Auditing An Oracle

Mel Duvall

Aug. 02, 2003
3 min read

Shareholders nearly deify Warren Buffett for the way he manages his diverse holding company, Berkshire Hathaway of Omaha. There’s little doubt that he’s squeaky clean in how he operates. But that doesn’t necessarily mean that other companies can or should follow the way the avuncular champion of business ethics conducts his own affairs. His approach: handshake deals on billion-dollar acquisitions and near-complete avoidance of technology in combating fraud.

The Oracle of Omaha was in classic form in early May, at his affectionately dubbed “Wood-stock for Capitalists.” For three days of worship, 15,000 Berkshire Hathaway shareholders had come to Nebraska to hear Warren Buffett’s wisdom on how to place trust and invest money in American companies.

Pausing occasionally for a swig of Cherry Coke, the sharp-witted 72-year-old blasted the lowlifes and criminals who have been unearthed like mealy bugs after a summer storm. “It prevails in almost every place,” said Buffett in his no-nonsense style. “And unless there is a countervailing force, it is hard to stop.”

He was, of course, referring to the ugly behavior of chief executives, financial officers and other managers of some of the largest U.S. companies. From phony accounting to “obscene” paychecks, Buffett left no doubt that the conduct of corporate America had reached its lowest point in his half-century of investing.

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“What we really deplore are the attempts by corporations to solve operating problems with accounting maneuvers,” he said in response to shareholders’ questions. “It catches up with you, sometimes with disastrous results. You might as well face reality immediately.”

Buffett’s criticisms carry extra weight because Berkshire Hathaway has become a beacon for good corporate governance. Shareholder groups and regulators alike have turned to Buffett for guidance on how to right an industry stuck in a morass of scandals. As recently as two years ago, the so-called sage was chastised for failing to invest in Internet companies because he couldn’t understand their business plans or underlying value. Today, his concerns look prophetic.

“Buffett is probably more honest than you or I,” said Jack Putnak, a 37-year-old investor from Charleroi, Pa., who arranged a two-week vacation in Omaha around the shareholders’ meeting. Putnak based his faith on Buffett’s practice of paying himself a nominal $100,000 salary and his aw-shucks way of heaping praise on managers while accepting blame for Berkshire’s mistakes.

Yet, while he may be prophetic, Buffett is not quite the gold standard of good corporate governance his followers hold him up to be. For Buffett, it’s often a “do as I say, not as I do,” approach to management. He cuts deals without following accepted rules for due diligence, gives Berkshire managers such loose reins that they are able to pile up losses for years before he will take action, and eschews many of the rules and technologies companies are deploying to get a firmer grip on financial reporting.

“There’s a difference between how they manage themselves and what they look for in companies they manage,” observes George Dallas, managing director of governance services at Standard & Poor’s in London.

For example:

Buffett tells new investors to approach every investment as though it is one of only 25 they’ll make in their lives.

He, on the other hand, cuts deals based on gut instinct and without common due diligence such as getting an outside audit. The latest: During two hours in May, he sealed the $1.5 billion purchase of Wal-Mart’s distributor, McLane Co.

“I literally shook hands and was done,” he told reporters. “There was no due diligence.”

Buffett argues companies need to be more open with shareholders. Yet he remains secretive about Berkshire Hathaway’s public investments and in providing details on the operation of Berkshire’s subsidiaries. In annual reports, for example, Buffett doesn’t offer individual sales, profits or expenses for each of his 64 companies; he aggregates most of them, making it hard to tell how any one company is doing.

When Buffett takes over a company, he lets the managers run the subsidiaries as they see fit. “They are the Mark McGwires of the business world and need no advice from us as to how to hold the bat or when to swing,” he says. But this hands-off policy has allowed some managers to strike out. The $8.3 billion in underwriting losses so far at General Reinsurance is the most glaring example.

Buffett faults many corporate boards for acting as the lap dogs of chief executives. But his own board has been highly criticized by some investor groups and pension fund companies, such as the California Public Employees Retirement System, for lacking independence. Buffett is both chairman and CEO, and his wife and son are directors.

Buffett says corporations should automatically answer vital shareholder questions. However, other than in general terms, he refuses to talk about his designated successor or successors—undoubtedly, the most important question for investors. He also engages in somewhat risky trading practices, such as Berkshire Hathaway’s recent purchases of $8 billion in junk bonds, without providing basic data on the companies involved or the terms.

Buffett says CEO pay, which is overseen by board members, is out of control. But he has served as an influential director for some of the corporations that have rewarded their chief executives handsomely. Berkshire is the largest shareholder in Coca-Cola, yet Buffett failed to curb the compensation of CEO Douglas Daft in 2001 that included $48 million in restricted stock and options worth up to $153 million. In his annual report to shareholders in March, Buffett admits this failing:

“Too often I was silent when management made proposals that I judged to be counter to the interests of shareholders.”