Risk RecognitionBy Mel Duvall | Posted 2003-08-01 Print
Shareholders nearly deify Warren Buffett for the way he manages his diverse holding company, Berkshire Hathaway of Omaha.
The key, says Craig Fink, a fraud investigator at utility firm FirstEnergy, is to compare databases that hold separate facts but together can indicate irregularities.
Fink has done investigations for 27 years, starting as a police investigator and moving to corporate work.
For example, while at General Public Utilities, which FirstEnergy bought in 2001, Fink wrote a database query that compared who was signing out company cars with subsequent expense reports. Several employees had used company cars but claimed mileage for using their own cars. Fink used the discovery to delve into what else those employees were doing. Some had bought personal items on company accounts, he found. "In our theory, a thief is a thief and he will steal from you any way he can," he says. "Once we identified them, we would make their lives an open book."
Many companies lack the internal audit talent to conduct thorough proactive fraud checks, Fink says. "They think, 'I run an honest company. This is overhead. We never had it before and we don't need it now.'"
Yet even someone such as Buffett, who contends his best management technique is to cultivate honest executives, will have to supply Deloitte & Touche, Berkshire's external auditors, with a complete, verifiable and measurable trail of transactions and internal controls to comply with Sarbanes-Oxley.
And that's across dozens of companies. Big companies, spread worldwide. Underwear maker Fruit of the Loom sells to 10,000 customers and has five distribution centers. Johns Manville is a $2 billion building-products company with 47 factories worldwide. Shaw Industries, the biggest carpet maker in the world, sells 1,600 different floor products to 50,000 retailers and distributors. Berkshire's Scott Fetzer home and industrial products company itself owns 21 companies. In all, Berkshire Hathaway entities together own or lease 100 million square feet of property and employ 147,000.
Only software can produce the documentation needed to track the movements at large, complex firms, says Dick Nolan, a Harvard Business School professor specializing in business transformation. "You don't just scale up a spreadsheet," Nolan says, referring to the fact that the simple spreadsheet is the way many companies track and consolidate finances.
Indeed, Deloitte & Touche itself recommends that companies set up internal controls that include a database detailing procedures and information systems related to every accounting mechanism in use. Technology, Deloitte says, can help measure how effective controls are and identify gaps, especially at complex companies with many reporting entities. A corporation with many manual controls is only in the "early stage" of Sarbanes-Oxley compliance, the auditor says.
Lots of software vendors are trying to capitalize, saying they address various aspects of the new regulations. Oracle announced a package in June to manage internal controls. Hyperion and SAS Institute push their analysis software as tools to help CEOs understand their companies better. Auditing-software makers ACL and CaseWare promote their fraud-detection software.
Their postulate: Technology can help prove to the world, or at least to regulators, that you're no Enron.
In response to a Baseline question at the Berkshire Hathaway meeting, Buffett said relatively few changes are planned as a result of the new regulations. In May, for example, he added two non-Berkshire directors to his close-knit group of seven board members. They are two longtime business associates: Tom Murphy, former chairman and chief executive of Capital Cities/ABC, and Donald Keough, chairman of investment firm DMK International and a former Coca-Cola president.
"We have to do certain things because we're told to do them by statute, but I don't regard them as improving in any way the reporting system we have here at Berkshire," he says.
Buffett's low-tech information systems and hands-off management philosophy have at times proven costly.
In June 1998, Buffett announced a $21.7 billion deal to buy property and casualty reinsurer General Reinsurance for stock. The acquisition was a good fit with Berkshire's other insurance businesses and provided Buffett with more cash to invest.
General Re came with a $15 billion float, which is money that the company holds against its liabilities but does not own. Buffett has invested the floats of Berkshire's insurance companies to reap much greater rewards than the company has had to pay out in insurance claims.
The problem was Buffett didn't realize General Re had taken on significant risks and was underpricing much of its policies to gain market share. Stephanie Eakins, a financial analyst at insurance rating service Weiss Ratings, says there is ample technology available to gauge a company's liabilities and risks against its reserves, from something as simple as a spreadsheet to more sophisticated systems such as executive dashboards.
"The tools are there but it's up to management to decide whether they want to take action or not," she says.
Buffett did not have an executive dashboard flashing daily alarms about General Re's exposure. Losses that began with a $370 million trickle in 1998 swelled to $1.4 billion in 1999. General Re suffered another $1.4 billion loss in 2000, and while he acknowledged several times that changes needed to be made at the subsidiary, Buffett refused to step in and take control. Instead, he steadfastly expressed faith in the experience and leadership of CEO Ron Ferguson.
While the exact events of Sept. 11, 2001, were close to impossible to foretell, Buffett later agreed that it was the job of a reinsurer to anticipate and correctly price policies to prepare for disasters such as terrorist attacks. Largely as a result of damage to the World Trade Center, General Re reported an underwriting loss of $3.7 billion in 2001. Ferguson decided to retire that same year.
Eakins says Berkshire was not alone in failing to keep adequate reserves or increase its premiums. The entire insurance industry found itself in trouble by the late 1990s after a pricing war. However, she says, Berkshire could be blamed for being too slow to react. Buffett agrees.
"Looking at the record, we needed to make a change at Gen Re, but I did not initiate it," Buffett said.
It wasn't the only time Buffett made this mistake. For years he allowed the Dexter Shoe unit to accumulate losses by failing to move production out of the U.S., as the rest of the industry was doing. In 2001, Berkshire's shoe group lost $46.2 million because of Dexter. "The ten-for-one wage advantage enjoyed by competitors producing elsewhere in the world finally forced us to act—after our having delayed longer than was rational," he told shareholders.
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