor of New York), Spitzer told George Stephanopolous on ABC This Week that Buffett was "only a witness." He called Buffett an "icon" who had "succeeded in the right way" and who stood for "transparency and accountability." One need not be a cynic to detectthat Spitzer might have been angling for an endorsement from the Buffalo News in the governors' race.
After New York handed the criminal charges over to the Justice Department for prosecution, Buffett still remained in some jeopardy. If prosecutors could find enough evidence to indict Buffett, they would certainly do so. The question was, what is "enough"?
Contrary to the way they are often portrayed on television, modern prosecutors are not simply on a moral crusade trying to bring the guilty to justice; they are pragmatists who make strategic and tactical decisions. Faced with Warren Buffett, America's icon of business ethics, the prosecutors churned through a unique calculus. There could be no greater prize for a prosecutor than to convict Warren Buffett; locking up Buffett could put a journeyman attorney on the road to the Supreme Court.
On the other hand, who would take the risk of prosecuting Warren Buffett and failing to convict him? If Buffett had been caught on videotape mugging and snatching a purse from a ninety-year-old lady, there was a pretty good chance a jury would decide that the tape was doctored, she was the mugger, and he deserved a medal--and he would walk. Not only that, prosecutors wanted Buffett as a potential witness because of the star power and credibility he would bring if he testified on their behalf.
In the end, Buffett was omitted from the government's list of unindicted coconspirators. Some believed that he received kid-glove treatment because of his status as an almost untouchable figure in business. Many in the insurance industry were infuriated because they felt Ferguson and the others were being treated unjustly, especially by comparison. Buffett was left wide open to such perceptions in part because Berkshire did not hire an outside law firm to conduct its internal investigation. Thus no matter how well MTO had performed its responsibilities, the appearance that the investigation was actually not independent was impossible to overcome.
In the trial, the defendants invoked a "Buffett defense," saying that Buffett had approved the outlines of the structured transaction and was involved in setting the fee. The question, however, was not whether Buffett knew about the transaction--he did--but whether he knew it was fraudulent.
General Re's CEO, Joseph Brandon, had been listed among the various unindicted co-conspirators in the case. He had received a "Wells Notice" (of possible civil fraud prosecution) from the SEC, although no civil charges were ever filed. He cooperated with federal prosecutors without asking for immunity. During the trial, Brandon was cited by the defendants' lawyers as having knowledge of the deal; General Re's chief operating officer, Tad Montross, was also named by the defendants as having knowledge of the transaction. In the end, none of the three men--Buffett, Brandon, or Montross--testified in the case.* After weeks in court and a short jury deliberation, in February 2008 all five defendants were convicted on all counts in the indictment and were sentenced to terms ranging from a year and a day (Robert Graham) to four years (Chris Milton of AIG). The convicted defendants said they would appeal.
In April 2008, shortly after the trial ended, Brandon resigned as CEO of General Re to help facilitate a settlement between the company and government authorities that has yet to take place. The settlement, when it comes, is likely to include fines, other penalties, and adverse publicity.
Only a month after the jury reached its verdicts, New York Governor Eliot Spitzer resigned following revelations that he patronized the prostitutes of an escort service called the Emperor's Club.
The Gen Re-AIG case he launched through his investigation was noteworthy in several respects. It is the only U.S. case in which financial reinsurance has resulted in criminal charges and prison sentences, rather than civil settlements. In recent corporate history, no other criminal aiding-and-abetting case has stuck; convictions in a Merrill Lynch case related to Enron were thrown out. For the first time, therefore, employees of one company were held responsible for a fraud committed by another company.
The Gen Re case also was one of the last corporate fraud cases prosecuted under the government policy of compelled waiver of the attorney-client privilege and the attorney work-product doctrine, which was revised after being declared unconstitutional by the U.S. District Court for the Southern District of New York. Thus, the defendants were arguably convicted using evidence that either would not have been available to prosecutors or would have been thrown out if the trial were held today.
Even though he was obsessed during this period with the investigation's potential to harm his reputation, Buffett was able to compartmentalize the way he always did. Whenever a business opportunity presented itself, he'd shift with startling speed from anxious ruminant to hungry great white shark. Buffett was never more himself than when given the chance to invest in something he wanted at a price of his choosing.