The Snowball

by Alice Schroeder

  If not exactly an ego booster, because of the snooty staff, Buffett’s 1969 meeting of the Grahamites at the Colony Club had at least provided mutual support in a challenging market. Since then Buffett had named them the Graham Group; Ed Anderson had planned the third outing in Williamsburg; Charlie Munger the fourth in Carmel, California. In 1971, Buffett made the meetings biennial. Out of loyalty, he let Ruane invite Malott—a favor normally verboten—and Malott and his wife, Ibby, became members for the next meeting in Sun Valley in 1973, planned by Rick Guerin.

  Malott, mightily impressed by the whole affair, stayed in Ruane’s fold, even though his complaints continued at a frequency and volume that still made Ruane fear his defection. By the end of 1974, however, while the market was down by more than twenty-five percent, the Sequoia Fund had at least managed to produce a smaller loss than the market’s.

  Nonetheless, the market’s cumulative toll on the Sequoia Fund was such that Henry Brandt and John Loomis, Carol’s husband, both of whom had gone to work there, feared the worst and cast off from what seemed a sinking ship.15

  Forbes captured Buffett’s attitude in an interview that November, which opened with a juicy quote: Asked how he felt about the market, “Like an over-sexed man in a harem,” Buffett replied. “This is the time to start investing.”16 He went on to say, “This is the first time I can remember that you could buy Phil Fisher [growth] stocks at Ben Graham [cigar butt] prices.” He felt this was the most significant statement that he could make, but Forbes didn’t include it; a general audience wouldn’t understand the references to Fisher and Graham.17 When Forbes asked for specific stock ideas, instead of mentioning what he was buying or had bought, Buffett turned impish and did one of his little experiments to see how well the reporter had researched him via other Forbes articles. “A water company is pretty simple,” he said, adding that Blue Chip owned five percent of…San Jose Water Works. The reporter took the bait; San Jose Water Works went in the story with no reference to the earlier piece insinuating he’d bought it using insider information.

  But despite his enthusiasm for the market so far in 1974, he had invested at a trickle, and mostly moved money around into Studebaker-Worthington, Handy & Harman, Harte-Hanks Newspapers, and Multimedia, Inc., and added to his Coldwell Banker position. He bumped up a few of his other shareholdings by ten or twenty percent. He had also bought 100,000 shares of Blue Chip from Rick Guerin. “He sold me at five bucks because he was getting squeezed,” Buffett says. “That was a brutal period.”

  The “harem” comment had a double meaning: While it was, indeed, the time to start investing, Buffett, for the most part, could look but not touch. One of National Indemnity’s business partners, an aviation broker, had run amok, selling money-losing aviation-insurance policies. The company had tried to stop the agent by revoking its authority but for several months was unable to shut it down.18 The accounting records were a shambles and the losses were unclear. National Indemnity had no idea how high the bill for the “Omni affair” would run, but worst-case estimates ran as high as tens of millions of dollars. The hope was that they were much less, because National Indemnity did not have tens of millions. Buffett was sweating.19

  Within a couple of months—by early 1975—his problems compounded monumentally. Chuck Rickershauser, a partner from Munger’s law firm, now renamed Munger, Tolles & Rickershauser, called him and Munger to say that the Securities and Exchange Commission was considering pressing charges against them for violating securities laws. What had seemed like a brewing but manageable problem had now exploded into a full-scale emergency.

  Rickershauser had first started doing legal work for Buffett and Munger during the See’s transaction. More recently he had been fighting a rear-guard action, ever since an SEC staff lawyer had called him and said he had some questions. Under the assumption that the matter was routine, Rickershauser had directed the man to Verne McKenzie, Berkshire’s controller.

  When McKenzie’s phone rang in Nebraska, he picked it up to find the head of the SEC’s Enforcement Division, Stanley Sporkin, the much-feared “tough cop” of the business world, on the other end of the line. Sporkin looked as though he spent his evenings hunched droopy-eyed under a desk lamp, personally drafting the charges against large corporations that for the first time in American history had frightened a remarkable number of them into settling with the SEC without ever setting foot in court.20 On the phone, he interrogated McKenzie on a wide range of subjects, from Wesco to Blue Chip to Berkshire and beyond. His tone was not friendly, but this, McKenzie had assumed, was simply his modus operandi. On the other hand, McKenzie did get the impression that Sporkin thought if you were rich, you must have done something wrong.21

  When Rickershauser heard that Sporkin, rather than a staff lawyer, had personally called and grilled McKenzie at length, he nearly had a heart attack. Sporkin’s batting average had made his jowly profile among the most recognizable in American business. In a practical sense he had more power than his boss, the chairman of the SEC.

  What seemed to have drawn the SEC’s attention was a project of nearly two years in which Buffett and Munger were trying to delicately untangle the many strands of spaghetti that connected the several companies they owned. Their first step had been to try to merge Diversified, the least essential piece, into Berkshire Hathaway. By 1973, Diversified had become little more than a vehicle for buying Berkshire and Blue Chip stock. But the Securities and Exchange Commission—whose approval was required—had delayed the Diversified deal. Munger had told Buffett that this was not anything serious. He directed Rickershauser to “invite anyone in the SEC” who had questions to call him directly, “if this will expedite his work and clearance of our papers.”22

  Instead, over the next eighteen months, the SEC staff seemed to have nosed around looking at Blue Chip Stamps and other investments; it concluded that Buffett and Munger had smashed up the Wesco–Santa Barbara deal deliberately by offering a high price for a quarter of the stock for the purpose of taking over the rest. At least, that must have been how it looked to Santa Barbara, for it had apparently turned in Blue Chip to the SEC.23

  For the first time they all realized that Blue Chip was in trouble.24 No sooner had Buffett achieved the glory of joining the Post board than his and Munger’s need for legal services was about to grow with stunning rapidity. Rickershauser, who already knew what it was like to work with Buffett, had once explained to a colleague that “The sun is nice and warm, but you don’t want to get too close to it.”25 He would spend the next couple of years testing what could be called Rickershauser’s Law of Thermodynamics.

  In February 1975, the SEC issued subpoenas and launched a full-blown investigation of Blue Chip’s purchase of Wesco: “In the Matter of Blue Chip Stamps, Berkshire Hathaway Incorporated, Warren Buffet [sic], HO-784.” The commission staff speculated that Buffett and Munger had committed fraud: “Blue Chip, Berkshire, Buffet [sic], singly or in concert with others…may have engaged in acts which have, directly or indirectly, operated as a device, scheme, or artifice to defraud; or included an untrue statement of a material fact or omitted…”

  The commission’s lawyers zeroed in on a theory that Blue Chip had planned from the beginning to take over Wesco Financial but had not disclosed that fact; that Blue Chip’s purchases of stock after the Santa Barbara deal dissolved must have been “tender offers” that were never registered with the SEC.26 This latter charge was most serious and carried with it the risk that the SEC would file, with great fanfare and publicity, civil fraud charges not only against Blue Chip but also against Buffett and Munger personally.

  In considering action against a target, Sporkin had a choice. He could prosecute or settle. A settlement was a way of allowing the target to say sorry without having to officially admit guilt; it neither consented to nor denied the charge of fraud but agreed to accept a penalty. And in agreeing to a settlement, the SEC could also choose whether to name the individuals involved or simply to make a deal with
the company itself without naming anybody. Being named in a settlement might not be the literal end of someone’s career, but there would be no elephant-bumping afterward. Having so recently been elevated into the high and mighty through Supermoney and Forbes and the board of the Washington Post, Buffett began to fight desperately to save his reputation.

  Instead, the investigation widened. Under subpoena, Buffett had to open his files—which, naturally, represented a huge and comprehensive collection of documents, just as huge and comprehensive as everything he had ever collected. In violation of his cherished privacy, lawyers from Munger, Tolles sifted out trade tickets, information about recent stock purchases, memos to bankers, letters to See’s Candies, notes to Verne McKenzie at the textile mill, and the like and shipped them off to investigators in Washington, D.C. Buffett felt persecuted. He and Munger were being chased in a nightmare by a huge, lumbering giant. To survive, they would have to outrun it.

  Letters flew back and forth like shuttlecocks between Munger, Tolles and the SEC. Buffett maintained a veneer of calm, but his back problems were plaguing him. Munger did not hide his agitation.

  By March 1975, the investigation had wound its way to a command performance at the SEC. Betty Peters was hauled in. “Is your lawyer here?” they asked. “No. Do I need a lawyer?” she replied. “Well, everybody comes with a lawyer,” they told her. “Don’t you just want to know what happened?” she asked. They interviewed Peters without a lawyer.

  Munger was summoned. For two days—also unaccompanied, for what additional legal counsel could Charles T. Munger possibly need?—he tried to defend Blue Chip against the charge that it was trying to bust up the Santa Barbara merger and to explain why Blue Chip had paid more than was strictly necessary for Wesco’s stock. Yes, Blue Chip had thought about getting control, he said, but those plans were only “remote and contingent” until the Santa Barbara merger blew up. This discussion became somewhat circular given his and Buffett’s role in talking to Vincenti and their admitted “wooing” of Betty Peters and the Casper family’s votes. Munger had a regrettable tendency to interrupt and lecture the SEC staff lawyer, Larry Seidman. “We wanted to look very fair and equitable to Lou Vincenti and Betty Peters,” he said.27 But the SEC lawyers had never met the intractable Lou Vincenti. They could not possibly understand. What about your Blue Chip shareholders? Seidman asked. Seidman saw no reason for Blue Chip to be so generous to Wesco shareholders; Wesco’s stock by then was largely in the hands of arbitrageurs.

  These were people who had bought Wesco’s stock knowing it would rise to the price that Santa Barbara had offered once the deal closed. They partly hedged their bets by shorting Santa Barbara’s stock, much as Graham-Newman had once bought Rockwood stock in exchange for cocoa-bean warehouse receipts. But when the Wesco deal blew up, it was as if the price of cocoa beans had collapsed.28 Why do the arbs a favor by propping up the price?

  Munger reached for his ultimate weapon—Benjamin Franklin. “We didn’t feel our obligation to the shareholders was inconsistent with leaning over backward to be fair. We have that Ben Franklin idea that the honest policy is the best policy. It had a sort of shoddy mental image to us to try to reduce the price.”29

  Seidman seemed a little baffled by this argument, and even Munger admitted that the details of what had been done did not look good. He begged Seidman to look at the big picture. “As you look at the overall records, we go way beyond any legal requirement in trying to be fair with people to observe the niceties of fair-dealing; I simply hope that you will reach the conclusion that this averages out as not an appropriate case for any sort of prosecution…. If there’s any defect at all, it’s not intentional.”

  When Buffett appeared, they asked him why he and Munger hadn’t let Wesco go into the tank so they could buy it cheap. “I think the general business reputation of Blue Chip would not have been as good,” Buffett said. “I think someone might have been sore about it.” But why should he care? Because, said Buffett, it was “important how Wesco management feels about us. You can say, well, we own the controlling interest, so it doesn’t make any difference. But Lou Vincenti doesn’t really need to work for us…. If he felt that we were, you know, slobs or something, it just wouldn’t work.”

  Now Buffett—who, like Munger, startled the enforcement lawyers by showing up alone—made himself helpful, venturing back to Washington several times, patiently explaining how Blue Chip worked, expounding on his investment philosophies, and talking about his childhood years in Washington. He made a favorable impression on Seidman, but not on the senior SEC staff lawyer who was in charge of the investigation, and who was known as a “tiger” whose motto was “They shall not pass.” He found these arguments unconvincing.30 The senior investigator’s attitude was that nobody who did anything close to the line would ever get by him.31

  The SEC staff kept delving. It seemed fascinated by the intricacies and complications of Buffett’s empire. It even started looking into whether he had traded on inside information about San Jose Water Works.32 The staff started kicking around Source Capital, the closed-end investment fund that Munger had bought a twenty percent interest in as a cigar butt and helped turn around. By then, the stock market had recovered. Ruane’s Sequoia Fund had made a huge comeback in 1975, up almost sixty-two percent compared to thirty-seven percent for the market. Munger had just about made back his partners’ money, with a seventy-three percent gain in 1975. He took no fees for himself, and was winding his partnership down. Explaining why their convoluted empire made sense based on the cheap prices paid for stocks at the time grew harder as the market recovered. The investigation kept growing hairy legs like a tarantula.

  Rickershauser had been studying a chart that showed all of Buffett and Munger’s complex financial interests. Buffett sat at the center, buying Blue Chip, Diversified, and Berkshire, Wattling them into so many pockets that it made Rickershauser shudder.33 Everyone knew Buffett, the great white shark, was virtually helpless to stop himself from acquiring these stocks. If he found ten bucks and spied a share of Blue Chip, Berkshire, or Diversified, he charged, grabbed, and threw the stock in the nearest drawer. After he and Munger had bought the first twenty-five percent of Wesco, Rickershauser had finally advised Buffett to buy stock only through formal tender offers to avoid the appearance of impropriety.34 The complex cross-holdings that Buffett had created made it seem as though he was trying to hide something. Rickershauser looked at the crazy diagram and fretted, “There’s got to be an indictment in there somewhere.”35 He didn’t think the SEC would have enough evidence to convict, but it would be awfully easy to accuse.

  In the greater sense, Munger was a two-bit player, his financial stake minute compared with Buffett’s. He had been snared as a petty accomplice. But since Blue Chip was his territory, he was a principal in the Wesco saga and thus played a central role in the SEC’s questioning.36 He admitted to Seidman, “We do have a very complicated set of business affairs, and I think we have learned, to our regret, that that may not be too smart. But we tried to keep all the balls in the air and properly sequenized with the other balls and handle them honorably.”

  Despite the pair’s protestations and the fact that it could find nothing wrong with the San Jose Water Works or Source Capital deals, the SEC kept going. The tiger of a prosecutor now recommended to Sporkin that the SEC file charges against Buffett and Munger personally. He was unswayed by Buffett’s and Munger’s testimony and believed that they had intentionally quashed the Santa Barbara merger by overpaying for Wesco’s stock. He was unsympathetic to the “who was harmed?” explanation for paying more for the stock and thought the pair was splitting hairs too fine in its explanations of events.37

  Rickershauser wrote Sporkin directly. He pleaded with him not to prosecute Buffett and Munger, “individuals who value their good names and reputations as their most priceless possessions,” because “many people, probably most people, assume evil conduct on the part of anyone civilly prosecuted by the commission.
” Even if Buffett and Munger consented to a settlement without admitting or denying the charges, merely filing them would cause “terrible, irreversible damage” because “the good reputation of the commission automatically and inexorably destroys the good reputation” of the defendants. “A giant’s strength should be used with great discretion,” he urged. “The risk from inadvertent oversights in business should not become so onerous that people who value their reputations are deterred from participation.”38 He begged to save Buffett’s and Munger’s reputations by offering to consent to an order on minor, technical disclosure violations on behalf of Blue Chip only, as long as the consent decree did not name any individuals.

  The panic inside Buffett’s mind can only be imagined. Within the office, he did his best to maintain an imperturbable facade so as not to alarm his office staff, any of whom might be interviewed by the SEC.

  Rickershauser worked like a stevedore to portray his clients as upstanding citizens from the perfect model families. He sent in biographies of Munger and Buffett to the SEC, stressing their charitable work, the many boards on which they served, Howard Buffett’s tenure as a Congressman, and the millions of dollars of taxes that Buffett had paid to the government since filing his first tax return at age fourteen. Buffett obviously had been grinding away at this document as if his life depended on it.