B000U5KFIC EBOK (39 page)

Charlie says as you get older you tolerate more and more in
your old friends and less and less in your new friends.

Warren Buffett.

HEN WARREN Bt1FFETT GOT THE call that something was amiss at
Salomon Brothers, it was 10:30 am. and he was standing at a noisy
pay phone kiosk inside a Lake Tahoe restaurant. Charlie Munger, Berkshire Hathaway's vice chairman and a Salomon board member, received
the message a few hours earlier as he was having dinner with his family at
his summer cabin in Minnesota.'

Ordinarily, nothing interrupts Munger's time at the lake. The summer of 1991 was different. Charlie's swift reaction to the telephone call
told the family that something serious was afoot.

"He doesn't show that he's under pressure to his kids," said Wendy
Munger. But "he was totally absorbed by it and engaged, and it was the
first time we ever saw him in a suit on Star Island."

This was the beginning of the most traumatic and public of Berkshire's troubles. The news was out about an illegal $12.2 billion Treasury
notes "short squeeze" at Salomon, a New York investment banking firm in
which Berkshire owned a considerable stake of preferred shares.

At the core of the widely reported episode was managing director
Paul W. Mozer, a 34-year-old bond trader who in December 1990 and February 1991, made Treasury securities trades above the legal limit allowed
for any one institution. Additionally, Mozer made secret and unauthorized
trades in the accounts of some Salomon clients, then switched the transactions onto Salomon's own books.

Munger first heard of the situation on Thursday, August 8, from
Salomon's president Thomas Strauss and its inside attorney Donald Feuerstein. From the very first telephone call, Munger harbored suspicions that Salomon's official story was incomplete.

Buffett was having dinner at Lake Tahoe with the executives of one
of Berkshire's subsidiaries when he talked to Strauss and Feuerstein. From
the sketchy details and matter-of-fact tone, the matter didn't strike Buffett
as an extreme crisis. It was Saturday before Buffett called Munger at Star
Island, and only then did he realize how serious the infraction was. Salomon's lawyer had read to Munger their talking points, an internal document Salomon executives would use during media interviews regarding a
news release that was about to be distributed. The talking points noted
that "one part of the problem has been known since late April." Munger
objected to the use of the passive voice, and demanded to be told who exactly knew.'

Though Munger challenged the wording of the talking points, the attorney explained that management and its lawyers were worried that different wording would threaten the firm's funding, its ability to roll over
the billions of dollars of short-term debt that became due daily. This was
dangerous because Salomon was highly leveraged, with only $4 billion of
equity. In addition to the short-term debt, Salomon was relying on $16 billion in medium-term notes, bank debt, and commercial paper.

In her account of the Salomon affair in Fortune magazine, Carol
Loomis wrote, "So Salomon's play was to tell its directors and regulators
that management had known of Mozer's misconduct, but to avoid saving
this publicly. Munger didn't like it, finding this behavior neither candid nor
smart. But not considering himself an expert on `funding,' he subsided."'

Munger was indignant at the attempt to brush over personal culpability, but perhaps because Charlie and Warren thought highly of Salomon's
Chief Executive Officer John Gutfruend and had a congenial relationship
with him, Munger admits that "Warren and I didn't see John's downfall"
that first evening.'

Nevertheless, Munger was certain from the very outset that Salomon
had stepped in a pile of horse manure. After all, Treasury securities, a
$2.2 trillion business, is the foundation of the United States financial system. Salomon is a primary dealer in U.S. government treasury securities,
one of only about 40 companies with the privileged status that allows
them to buy bills, notes, and bonds from the federal government and resell them to customers. Individuals in America and abroad, businesses,
and other governments invest in U.S. Treasury securities because they
trust the U.S. government and its public finance system. However, the
system itself operates on a delicate balance of trust, and some experts
feared that the Salomon breach of conduct would ruin the reputation of American securities markets worldwide and raise the government's cost
of debt financing.'

Munger and Buffett continued to communicate about the problem,
and planned a board meeting by conference call the next Wednesday, August 14. During that conference call, the board was read a second press
release, which included three pages of details. The hoard members exploded in unified objection to a phrase stating that management had
failed to go to the regulators for nearly four months due to the "press of
other business." That lame excuse, the board felt, would not fly. The
wording was changed, and in time, Munger and Buffett learned that management had met the previous April and agreed that something criminal
had occurred and it should be reported to regulators immediately. For
some inexplicable reason, nobody in the group did so.'

By late summer, the New York Times and the Wall Street Journal
were broadcasting the story on their front pages and tension escalated.
The securities markets reacted with a run on Salomon's own corporate securities. On Friday, Charlie donned a suit and caught a flight from Bimidji
to New York for one of the most hectic episodes of his life.

SALOMON WAS FOINDSll IN 1910 and became one of the largest, most profitable and most admired brokerage houses in the United States. Buffett
and Munger's connection with Salomon went back many years during
which Salomon performed investment banking and brokerage services
for Berkshire. Berkshire bought into Salomon in 1987, when the firm became the target of a hostile takeover by corporate marauder Ronald O.
Perelman, chairman of Revlon Inc. Gutfruend dodged that bullet by approaching Buffett and asking that Berkshire take a financial position to
stave Perelman off.

Bob Denham, Berkshire's main lawyer, remembers the weekend in
September when he first became involved with Salomon. Denham got a
telephone call on a Saturday morning. "I walked in the door from coaching a soccer game when they called to say they'd struck a deal to buy,"
said Denham. "They asked if I could work on it right away. I went to the
office and got others in to work with me. An agreement was signed on
Monday. That deal was more compressed than usual, but it is typical of
working with Charlie and Warren, because they worked so closely together. They're two of the smartest and most creative businesspeople
America has produced. They are always thinking of novel ways to slant investments. There is a high level of trust. They never try to undercut. They
seldom disagree. If they do, they talk it out."

In the fall of 1987, Berkshire allocated $700 million of Berkshire's
cash, the company's biggest investment to that time, to Salomon redeemable convertible preferred stock. The preferred securities paid 9
percent and were convertible after three years into common shares at
$38. At that time Salomon's common stock was trading at around $30. If
not converted, the shares would be redeemed over five years beginning
in 1995. The deal also provided for a seven-year "standstill" during which
Buffett agreed not to purchase any more Salomon shares.

In effect, Berkshire got a 12 percent stake in Salomon and became
the company's largest shareholder. The deal was structured so that Berkshire's $700 million would be used to buy out a 12 percent stake in
Salomon owned by Minerals and Resources Corp., Ltd. (Minorco) a subsidiary of the giant South African conglomerate Anglo-American Corp.
Gutfreund worried that the Minorco interest would fall into the hands of
Perelman or some other unfriendly takeover artist.?

The move angered some shareholders, who thought they should have
had the opportunity to consider Perelman's proposition. Furthermore,
some Salomon officers considered Berkshire's deal a sweetheart arrangement that took advantage of Gutfreund at a vulnerable time. But shareholders also got considerable benefits from the deal between Gutfreund
and Buffett. The transaction increased Salomon's capital, provided a financial cushion for losses, and put Gutfreund into a relationship of his
own choosing.'

As part of the deal, Buffett and Munger got seats on Salomon's board
of directors.

"We had some pretty good foresight," said Munger. "When we
bought big positions in ABC and in Salomon, Warren suggested I go on
ABC's board. I said, `you never will need me (there).' Salomon could get
into enough trouble that it would need both of us.'"

Wall Street veterans were surprised and puzzled at the Salomon investment, since Buffett and Munger often made disparaging remarks
about the quality of work in the brokerage and investment industry as
well as the high salaries and lavish lifestyles enjoyed by top executives. In
Berkshire's 1982 annual report, Buffett scolded investment bankers for
providing whatever advice would bring them the most income: "Don't ask
your barber whether you need a haircut," he wrote.9

Buffett explained later that he knew the Salomon investment wouldn't
be one of his famous "three baggers," but he was having a hard time finding suitable investments for his cash holdings, and he'd had good experiences working with Salomon in the past, especially from 1976 to 1981
when Berkshire was purchasing the first half of GEICO."

Nevertheless, there were always differences of perception between
Buffett's and Munger's ideas of how business should be conducted, and
those of Wall Street regulars. Salomon felt the sting of the Midwesterner's
conservatism.

"When they went on the Salomon board, Salomon had a star chef on
call," recalled Charles Munger, Jr., "The first time Warren sat down with
a Coke and a hamburger, some changes in culture had been introduced."

Even before the Treasury scandal, there were early rumors that Buffett and Munger were unhappy with Gutfreund, but in Berkshire's 1987
Annual Report Buffett tried to lay those stories to rest: "We have no special insights regarding the direction or future profitability of investment
banking. What we do have is a strong feeling about is the ability and integrity of John Gutfreund, CEO of Salomon, Inc.""

He said Gutfruend had at times advised clients to stay away from
deals, even in cases where Salomon would have reaped huge fees. "Such
service-above-self behavior is far from automatic on Wall Street," said
Buffett. 12

Gutfruend impressed Warren and Charlie when in 1987 Salomon
took a large trading loss, and then in a restructuring laid off 800 employees. That year Gutfreund declined a bonus worth about $2 million. Again
in 1989, when profits were down, he took a $500,000 pay cut to $3.5
million."

By the 1990s, however, Buffett and Munger had become uneasy about
the chaos and lack of attention to procedure that seemed to be inherent in
Salomon's culture. For example, they were disturbed that at board meetings, directors were given out-of-date balance sheets.''

Those concerns rose to the top in August 1991, when under pressure
from federal regulators, Salomon made its disclosure regarding irregularities and rule violations in connection with its Treasury securities bids.
The government probe was initiated after other firms complained that
Salomon had seized more than its legal share of the $12.26 billion in
notes, then squeezed competitors by driving up the prices.

Paul Mozer at one point claimed that he'd been unfairly accused of
misdeeds, and that he was guilty only of one "spur of the moment" decision to flout the rules of a single Treasury auction in February 1991.
Mozer insisted he had been used as a scapegoat. He told the Wall Street
Journal that when he made the trades he was just trying to accommodate
a request by Salomon's government arbitrage trading desk to bid for $1.5
billion worth of notes, even though Salomon would be bidding for much
more than government rules allowed.15 To prevent big players like
Salomon from cornering the market, the Fed had issued a rule in 1990 barring a single firm from bidding for more than 35 percent of the Treasury securities offered in any one auction.

Later investigations and court cases showed that Mozer had been involved in more than one incident of illegal trading in 1990 and 1991. Apparently afraid that he was about to be found out, Mozer disclosed some
trading infractions to Salomon's vice chairman John Meriwether as early
as April. The reactions of Gutfruend and Salomon's president Thomas
Strauss, when they learned of the problems, dug Salomon in even
deeper.

"What happened was Meriwether came to Gutfruend and said, hey, I
have this problem, and it's my responsibility to report it to you," said
Munger. "Meriwether, the supervisor, in essence was washing his hands
of it, protecting himself by disclosing it to Gutfruend-handing the problem up. But Meriwether also added, 'I hope you can figure out a way to
save this fine young man (Paul Mozer).' Gutfreund talked to the general
counsel, who told him to immediately report to the Feds and throw himself on the mercy of the Federal Reserve Bank of New York. Gutfruend
was indecisive-`How can I save my profit center, this employee, etc.,
etc.' He procrastinated and didn't level with the board until the Fed
threatened him-and then he still didn't fully disclose. The general counsel should have told him, `Hey, if you don't do as I say you'll lose your job,
your reputation, your standing in the community, your wife will be mad
at you, and your kids will be embarrassed to admit you're their dad. Tell
the truth, tell it fully, tell it fast.' He would have had to cashier the trader,
but he got cashiered anyway."