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Arnold's top-dollar economic adviser is also a hypocrite.

Schwarzenegger's campaign to become California governor got a massive boost when Warren Buffett, CEO of

Berkshire Hathaway

(BRKA)

and the possibly the world's savviest investor, agreed to serve as the Terminator's adviser on economic matters.

Buffett, estimated to be the world's second-richest man, has gained prophet status in the world of business by calling on corporate America to become cleaner, better governed and more transparent. Because of this towering reputation, people sit up and listen when he preaches on things like financial disclosure and corporate governance. Problem is, his own actions at Berkshire Hathaway do not match his words.

Perhaps because the returns have been so good, observers have tended to overlook the transgressions of Berkshire and Buffett. But topping the list of sins is an insurance deal Berkshire did that helped disguise serious problems at an ailing Australian insurance company called FAI.

Soon after the deal, Australia's largest insurance company, HIH, bought FAI, whose problems helped bring about HIH's dramatic collapse in 2001. While Berkshire's involvement in the deal with FAI did receive a small amount of press in the U.S., an Australian judicial investigation reveals in lurid detail the critical role that Ajit Jain, still a senior executive at Berkshire, played in the deal. In helping to hide problems at the failing insurance company, Berkshire arguably behaved like the big-name U.S. banks that set up dubious financings to help Enron doctor its books. Yet Buffett showered Jain with praise after his involvement in the Australian deal was reported, and is said to remain very close to the executive.

When asked for comment, Buffett's assistant said he isn't doing interviews. In a telephone message returning a call, Jain said, "This is a hot topic and there is a lot in the public domain." He declined to comment further.

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Too Quiet?

It is startling how inconsistent Buffett can be. He has long called on directors to rein in management. Yet, till earlier this year, when new rules were introduced forcing companies to take on more independent directors, Berkshire's board was crowded with family members and individuals whose companies have received income or investments from Berkshire. In Berkshire's 2002 annual report, Buffett argues that the presence of independent directors is no guarantee that managements will behave better -- but Berkshire has hardly given them a chance. Buffett has also been quick to criticize accounting practices at companies. But he didn't criticize

Coca-Cola

(KO) - Get Coca-Cola Company Report

, one of his multibillion-dollar holdings, for a return-boosting maneuver that involved selling majority stakes in its bottling operations while retaining de facto control over them.

Buffett has also called on companies to improve their financial disclosure. Yet, in the second quarter of 2003, Berkshire convinced the nation's stock market regulator to allow him to withhold disclosure of his much-watched stake in a telecom company. His holding of

Level 3 Communications

(LVLT)

stock was listed in the first-quarter filing of Berkshire's stakes, but it vanished in the second quarter, during which Buffett obtained a large number of shares in the company by converting a debt security into common stock. Level 3's stock has slid sharply since mid-June. Is that decline due to Buffett selling? Without regular disclosure from Berkshire, investors have little way of telling.

Still, the case of Ajit Jain is the most damning for Buffett. Here's what happened. Jain, as head of Berkshire's subsidiary National Indemnity, was personally involved in a dodgy-looking reinsurance deal in 1998 with struggling property and casualty insurer FAI. Just weeks later, FAI was bought by Australia's then-largest insurance company, HIH. The problems at FAI contributed substantially to HIH's spectacular collapse and liquidation in 2001. With HIH unable to honor an estimated $2 billion to $3 billion of liabilities, it was Australia's largest-ever bankruptcy.

A Royal Commission investigating the collapse shows that, by doing the questionable reinsurance deal with National Indemnity, FAI was able to look markedly more healthy than it truly was at the end of its 1998 fiscal year, ended June 30. The commission's report says FAI ultimately booked a gain of 29 million Australian dollars in its 1998 year, or $19 million (U.S.) at the current exchange rate. Without the bogus earnings, HIH may never have bought FAI a little later that year.

The reinsurance deal looks bad because it was constructed in such a way that it allowed FAI to book a big profit-boosting reinsurance gain in 1998, while forcing the company to effectively foot the cost of this gain over time. According to an email from an reinsurance broker working on the deal, FAI CEO Rodney Adler was rushing before the end of the company's fiscal year to find cover "to try and ensure his earnings meet expectations."

The deal was structured so that there was almost no credit risk borne by National Indemnity, which, according to commission documents, expected to book a hefty premium when the deal had run its term. How was it that the deal could be classified as reinsurance and not a financing, which it ultimately was? Because it was built in such a way that had National Indemnity taking some risk under a scenario the commission called "remote": It agreed to pay out a certain sum if there was earthquake in Australia causing a certain amount of total damage. Experts put the probability of the earthquake event occurring over the life of the contract at 1.8% to 3.3%. Stunningly, the commission report adds: "FAI had not sought earthquake cover. It was suggested by NI."

In addition, documents supplied by the commission show Jain playing a key role in the back-and-forth of the deal. At one point, a deal structure proposed by FAI was rejected by Jain because he "thought it too transparent and problematic if discovered by the regulator," according to a witness heard by the commission.

True, a few days later National Indemnity said it wanted the amended deal terms to be disclosed to the Australian insurance regulator, the Insurance and Superannuation Commission, or ISC. But the Berkshire unit later agreed to a version that had a much softer requirement regarding the regulator, according to the report. All that FAI had to do was "provide details of the contract to the ISC in accordance with the provisions of the Insurance Act," the Royal Commission report says. It explains: "To comply with that clause FAI would only need to provide details of the contract to the ISC in accordance with their usual procedures for reinsurance."

Playing a Game?

For all intents and purposes, National Indemnity made a disguised loan to FAI to add illusory strength to its balance sheet and income statement. Again and again, Buffett has come down hard on accounting practices that cover up the true strength of a company. He did so most vociferously in Berkshire's annual report for 1998, the year the FAI deal was struck. Yet Jain has remained at the company, and is often touted as a successor to Buffett as CEO of Berkshire.

Buffett has also made great efforts to stick by the exec. In March last year,

Barron's

ran an article that looked, without too much depth, into Jain's dealings with FAI. A few weeks later in Berkshire's 2001 annual report, Buffett boasted: "At the National Indemnity reinsurance operation, Ajit Jain continues to add enormous value to Berkshire. ... I have known the details of almost every policy that Ajit has written since he came with us in 1986." Does that include the FAI deal?

Moreover, if the HIH collapse happened in the U.S., it's inconceivable that Berkshire would escape scrutiny. After all, banks like

J.P. Morgan Chase

(JPM) - Get JPMorgan Chase & Co. Report

and

Citigroup

(C) - Get Citigroup Inc. Report

paid out big fines in July for extending credits to

Enron

and

Dynegy

(DYN)

that were disguised as trading activities.

But Buffett inconsistencies continue. One of his more risky investments has been in Level 3, whose CEO Walter Scott sits on Berkshire's board. Buffett has repeatedly criticized companies for poor disclosure, but in the second quarter Berkshire persuaded the

Securities and Exchange Commission

to allow the company to keep its Level 3 holdings from the public eye for a certain period.

Normally, investors with more than $100 million in stocks have to regularly file their holdings with the SEC, but a 1975 provision allows investors to request that certain holdings not be divulged if doing so would harm their investment strategies. Notably, in the second quarter, the SEC did not permit Berkshire to keep small holdings in two companies confidential.

However, it permitted confidential treatment for Level 3. Berkshire disclosed owning just $4.5 million worth of Level 3 stock in the first quarter of this year. The filing for the second quarter doesn't contain the Level 3 stake because, Berkshire says, confidential treatment was obtained. How convenient. In the quarter, Berkshire exchanged convertible securities into common stock, and received an extra slug of stock for agreeing to the conversion.

Doing the math shows Berkshire could hold around 36 million shares as a result of the conversion. Such a stake would be worth around $160 million. Buffett may own more if he also exchanged Level 3 bonds, which he is rumored to own, for common stock. Buffett is a big holder, but another very large holder of Level 3 stock,

Legg Mason

funds,

has

disclosed its second-quarter stake. So why is Buffett hiding his?

It should be clear by now: One rule for Buffett, another for the rest of corporate America.

In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send any to

peter.eavis@thestreet.com.