The Fine Print: How Big Companies Use Plain English to Rob You Blind

by David Cay Johnston

  Complicating all of this are corporate teams armed with spreadsheets and databases that make instant calculations. When one airline changes its prices, every other airline adjusts the prices for countless seats on thousands of flights in a matter of minutes. This ability to match almost instantly any competitor’s price poses fundamental challenges to the idea of price competition.

  In order to penetrate the strata of obfuscating language and seemingly disconnected laws and regulations of the marketplace, with its fluidity and its boundless opportunities, let’s mine one story to see why prosperity is eluding more and more people.

  In 2009, financier Warren Buffett decided to buy out shareholders in the BNSF Railroad. BNSF had been formed by the mergers of many railroads, the last two giants supplying the name: the Burlington Northern and Santa Fe. The BNSF was a consequence of a massive consolidation of railroads that began after a major change in federal law in 1980 that its sponsor, Representative Harley Staggers, a West Virginia Democrat, said would ensure robust railroad competition. Remember that name.

  Buffett paid a stiff premium for the BNSF railroad shares he did not own, but told the world he did so gladly. “It’s an all-in wager on the economic future of the United States,” Buffett announced—a line that appealed to the patriotic instincts of broadcasters, print reporters and politicians. He got ample press coverage, but few questions were asked about the deal. Buffett sealed his message with a promise that he would make the economy better. “Our country’s future prosperity depends on its having an efficient and well-maintained rail system,” Buffett said.

  The facts of the deal were clear enough: Buffett’s Berkshire Hathaway holding company paid $100 per share for the 77 percent of the company it did not own, offered in cash or in shares of Berkshire. Add in the piece of the company Berkshire already owned and $10 billion of debt the railroad owed, and the deal established a value for BNSF of $44 billion.

  One question nobody asked at the time was just what attracted Buffett to the railroad in the first place. Nor was there much analysis by financial journalists of how the railroad and its competitors were performing as investments. Business writers, like those they cover, tend to look forward rather than back. And they have a soft spot for positive news—a subtle but powerful bias.

  Had you put a dollar into an index mutual fund comprised of the entire American stock market at its peak on March 23, 2000, just before the Internet bubble collapsed, you would soon have lost more than a third of your money, including reinvested dividends, after taking inflation into account. Your investment would be down to less than sixty-seven cents by the day Buffett announced his deal in 2009. Had you put a dollar into BNSF, however, your dollar would have grown to $3.75.

  How did BNSF stock do so much better than the market?

  You probably have guessed that hauling coal from the Powder River Basin is big business for BNSF; certainly it’s profitable. But look a little deeper and you’ll find that Buffett’s railroad also ships grain. For many farmers, especially in the Dakotas and Montana, BNSF is often the only rail line farmers can use to send their wheat to buyers. So the railroad provides a necessary service, right?

  A look at government data shows that BNSF routinely gouged farmers who had no alternative shipper, charging much more than what is known as its variable cost to ship their grain (variable cost acknowledges that a corporation’s expenses will vary with production volume). The Surface Transportation Board (STB), which regulates some railroad prices, allows the rails leeway, permitting charges up to 1.8 times its variable cost before asserting that the costs have become price gouging. But BNSF routinely charged farmers 2.5 to 4 times its variable cost in the decade before and after the turn of the millennium. According to government documents, BNSF jacked up some prices 40 percent faster than the economic data showed was warranted based on costs.

  BNSF got away with this because, buried in the fine print, there are rules about who can file price-gouging complaints. Even though farmers bear the cost of shipping their wheat to market, grain companies who buy from farmers contract for most shipping. Two of the biggest grain shippers are Cargill, the privately owned business that is the world’s largest grain dealer, and Archer Daniels Midland or ADM (a major beneficiary, by the way, of a long-running subsidy for ethanol that was also involved in the global price-fixing scandal for another product, lysine). Under rules of the Surface Transportation Board, Cargill, ADM and their like can file complaints, but typically farmers don’t have standing. They can’t sue.

  Customers who have access to only one railroad are known as captive shippers. As in any business, captives are likely to be mistreated and, in one two-month period at fall harvest time, official data show, BNSF failed to provide more than twenty-two thousand grain-hauling cars when they were scheduled to be filled with wheat and other crops. More than 70 percent of these railcars that arrived late were in the Northern Plains—Montana, the Dakotas and Minnesota—where farmers were BNSF captives. Missed shipments can cost farmers a great deal (grain prices change from one day to the next) and that’s exactly what happened repeatedly: prices slipped during the time grain went unshipped.

  Congress periodically holds hearings into how railroads are operating. A steady stream of complaints about railroad price gouging are heard, but few real changes are made. Congress was given clear evidence of price gouging in 2008 when a study by Escalation Consultants showed that, depending on the commodity being shipped, BNSF was the worst or second-worst offender. But nothing happened.

  Wayne Hurst, past president of the Idaho Grain Producers Association, complained in 2007 that since that 1980 change in railroad law, “the degree of captivity in many wheat-growing regions has increased dramatically.” Farmers were getting hit with a double whammy of “unreliable service and higher” rates. Hurst traced the problem to a wave of consolidations in the railroad industry. Less competition meant railroads could lower the reliability of service, cutting where and how often they would pick up grain and other crops. Increasingly, they refused to pick up partially filled railcars, forcing farmers to truck wheat to central pickup points. The railroads “view efficiency as hauling larger and larger movements of a single crop from a single origin to a single destination,” Hurst said, rather than supporting a diversity of farmers and grain users, which would facilitate a competitive market.

  All that means farmers have to spend more to haul grain by truck to a central pickup point, which also shrinks the number of buyers they have bidding for their crop. That means less competition not just in rail services, but in the grain business too.

  Ironically, railroading was the first industry subject to price regulation by Congress when it created the Interstate Commerce Commission (ICC) in 1887. While complaints by western farmers about price gouging and lousy service prompted the law, the railroads played a major role in shaping the legislation as it moved through Congress. Subsequently the STB replaced the ICC, but things haven’t changed a great deal.

  In recent public talks, board members focused largely on the concerns of the railroads rather than their customers. In 2009, for example, the acting chairman of the STB, Francis P. Mulvey, told a conference that railroad profits were up, the numbers of rail workers slashed and the share of shipping on barges and trucks down. Still, he said, most railroads “are not revenue adequate on a system basis.”

  “Revenue adequate” is bureaucratese for “not charging high enough prices.” What could be sweeter to the ear of anyone in a regulated industry than to be told they should charge higher prices? Warren Buffett was presumably listening: within a year of hearing that the official line was that railroads were not charging high enough prices, he made his move to own all of BNSF.

  WARREN WORKS THE RAILROAD

  Mulvey’s remarks on revenue adequacy are consistent with how government agencies created to control rapacious conduct now regularly facilitate it. Looking over the backgrounds of appointees to a host of federal and state regulatory boards, strikingly fe
w have any background as advocates for consumers, whether that consumer is Joe Sixpack or a mighty corporation that depends on a regulated industry for services. While industry-friendly regulators have always been around, when I started covering these issues in the late 1960s and on into the early 1980s, these boards typically included one or more people not beholden to the industry they were supposed to monitor. And more than a few of these boards had well-informed critics, some of them successful business owners and executives with no ties to the industry they swore to regulate in the public interest.

  Congress knows all about this, but does nothing. Hurst, the Idaho grain farmers’ leader, pointed to studies by the Government Accountability Office, the investigative arm of Congress, from 1999, 2002 and 2006. He said they “all point to the same conclusion—that the [Surface Transportation Board] is not adequately protecting large parts of the country from market abuse where no competition exists.”

  This was not supposed to happen after Congress adopted the Staggers Rail Act in 1980. A related law, known as the Long-Cannon Amendment (named after senators Russell B. Long and Howard Cannon), required that railroads take steps to maximize competitive pricing. Together the Staggers Act and Long-Cannon were sold as ways to ensure competition and give shippers better deals. In some cases it has, but overall the Staggers Act has been a powerful weapon wielded against any hint of real competition, not least because it permits railroads to sign secret contracts with customers.

  The Staggers Rail Act is to transparency in railroad freight rates as Wyoming clinker is to that ancient swamp. It acts as a rock-hard shield to hide the information that could lower prices and foster actual competition. Information, not secrecy, promotes competition. Secrecy enhances the power of monopolists. And monopoly power is money. As Toby Kolstad, president of Rail Theory Forecasts, put it: “In recent years, freight rate increases for coal shipments have provided much of the increased earning power of the railroad industry.”

  Thanks to the Staggers Act, from the moment that coal is loaded onto the railcar until you pay your electric bill, every step of the journey is crafted to take as much money as possible out of your pocket by avoiding the rigors of market competition; inflating costs; avoiding taxes; shifting the costs of safety and environmental protections on to you; and making the billing as complex and incomprehensible as possible.

  The demand for more coal to generate more electricity underlies a calculus that is, once again, complicated and yet not so hard to discern if you know how and where to look. At each step along the way, our government now helps rail and other companies pick your pocket by erecting barriers to complaints, as with the wheat farmers who are technically not customers even though they pay the freight. This makes it virtually impossible for consumers to bring rate cases. Then there is the growing practice of granting automatic rate increases under the guise of adjusting for inflation or imagined higher costs, while simultaneously stopping the collection of data needed to evaluate business practices.

  Railroad price gouging is so out in the open that the industry’s own commentators write and talk about it freely. Few citizens, however, are aware of it because industry’s specialized journals attract few readers. Much commentary is also couched in dense bureaucratese, a language as alien to most people as ancient Greek.

  Protecting railroads from competition has an obvious implication: every time you turn on a light in your home or buy a product made with the help of electricity, you’re paying more than you would in a competitive market. When a business has a monopoly, as railroads do in many parts of the country, regulation is supposed to act as a substitute for competition, a proxy for market forces. But that assumption breaks down when regulators identify with the industry more than with customers; then the captains of industry get both undeserved riches and the wherewithal to further the tilt of the system in their favor. Easy profits enable them to make more political donations and offer more jobs to former regulators and their spouses, some of whom know how to get politicians on the oversight committees to make sure that no matter what is said, nothing happens to harm the protected industries.

  In a competitive market, when companies raise prices, they lose business as customers switch to other suppliers or cut back on spending. But a railroad with an iron grip on its customers will likely keep every one of them, even when prices go up. When an industry can raise prices in the absence of increased demand, it is said to have “market power,” and the result is usually twofold. First, it means more money for the railroad owners; second, it comes at a price to society that economists call a “deadweight loss.”

  Government policy enables this subtle transfer of wealth from you and others to railroad investors. Here is what the Justice Department’s Antitrust Division told Congress about market power in the railroad industry and the shortcomings of regulation by the Surface Transportation Board:

  One reason for the current market power enjoyed by the U.S. Class I railroads is the past mergers that have already been allowed by the STB—some of which…were either opposed by the Antitrust Division or recommended only with more stringent conditions than were imposed by the STB. The result of these mergers has been two mammoth regional duopolies in which neither duopolist aggressively seeks to poach business from the other. Thus, had antitrust jurisdiction rested with the Antitrust Division at the time these mergers were proposed, the industry likely would be more competitive today.

  This means the cozy duopolies—one in the West, one in the East—can escape the rigors of competition and enjoy what are in effect monopoly profits so long as each cooperates in keeping prices high and does not compete for more business by cutting prices. Keep in mind that 44 percent of the tonnage hauled by railroads is coal. But the coal buyers are not a competitive group, either. The corporate-owned electricity business is also highly concentrated, if not to the degree of the railroads. Just fifty companies collected 95 percent of electric revenues in 2010, the year Buffett bought total control of the BNSF railroad. One of the biggest of those fifty electric companies was MidAmerican Energy Holdings. Its subsidiaries serve customers from Oregon and California east to Illinois. MidAmerican is owned, in turn, by Buffett’s Berkshire Hathaway.

  Like most electric utilities, MidAmerican is not all that sensitive to the price it pays for shipping coal, whether it comes from its corporate sister BNSF or another railroad. That’s because state regulatory commissions let companies add to customer bills whatever they pay for coal and other fuels, as long as the price is deemed reasonable. Because “reasonable” means what other monopolies are charging, once again there is no downward pressure on rates paid to haul coal.

  Owning complementary monopolies dovetails with Buffett’s announced policies to buy businesses with both minimal competition and the power to raise prices. Owning a monopoly is nice. Being able to leverage one monopoly, a railroad, say, with another, such as a coal-buying electric utility, is like winning the lottery every day. But what’s terrific for the winners is costly for those of us who pay the price every day.

  Wall Street even measures companies by their success in creating barriers to competition. The investment research firm Morningstar rates companies using a “moat index” to measure success at avoiding the rigors of market competition. Pay close attention, especially to the last line, of what Morningstar candidly says:

  The concept of economic moats is a cornerstone of our stock-investment philosophy. Successful long-term investing involves more than just identifying solid businesses, or finding businesses that are growing rapidly, or buying cheap stocks. We believe that successful investing also involves evaluating whether a business will stand the test of time.

  The concept of an economic moat can be traced back to legendary investor Warren Buffett, whose annual Berkshire shareholder letters over the years contain many references to him looking to invest in businesses with “economic castles protected by unbreachable ‘moats.’”

  Moats are important to investors because any time a company
develops a useful product or service, it isn’t long before other firms try to capitalize on that opportunity by producing a similar—if not better—product.

  Basic economic theory says that in a perfectly competitive market, rivals will eventually eat up any excess profits earned by a successful business. In other words, competition makes it difficult for most firms to generate strong growth and margins over an extended period of time.

  There you have it—competition “eats up any excess profits.” And so what the serious investors want is to avoid competition, which in turn destroys the benefits of market capitalism that Adam Smith figured out back in 1776.

  Another Buffett strategy is to earn profits today but pay taxes in the future. MidAmerican is a major beneficiary of Congress’s profit-now, pay-later corporate tax laws. In 2009 MidAmerican’s income tax bills, Buffett wrote in his annual letter to his shareholders, came to just $313 million on a pretax profit of $1,846 million. That is less than 17 percent—and less than half the posted corporate income tax rate of 35 percent, which MidAmerican gets to include in full in the price it charges every customer every month. That means customers of MidAmerican pay electric bills calculated on the assumption that the utility is paying 35 percent income tax, although in fact the government collects only half the money.

  As a result of my work a few years back, Oregon passed a law requiring that electricity and natural-gas utilities taxes must be paid over to government or given back to customers. As soon as it was enacted, Buffett’s lobbyists began working to restore the system that let Berskshire Hathaway’s PacifiCorp electric utility in the Beaver State pocket taxes, diverting them from public coffers to Berkshire Hathaway’s accounts. In 2011 they had spread around enough money that the law was repealed. Once again, Buffett is profiting off taxes paid by his captive Oregon customers.