Warren Buffett's Problem Child

Now at the center of a series of investigations, General Re is one of Berkshire Hathaway's biggest buys -- and worst investments

By Pallavi Gogoi

When Salomon Brothers was embroiled in a bond-rigging scandal in 1991, Warren Buffett, its largest investor, took the helm as chairman and chief executive of the embattled company for an annual salary of $1. In testimony before Congress, Buffett said his message to Salomon employees was he would understand if they lost money for the firm. But then he warned of his less-understanding side: "Lose a shred of reputation for the firm, and I will be ruthless."

How ruthless can Buffett really be? We may soon find out. Fourteen years after his testimony, the Sage of Omaha is faced with a corporate-reputation scandal that may rival the Salomon one. The stink is coming from General Re, a division of Berkshire Hathaway (BRKA ) that's under investigation by New York Attorney General Eliot Spitzer, the Securities & Exchange Commission, and the Justice Dept. over deals it did with insurance giant AIG (AIG ), which is also under investigation.

At issue: the transfer of $500 million of premiums from General Re to AIG during the winter of 2001, which investigators say AIG should have considered a loan rather than revenue. Gen Re spokesman James Heslin says the company isn't commenting on any questions involving the investigations.

STRATEGIC SHIFT?

  Two former General Re executives have pleaded guilty to criminal conspiracy to commit fraud, while Berkshire has terminated the consulting services of former General Re CEO Ronald Ferguson and placed another senior executive in Europe on leave. On June 13, reports circulated that General Re was in settlement talks with the government.

A key difference between this case and the Salomon one: Buffett is the CEO of Berkshire, 100% owner of the troubled General Re. True, he acted swiftly to assist in the AIG investigation, offering details of the transactions and severing ties with any executives who refused to cooperate with the investigators.

But will Buffett be ruthless enough to cut Gen Re loose? That's unlikely, because he generally keeps hold of the companies he buys. Buffett was unavailable for comment for this article, according to his assistant, Debbie Bosanek.

Still, if Berkshire's stock continues to suffer because of General Re, Buffet may have to rethink his strategy. Berkshire's "A" shares have fallen 7% so far this year, recovering 1.26% on June 13 on news of the settlement talks. "Reputation and character are more important to Warren than anything," says Robert Miles, an investment adviser, Berkshire shareholder, and author of several books on Buffett. "He certainly won't tolerate any misbehavior."

"HANDS-OFF MANAGER."

  Buffett loyalists, who can be counted in the thousands, believe he knew very little of the questionable AIG-General Re transactions. General Re is Berkshire's largest division, but Buffett is CEO of a corporation that comprises 65 operating companies ranging in scope from See's Candies and Fruit of the Loom to MidAmerican Energy Holdings. Buffett acquired these companies over the last four decades and prefers to let the various CEOs run their individual units.

"Warren Buffett has a reputation for being a very hands-off manager, and I think that this is part of the success of Berkshire Hathaway," says John Price, an avid follower of Buffett's investing style and a founder of Conscious Investing USA.

But Buffett is no doubt miffed with the latest turn of events at Gen Re. Even though he said as recently as May that it has turned out to be a great investment, Gen Re has in reality been anything but. When Buffett bought it in 1998 for $22.3 billion, it was Berkshire's biggest acquisition to date -- and it quickly became one of its biggest problems. More than once, Buffett has had to devote paragraphs of his famous annual shareholder letter to explaining the losses at General Re. Red ink in underwriting that began with a trickle in 1998 -- just $370 million -- reached $3 billion in 2001.

ESCALATING PROBLEMS.

  In November, 2001, Buffett sent an unprecedented midterm letter to shareholders in which he scolded Gen Re executives for breaking all three of the basic rules in insurance: "accept risks you can evaluate, limit business so that you don't suffer losses from a single event, and avoid businesses involving 'moral risk' -- improper or illegal acts."

Worse followed. In 2002, General Re executives were subpoenaed in an investigation into another failed insurer in Virginia. General Re is still fighting lawsuits filed by insurance regulators from Virginia and Tennessee for contracts with the failed insurer.

General Re is also part of a probe in Australia over the failure of HIH Insurance, which became that nation's biggest corporate failure when it collapsed in 2001. And now there's the latest scandal -- one large enough to bring down AIG's legendary chairman and CEO, Maurice "Hank" Greenberg.

BOOMERANG EFFECT.

  Buffett has offered prosecutors all possible assistance with their current investigations. That could translate into better settlement terms for Gen Re and help Berkshire -- and Buffett -- save face. Indeed, Berkshire shareholders believe the folksy billionaire will come out unscathed. "In an era of corporate witch hunts, General Re's and Berkshire's involvement is being blown out of proportion," says Mohnish Pabrai, who manages $231 million at Pabrai Investment Funds. Five percent of his fund is invested in Berkshire shares.

Such optimism could be wishful thinking. General Re's problems are obviously far from over. Some observers have argued that if Buffett does keep General Re, he should be more hands-on -- especially since it's Berkshire's single-largest division. After all, at a certain point a company's reputation and that of its CEO can become inextricably linked.

Gogoi is a reporter for BusinessWeek Online in New York

Edited by Patricia O'Connell

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