The Berkshire Hathaway Corporate Governance Performance

Warren Buffet carefully cultivates a CEO-savant persona.

Most media enable him.

His latest stunt, ostensibly meant to save Bank of America while closing a savvy deal for Berkshire Hathaway, garnered laudatory headlines. Bank of America spun Buffett’s $5 billion investment for maximum effect.

Buffett supposedly came up with the idea in the bath. Several journalists added to his repertoire of folkways by reporting it.

Unfortunately, Bank of America is going to need more than $5 billion and temporary use of Warren Buffett’s aura to solve their problems.

The Wall Street Journal, September 2, 2011: U.S. regulators have pushed Bank of America Corp. to show what measures it could take if conditions worsen for the Charlotte, N.C., lender, according to people familiar with the situation.

Executives of the bank recently responded to the unusual request from the Federal Reserve with a list of options that includes the issuance of a separate class of shares tied to the performance of its Merrill Lynch securities unit, these people said. Bank of America purchased Merrill Lynch in 2009, and it has become the bank’s most profitable division.

It’s easy to forget that Buffett is the CEO and Chairman of a publicly held company when he’s seen scurrying around like Mighty Mouse, nibbling at failing banks and pulling billions from his fanny pack. Berkshire is a big company with some shareholders that aren’t him, his family, or his ego-stroking entourage otherwise known as the Board of Directors.

Buffett’s Bank of America move is not the kind you see most fiduciaries, bound by duty and good faith, make. It’s a public relations coup as performance, designed to leave a refreshing aftertaste.

Instead, investors are often stuck with a bitter one.

The next time something goes terribly wrong at a Berkshire Hathaway company, there’s a strong possibility no one will hear about it. Warren Buffett and Charlie Munger won’t be held directly responsible either. That’s the beauty of Buffett’s version of a conglomerate corporate structure, decentralized to such an obscene level such that its minimalism is brandished as a feature not a bug.

As our first owner-related principle tells you, Charlie and I are the managing partners of Berkshire. But we subcontract all of the heavy lifting in this business to the managers of our subsidiaries. In fact, we delegate almost to the point of abdication: Though Berkshire has about 260,000 employees, only 21 of these are at headquarters.

Buffett judges the investments he makes ruthlessly, but allows his operating companies to run on autopilot. It’s a wonder such financial, legal, and regulatory issues as the Salomon Brothers slip-up, Berkshire’s non-prosecution agreement with the Department of Justice over its dealings with AIG from 2000-2004, the James River lawsuit, and Sokol’s usurpation ever saw the light of day. It’s a testament to a few diligent folks who pushed those rocks, like Sisyphus, up transparency hill.

None of the issues mentioned above has tarnished Buffett’s halo for long, but the list of missteps grows longer. The Berkshire chairman claims plausible deniability. That’s made possible by the insatiable appetite of investors for gurus and sages rather than sirens.

The most frequent rebuttal to any attempt to burst Buffett’s bubble of infallibility is that “proof is in the performance”. Lots of long-term investors swear by Berkshire Hathaway stock and hang on every word from Buffett and Charlie Munger for investment insight.

But, as Aaron Task at Yahoo’s Daily Ticker recently reminded us, all that glitters is not gold:

“…investors who’ve followed Buffett into investments like Goldman Sachs and GE got burned, assuming they adhered to Buffett’s dictum about “forever” being the best holding period. The rest of us didn’t get the big dividends Buffett earned and both stocks are currently trading below the levels when Buffett made his “confidence-boosting” investments in 2008, Goldman by 12% and GE by 37%.

Finally, shares of Buffett’s own company, Berkshire Hathaway, have underperformed the S&P 500 in the past year and the company recently split its B-shares, violating yet another of Buffett’s not-so-sacred tenants.”

Buffett himself has admitted that being too big now affects his ability to capture outsize returns for the primary business of producing cash from other companies.

From the Berkshire Hathaway 2010 Annual Report:

The past growth rate in Berkshire’s book value per share is not an indication of future results.

In the years since our present management acquired control of Berkshire, our book value per share has grown at a highly satisfactory rate. Because of the large size of our capital base (shareholders’ equity of approximately $157.3 billion as of December 31, 2010), our book value per share will very likely not increase in the future at a rate even close to its past rate.

Buffett’s reluctance to sell loser portfolio operating companies or fire under performing managers means he has to make repetitive $5 billion Bank of America and Goldman Sachs preferred stock plays to compensate for tragic flaws like misplaced loyalty and day-to-day conflict avoidance.

And then there’s the numbers.

Berkshire Hathaway is a publicly traded company, listed on the New York Stock Exchange and regulated by the Securities and Exchange Commission. The integrity of Berkshire Hathaway’s external financial reporting should be ensured by the strictures of the Sarbanes-Oxley Act of 2002. Berkshire Hathaway and Warren Buffett, however, pay no more than lip service to the requirements and reject many other recommended corporate governance practices.

What’s left – of the financial reporting process, the internal audit organization, and the external audit relationship – is not enough, in my opinion, to prevent someone from spinning straw into gold.

Questionable corporate political campaign finance practices and foreign corrupt practices in the mid -1970s prompted the U.S. Securities and Exchange Commission and the U.S. Congress to enact campaign finance law reforms and the 1977 Foreign Corrupt Practices Act (FCPA) which criminalized transnational bribery and required companies to implement internal control programs. The Treadway Commission, a private-sector initiative, was formed in 1985 to inspect, analyze, and make recommendations on fraudulent corporate financial reporting. The original chairman of the Treadway Commission was James C. Treadway, Jr., Executive Vice President and General Counsel, Paine Webber and a former Commissioner of the U.S. Securities and Exchange Commission.

The accounting industry regulator, the PCAOB, tells us that existing auditing standards are neutral regarding the internal control framework that auditors use for obtaining an understanding of internal controls over financial reporting (ICFR), testing and evaluating controls, and, in integrated audits, reporting on ICFR. For integrated audits, PCAOB standards state that auditors should use the same internal control framework that management uses.

Since the Committee Of Sponsoring Organizations of the Treadway Commission’s (COSO) Internal Control-Integrated Framework (IC-IF) was published in 1992, many companies and auditors have used IC-IF as their framework in considering internal control over financial reporting. Also, since companies and auditors began reporting on the effectiveness of ICFR pursuant to §404 of Sarbanes-Oxley Act of 2002, many of those companies and auditors have used IC-IF as the framework for evaluating and reporting on ICFR.

Before leading the Treadway Commission, before the savings and loan scandals of the 1980’s, before Enron and the rest of the scandals of the 90’s such as WorldCom, Tyco, Adelphia, HealthSouth, and many others, James Treadway, SEC Commissioner, made a speech about financial fraud. His remarks specifically mentioned corporate structure, in particular a decentralized organizational structure, as a common characteristic of companies involved in financial fraud.

An excerpt of remarks by James Treadway to the Third Annual Southern Securities Institute, Miami Beach, Florida, April 8,1983

I refer to a decentralized corporate structure, with autonomous divisional management. Such a structure is intended to encourage responsibility, productivity, and therefore profits—all entirely laudable objectives. But the unfortunate corollary has been a lack of accountability.

The situation has been exacerbated when central headquarters has unilaterally set profit goals for a division or, without expressly stating goals, applied steady pressure for increased profits. Either way, the pressure has created an atmosphere in which falsification of books and records at middle and lower levels became possible, even predictable. This atmosphere has caused middle and lower level management and entire divisions to adopt the attitude that the outright falsification of book and records on a regular, on going, pervasive basis is an entirely appropriate way to achieve unrealistic profit objectives, as long as the falsifications get by the independent auditors, who are viewed as fair game to be deceived.

Treadway goes on to describe a company that’s almost an exact replica of Berkshire Hathaway. What’s most troubling is that nearly thirty years later there’s no excuse – lack of technology, real time communications, or specific regulatory requirements – for these conditions to still exist in a company of the size and systemic importance of Berkshire Hathaway. The weaknesses remain by design, not by default, which begs the question of whether they could serve an illegal or unethical purpose at any time.

Treadway’s speech goes on to describe eight characteristics of decentralized companies that promote lack of accountability and, potentially, the existence of financial fraud. I repeat them here, in italics, with a few comments after each related to Berkshire Hathaway.

1.The divisions and subsidiaries were autonomous, with little or no oversight by headquarters, particularly in the areas of auditing, accounting, and internal controls.

Berkshire Hathaway’s divisions and subsidiaries are, by Buffett’s admission, run with little or no oversight by Omaha headquarters. Each year he sends the CEOs a general letter outlining high-level goals and requires very few reports or status updates. One-way communication of monthly and quarterly financial results is the primary method used by most of the business units to report to headquarters.

From Warren Buffett’s annual letter to shareholders this past February, 2011:

At Berkshire, managers can focus on running their businesses: They are not subjected to meetings at headquarters nor financing worries nor Wall Street harassment. They simply get a letter from me every two years and call me when they wish. And their wishes do differ: There are managers to whom I have not talked in the last year, while there is one with whom I talk almost daily. Our trust is in people rather than process. A “hire well, manage little” code suits both them and me.

Berkshire’s CEOs come in many forms. Some have MBAs; others never finished college. Some use budgets and are by-the-book types; others operate by the seat of their pants. Our team resembles a baseball squad composed of all-stars having vastly different batting styles. Changes in our line-up are seldom required.

2. Constant pressure was strongly exerted by distant top management on subsidiaries and divisions to achieve profit goals set unilaterally and arbitrarily by corporate headquarters.

I don’t know to what extent pressure is brought to bear on subsidiaries by headquarters to meet specific numeric goals. What we have seen, in the Sokol scandal most recently, is that joining the Berkshire family may give some CEOs the impression they can break rules as long as they deliver expected results. In fact, they may even be touted as a possible Buffett successor.

Sokol’s Ways Questioned in Past Suits, The New York Times, April 4, 2011: Lawsuits involving David L. Sokol after he joined Berkshire Hathaway suggest that management had some warnings about his rules-pushing nature long before his resignation last week for buying stock in a company shortly before Berkshire acquired it. The most serious lawsuit centered on the accounting of an irrigation project by MidAmerican Energy, where Mr. Sokol was chief executive when Berkshire bought it in 1999.

In a rebuke last year, the judge ruled in that case that MidAmerican had improperly changed its accounting on the project and criticized Mr. Sokol directly. The change in accounting was “intended to eliminate the minority shareholders’ interests,” the judge wrote, awarding more than $32 million to the minority shareholders. The case had taken more than five years to work its way through the courts. During that time, Warren E. Buffett, the chief executive of Berkshire, expressed confidence in Mr. Sokol by broadening his portfolio beyond MidAmerican to include Netjets, a company that sells fractional use of private aircraft.

After Mr. Sokol took over Netjets in July 2009, some critics complained about his management style and his strategy for shrinking the company, which had been ailing even before the financial crisis did more severe damage.

3.  Communications between divisions and headquarters about the practicability of reaching established profit goals ranged from limited to non-existent.

From the 2010 Berkshire Hathaway Annual Report:

Berkshire’s operating businesses are managed on an unusually decentralized basis. There are essentially no centralized or integrated business functions (such as sales, marketing, purchasing, legal or human resources) and there is minimal involvement by Berkshire’s corporate headquarters in the day-to-day business activities of the operating businesses.

4. Headquarters and top management created an atmosphere in which sales and marketing functions in the divisions we reviewed as more important than accounting and auditing.

To say that there’s a strong focus on sales and marketing at Berkshire Hathaway would be a significant understatement. Buffett himself calls the company’s annual meeting “Woodstock for Capitalists”. Reports of the proceedings describe a carnival like atmosphere. Some of the highlights of the weekend are a showcase for the portfolio companies highlighting their products and services, a Q&A for international journalists held in the dazzling Borsheim’s jewelry showroom, and a BBQ at their Nebraska Furniture Mart.

But for a taste of the performance art purveyed in service to the Buffett cult, take a look at this excerpt from Michael de la Merced’s live blog for The New York Times Deal Book:

9:41 A.M. A brief commercial break

Because this is a haven for capitalism, there’s a brief commercial break. There’s Coca-Cola, one of Mr. Buffett’s most famous investments, and there’s Geico’s commercial about woodchucks chucking wood.

9:38 A.M. The Gekko arrives, and the day is saved

The Geico Gekko is one of several Berkshire employees to appear — along with Charlie Munger and Mr. Buffett’s assistant Debbie Bosanek — offering the MBA cyborg insurance. The MBA responds: “I’m self-insured.”

Of course, Ah-nuld and Mr. Buffett show up to save the day.

9:35 A.M. Buffett, action movie star

The movie begins with an animated segment about the “MBAs,” ruthless trading machines who plan to destroy the world.

The only hope is Warren Buffett.

We’ve already got a couple of celebrity cameos. Arnold Schwarzenegger is suiting up as “The Governator,” shortly after having stepped down as governor of California. (And there’s Larry King asking him a question!)

9:30 A.M. The lights have dimmed

After a brief introduction from Mr. Buffett, explaining the movie and asking shareholders not to record it (in part to assuage the famous people — who, “surprise, surprise” work for Berkshire for free), the movie begins.

It’s a time-lapse video of the prepping of the Qwest Center for the Berkshire annual meeting, set to U2’s “Beautiful Day.” It’s really amazing to see just how people flow into the arena and fill it to the brim.

It’s also amazing how the crowd, so noisy just minutes ago, has turned silent in the dimness.

9:26 A.M. Ladies and gents, take your seats

It’s almost showtime. A gravelly announcer — who sounds awfully similar to that guy from all the movie trailers — tells of those who have gathered for “one gloriously capitalistic weekend.” He further intones, “All roads led them to Omaha” before the big finish: “You’ve arrived at the Berkshire Hathaway shareholders meeting. The movie will begin in 10 minutes.”

5. That atmosphere caused divisional managers and personnel to believe that falsifying or “cooking the books” was the only way to achieve the profit demands, and that this was acceptable to headquarters. The divisional personnel engaged in the improper activities as part of an admitted” team effort.” In some instances, divisional employees stated that they believed it a “mortal sin not to meet the profit goals.

Here’s an excerpt from Buffett’s letter to his CEOs (“The All-Stars”) in July of 2010:

Somebody is doing something today at Berkshire that you and I would be unhappy about if we knew of it. That’s inevitable: We now employ more than 250,000 people and the chances of that number getting through the day without any bad behavior occurring is nil. But we can have a huge effect in minimizing such activities by jumping on anything immediately when there is the slightest odor of impropriety. Your attitude on such matters, expressed by behavior as well as words, will be the most important factor in how the culture of your business develops. Culture, more than rule books, determines how an organization behaves.

In other respects, talk to me about what is going on as little or as much as you wish. Each of you does a first-class job of running your operation with your own individual style and you don’t need me to help. The only items you need to clear with me are any changes in post-retirement benefits and any unusually large capital expenditures or acquisitions.

6. No employee involved received any direct personal benefit from theft, bribes, kickbacks, or diversion of assets.

What was so disturbing to so many about the Sokol scandal at Berkshire Hathaway last spring was the sheer audacity of David Sokol putting himself first, not the company. That was surprising to observers and seemed to take Warren Buffett by surprise, also. But it’s not so clear that Buffett had made Sokol, and by implication perhaps his other CEOs, understand where he truly draws the line and when, and if, failure and bad behavior would be subject to punishment or banishment.

Warren Buffett, Unplugged, The Wall Street Journal, November 12, 2005: Mr. Buffett tends to stick to investments for the long haul, even when the going gets bumpy. Mr. Sokol recalls bracing for an August 2004 meeting at which he planned to break the news to Mr. Buffett that the Iowa utility needed to write off about $360 million for a soured zinc project. Mr. Sokol says he was stunned by Mr. Buffett’s response: “David, we all make mistakes.” Their meeting lasted only 10 minutes. “I would have fired me if I was him,” Mr. Sokol says. “If you don’t make mistakes, you can’t make decisions,” Mr. Buffett says. “You can’t dwell on them.” Mr. Buffett notes that he has made “a lot bigger mistakes” himself than Mr. Sokol did.

7. The falsifications were large, simple, and direct. Expenses were improperly shifted from one accounting period to another. Goods ready for shipment, sometimes not even manufactured, were accounted for as sales in the current period, even though not actually shipped or manufactured until a succeeding period. False statements were made to auditors. Multiple sets of expense records were kept. Shipping invoices and bills were altered, with third parties sometimes enlisted to assist.

Buffett once criticized derivatives, for which there are particularly complicated rules and often difficult to determine values, as “financial weapons of mass destruction”.  Now he likens them to insurance and counts on the contracts to juice his earnings.

From Warren Buffett’s annual letter to shareholders this past February, 2011:

Two years ago, in the 2008 Annual Report, I told you that Berkshire was a party to 251 derivatives contracts (other than those used for operations at our subsidiaries, such as MidAmerican, and the few left over at Gen Re). Today, the comparable number is 203, a figure reflecting both a few additions to our portfolio and the unwinding or expiration of some contracts.

Our continuing positions, all of which I am personally responsible for, fall largely into two categories.

We view both categories as engaging us in insurance-like activities in which we receive premiums for assuming risks that others wish to shed. Indeed, the thought processes we employ in these derivatives transactions are identical to those we use in our insurance business. You should also understand that we get paid up-front when we enter into the contracts and therefore run no counterparty risk. That’s important.

But for the benefit of you, the investor, he tries to “keep it simple, stupid.”

On Reporting and Misreporting: The Numbers That Count and Those That Don’t

Earlier in this letter, I pointed out some numbers that Charlie and I find useful in valuing Berkshire and measuring its progress.

Let’s focus here on a number we omitted, but which many in the media feature above all others: net income. Important though that number may be at most companies, it is almost always meaningless at Berkshire.

Regardless of how our businesses might be doing, Charlie and I could – quite legally – cause net income in any given period to be almost any number we would like… If we really thought net income important, we could regularly feed realized gains into it simply because we have a huge amount of unrealized gains upon which to draw. Rest assured, though, that Charlie and I have never sold a security because of the effect a sale would have on the net income we were soon to report. We both have a deep disgust for “game playing” with numbers, a practice that was rampant throughout corporate America

in the 1990s and still persists, though it occurs less frequently and less blatantly than it used to.

Operating earnings, despite having some shortcomings, are in general a reasonable guide as to how our businesses are doing. Ignore our net income figure, however. Regulations require that we report it to you. But if you find reporters focusing on it, that will speak more to their performance than ours.

Contrast that tough talk with their actions when questioned by the S.E.C. about the declining values of some of their equity investments. Warren Buffett and Berkshire Hathaway had to be dragged kicking and complaining to recognize those significant unrealized losses. They resisted taking others.

They hate to admit a loser.

Berkshire Wrote Down Stocks After SEC Query, The Wall Street Journal, March 29, 2011: Warren Buffett‘s Berkshire Hathaway Inc. took an accounting charge to reflect the declines of three stocks in its portfolio after regulators asked about the company’s policy for writing down investment losses.

But Berkshire pushed back when securities regulators asked about two of its largest holdings, including its $11.1 billion stake in Wells Fargo & Co., saying it didn’t plan to write down losses on those investments… Chief Financial Officer Marc Hamburg complained…Despite Mr. Hamburg’s objection, the company recorded $938 million in impairment charges in the fourth quarter to reflect declines in shares of Swiss Reinsurance Co., U.S. Bancorp and pharmaceutical firm Sanofi-Aventis SA….

“Berkshire management,” Mr. Hamburg wrote, “does not believe that the validity of the efficient market hypothesis as suggested by the Commission can either be proven or disproven. Information made available by the issuer of a security including current results and expectations regarding the future will likely be interpreted differently by individual investors.”

Berkshire also told the SEC it wouldn’t write down its $413 million in unrealized losses in Wells Fargo or a smaller loss on its investment in Kraft Foods Inc. The two companies are among the largest holdings in Berkshire’s stock portfolio.

8. The falsifications were undetected by top management, not for brief periods of time, but for years and years. In short, the break-down was systemic.

If systemic breakdowns in accounting and financial reporting in Berkshire Hathaway companies, or via “top-side” journal entries made at headquarters, ever surface, they will have gone undetected for years. The revelations may not come until Warren Buffett no longer sets the high water mark.

After Enron, Buffett criticized “toadie” auditors and lackadaisical audit committees.

But perhaps the best place to focus attention is on the audit committee of boards of directors. Warren Buffett proposes that the audit committee have a Q&A session with auditors.

“You can’t meet on an audit committee for two hours twice a year and really know what’s going on,” says Buffett. “Auditors most of the time will know–put them on the spot.” And Buffett wants these questions and answers to go into the minutes unfailingly.

However, Berkshire’s own audit committee was seriously understaffed last year when the Sokol debacle played out and met only five times in 2010, mostly without its third member. When the audit committee launched an investigation of the Sokol scandal, they used the house law firm, Munger, Tolles rather than an independent one, even though a Munger, Tolles partner is the company’s ad-hoc General Counsel and was already being sued, along with the rest of the directors including audit committee members, over their handling of the issue.

James Treadway goes on to discuss, in his 1983 speech, the role of the auditor in finding fraud. What’s sad is that the examples he cites – auditors abdicating their duty to shareholders -are eerily similar to the ones cited recently by PCAOB Chairman Jim Doty. Doty has been emphasizing the need for more auditor skepticism. PCAOB inspectors see an appalling lack of it and the deficiencies cited in their reports are increasing rather than decreasing.

Preventing “cooked books” requires careful attention to sound accounting controls and procedures, and a corporate atmosphere and structure that emphasizes the significance of such controls and procedures — at all levels. But that lesson of attention to detail and the need for verification and sometimes tough-minded questioning seems difficult to learn.

To draw a parallel, let me quote from a few Accounting Series Releases over the last four decades.

“The time has long passed, if it ever existed, when the basis of an audit was restricted to the material appearing in the books and records …. [T]he partner in charge.., was not sufficiently concerned with the basic problems of internal check and control to make the searching review which an engagement requires.”

ASR-19, 1940. In the Matter of McKesson & Robbins, Inc.

“We have also found that in certifying such financial statements the respondents failed to comply with generally accepted auditing standards … by their reliance upon the unsupported and questionable representations of the Seaboard Management …. ”

ASR-78, 1957. In the Matter of Touche, Niven, Bailey & Smart, et al. (Seaboard Commercial Corporation.)

“A major deficiency of the Stirling Homex audit was Peat, Marwick, Mitchell & Co.’s reliance on the unsupported, undocumented representations of management.”

ASR-173, 1975. Mitchell & Co.

In the Matter of Peat, Marwick, (Stirling Homex.)

“Throughout the years, it appears that no auditor ever asked for supporting documentation for this asset account, nor did the auditors ever confirm with outside sources the existence of the balances.”

ASR-196, 1976. In the Matter of Seidman & Seidman. (Equity Funding.)

I’ll write next about Berkshire Hathaway’s relatively small spend for internal audit, external audit, and internal controls over financial reporting. (Berkshire Hathaway’s external auditor is Deloitte.) If something goes sideways at Berkshire Hathaway,there’s very little besides “culture, not rule books” to regulate behavior and insure financial reporting integrity.

Here’s an Andy Kaufman performance treat. The late comedian was famous for his put-ons. Or were they?