With all the attention on Valeant lately it has reminded me of Buffett’s Salomon adventure. No, I am not saying these two situations are “exactly” the same but there are a ton of similarities. For those who want the crib notes:
1- Buffett made his largest single investment ever in a company when he put $700M into Salomon (~$1.25B today)
2- That was 1987 and Buffett also took a seat on the Board
3- In 1990-91 Salomon traders broke the law in rigging Treasury auctions (details below)
4- Where it not for Buffett agreeing to help run it, Salomon would have probably filed Chapter 11 as the NY Fed was about to cut it off and his entire investment then lost as it was levered ~33-1 at the time (Lehman at its collapse was only 30-1).
From Fortune (full article here)
HOW IT BEGAN
That Sunday in August was a far cry from the commercialism of another Sunday, Sept. 27, 1987, when Buffett and John Gutfreund, then Salomon’s chairman and CEO, agreed that Berkshire Hathaway would buy $700 million of Salomon convertible preferred stock, which equated to a 12% stake in the company. The deal allowed Gutfreund to stave off takeover artist Ronald Perelman, who seemed poised to buy a large block of Salomon common stock from certain South African investors wanting to sell. With Berkshire’s $700 million, Gutfreund was able to strike a deal that allowed Salomon itself to buy the South African stock–and with that, Perelman was dispatched.
[drizzle]It was easy to see why Gutfreund welcomed Warren Buffett, White Knight. It was less easy to see why Buffett wanted to hook up with Salomon, much less trust it with this mint, $700 million–the largest amount he’d ever invested in a single company. Over the years, Buffett had derided investment bankers, deploring their enthusiasm for deals that provided huge fees but that were turkeys for their clients. He has also spoken often of wanting to work only with people he likes. So here he was, handing over mountains of Berkshire’s carefully accumulated and husbanded cash to the high-living, cigar-chomping, corner-cutting crowd soon to be made infamous in Liar’s Poker?
Several reasons explain the move, none of them really good enough in the light of what followed. One is that Buffett had been having trouble for a couple of years finding stocks he thought reasonably priced and was looking for fixed-income alternatives. A second is that the Salomon proposal came from John Gutfreund, whom Buffett had seen do principled, non-greedy, client-friendly work for GEICO, in which Berkshire was then a major stockholder (and which is now owned 100% by Berkshire). Buffett liked Gutfreund–still does, in fact.
A third explanation was simply that Buffett thought the terms of the deal worth accepting. In effect, convertible preferreds are fixed-income investments with lottery tickets attached. In this case, the security was to pay 9% and be convertible after three years into Salomon common stock at $38 a share–against the $30 for which the stock had been selling. If Buffett did not convert the stock, it was to be redeemed over five years beginning in 1995. To Buffett, it looked like a decent proposition. “It’s not ‘a triple,’ which is what you’d like to have,” he said to me in 1987, “but it could work out okay.”
To some of the brainy, mathematical types at Salomon, that appraisal would have qualified as the understatement of the year. From Day One, they thought–and let it be known to the press–that Buffett had exploited Gutfreund’s fear of Perelman and had secured a dream security, with a too-high dividend or a too-low conversion price or some combination thereof. Over the next few years, this opinion did not die at Salomon, and more than once executives of the firm (though never Gutfreund) came to Buffett with propositions for deep-sixing the preferred.
It’s fair to say that Buffett might have taken those offers more seriously had he known that ahead lay the business-wrecking, profit-shredding scandal that broke in August 1991–and that turned the world upside down for both Salomon and him.
A little stage setting here: Before the crisis hit, Salomon was on its way to an excellent business year, marred only by a Treasury investigation into a May T-bill auction in which Salomon was thought perhaps to have engineered a short squeeze. Despite that sticky matter, Salomon’s stock had climbed to $37 a share, a price very near Buffett’s conversion point of $38.
THE PHONE CALL
For the story of what then happened, we may begin with Buffett in Reno. Yes, Reno, which was the spot two executives of a Berkshire subsidiary had picked for an annual getaway with Buffett. Arriving in Reno on the afternoon of Thursday, Aug. 8, Buffett checked with his office and found that John Gutfreund, en route at that moment from London to New York, wanted to talk to him that evening. Gutfreund’s office said he’d then be at Salomon’s principal law firm, Wachtell Lipton Rosen & Katz, and Buffett agreed to call him there at 10:30 P.M. New York time.
Mulling this over, Buffett concluded that it couldn’t be bad news, because Gutfreund hadn’t been in New York to attend to it. Maybe, he thought, Gutfreund had made a deal to sell Salomon and needed a quick okay from the directors. Heading out to dinner in Lake Tahoe, Buffett actually told his group that he might be hearing “good news” before the evening was out–a characterization indicating Buffett was ready to bail from this supposedly plummy deal he’d got into four years earlier.
At the appointed time, breaking from dinner, Buffett stood at a pay phone to make his call. After a delay, he was put through to Salomon’s president, Tom Strauss, and its inside lawyer, Donald Feuerstein, who told him that because Gutfreund’s plane had been held up, they would instead brief Buffett on “a problem” that had arisen. Speaking calmly, they said that a Wachtell Lipton investigation commissioned by Salomon had discovered that two of its government securities traders, including the top gun, managing director Paul Mozer (a name Buffett didn’t know), had broken the Treasury’s bidding rules on more than one occasion in 1990 and 1991.
Mozer and his colleague, said Strauss and Feuerstein, had been suspended, and the firm was now moving to notify its regulators and put out a press release. Feuerstein then read a draft of the release to Buffett and added that earlier in the day he had talked at some length to Salomon director Charles T. Munger, Berkshire’s vice-chairman and Buffett’s sidekick in everything important.
The release contained only a few details about Mozer’s sins. But a fuller account dribbled out over the next few days, depicting a man at war with the Treasury over bidding rules that he despised. A new rule, promulgated in 1990 to prevent such behemoths as Salomon from cornering the market, said that a single firm could not bid for more than 35% of the Treasury securities being offered in a given auction. In December 1990 and again in February 1991, Mozer simply made hash of this rule by, first, bidding for Salomon’s allowable of 35%; second, submitting, without authorization, separate bids for certain customers; and, third, simply stuffing the securities that these bidders won