Berkshire's In for a Bruising

Someone please tell Eliot Spitzer that no one -- not even the nation's second-richest man -- should receive preferential treatment under the American system of justice.

One of the most glaring and disconcerting features of the current insurance scandal is New York Attorney General Spitzer's insistence that Warren Buffett, the CEO of Berkshire Hathaway ( BRKA), is merely a witness in his insurance probe -- and not a target. Just this Sunday on ABC's This Week, Spitzer said that Buffett was "not a subject or a target of our investigation," even though Buffett knew about a Berkshire deal that is being examined by Spitzer and other regulators.

The deal, which Berkshire subsidiary General Re did with insurance giant AIG ( AIG), is a type of finite reinsurance, a product that regulators are targeting because it is often used to give a fake boost to the financial statements of insurance companies.

Due to Berkshire's involvement in a number of finite reinsurance transactions, and the refusal of other regulators to give Buffett an easy ride, Spitzer's kid-gloves approach won't look tenable for much longer. It's almost impossible to see how Berkshire can emerge from the insurance scandals without suffering some legal penalty and a dent in its reputation. And as Berkshire's finite deals come under greater scrutiny, Buffett will likely be called on again to say whether he was personally involved in them.

Berkshire stock fell $460 Wednesday to $87,490.

Hot Seat

At a Securities and Exchange Commission office in New York Monday, Buffett answered regulators' questions about the AIG deal, which was put together in late 2000. AIG, conducting an internal probe, now says the deal was "improper." It appears to have been done simply to help AIG give an artificial $500 million boost to the reserves it keeps against future insurance payouts. AIG's former CEO Hank Greenberg, who left the company in a storm last month, played a hands-on role in the transaction. On Tuesday, Greenberg was questioned by regulators in New York, but invoked his constitutional right not to testify.

Buffett's only public comment on the AIG deal came on March 29, when Berkshire said that its CEO "was not briefed on how the transactions between Gen Re and AIG were to be structured or on any improper use or purposes of the transactions." Reportedly, Buffett stuck to this position when questioned Monday by officials from the SEC and Spitzer's office.

So, why not take Buffett's word for everything and go along with Sptizer's view that he should be viewed only as a witness?

First, Spitzer's motives may not align with good justice. Payback could be a partial motive: Berkshire's lawyers have provided regulators with much material that has helped them corner Greenberg and AIG. The same material could be used against Berkshire, of course, but the case against Berkshire might be slightly more sophisticated, given that the company appeared to be providing the questionable insurance and not using it to improperly enhance its own financial statements.

Moreover, Spitzer's tactic again and again has been to put recognizable figures in the spotlight and then leak like crazy to the media so as to try his targets in the court of public opinion and bully a settlement out of them. Buffett is way too popular with investors and "ordinary people" to make that approach easy; indeed, he may be one of the few sacred cows left in American capitalism.

For the Record

It's also important to recognize how far Spitzer has gone out on limb in classifying Buffett solely as a witness. A person familiar with the SEC's stance said that the agency was not approaching Buffett merely as a witness and hadn't ruled out the possibility of the executive being a potential target. It's not often that the SEC takes a markedly tougher stance than Spitzer.

Indeed, usually it's the other way around. For example, in late 2003, Spitzer said his office was going to continue its probe of mutual fund firm Putnam Investments, even though the SEC announced that it had reached a tentative settlement with the company. That was a very public maneuver that told the mutual fund industry that Spitzer thought the SEC was being too lenient. In a similar way, the SEC is signaling now that it's not ready to take a softer line toward Buffett.

To be sure, if Buffett does become a target, it won't matter much that -- unlike Greenberg -- he didn't speak under oath. His responses in the Monday interview could in theory be used against him if they are found to contradict other evidence. True, he couldn't be charged with perjury. But the government could still prosecute him if it found he made false statements -- the very charge that landed Martha Stewart in jail. And if Buffett does become a government witness in any trial proceedings, there is actually a slight advantage to have him avoid sworn testimony at this early stage. That's because lawyers for the opposing side can look for small discrepancies in testimony given under oath and use them to discredit the witness.

Other developments show that Buffett is not in the clear.

The AIG-General Re deal is clearly shaping up as Buffett's word against that of Ronald Ferguson, the Gen Re exec who worked with AIG to put the deal together. Buffett says that he didn't know the details of the deal, but the Washington Post, citing an unnamed regulatory source, says that Ferguson has testified that he gave Buffett details of the deal. No outsider to the deal or the investigative process can know who's right.

But it is noteworthy that Buffett reportedly did tell regulators Monday that, in connection with the AIG deal, he and Ferguson did discuss Greenberg's alleged desire to boost reserves. That's important because surely Buffett knows that if an insurance company wants to boost its reserves, it just goes ahead and boosts them. Of course, that usually means a hit to earnings and capital. So eyebrows should be raised as soon as any insurer expresses the desire to boost reserves without taking any real dent in its income statement or balance sheet. Seeing as Buffett knows that, it would seem logical that he then inquired why AIG needed a product that might allow it to avoid the income statement pain that should come with reserve strengthening.

It's also a mistake to get too wrapped up in this one AIG deal. There are other Gen Re transactions that will be looked at in due course. There is no indication yet of Buffett's involvement in these, but regulators haven't really delved deeply into these.

Down Under

However, there is a wealth of detail available on a 1998 deal that National Indemnity, another Berkshire subsidiary, did with a shaky Australian financial company called FAI. The transaction made FAI look far healthier than it was. FAI was then bought a few months after the National Indemnity deal by another Australian insurer, HIH, which later crashed, in part due to the hidden weaknesses at FAI.

An Australian government report shows in meticulous detail the role National Indemnity played in the FAI deal. (Detox first looked at it in 2003.) And this deal could come under the SEC's scrutiny, even though it was done with a foreign company. Berkshire's publicly traded status in the U.S. means anything it does falls under the jurisdiction of the SEC.

While it is still debatable whether Buffett himself will end up in real trouble, it is hard to argue that Berkshire won't get penalized in some way. Its role in helping AIG carry out an apparently improper deal is really no different from the roles that J.P. Morgan ( JPM), Citigroup ( C) and Merrill Lynch ( MER) played in allegedly providing Enron with products that allowed the failed energy giant to make its financial statements look stronger than they were. The SEC obtained highly embarrassing settlements from each financial institution in connection with the products they provided to Enron.

And it's not even certain that Berkshire has been accounting for its finite deals properly. The Wall Street Journal last month reported that Gen Re's lawyers have said that the unit accounted for the AIG transaction properly. But how does an insurance company account for a deal that isn't really insurance, as appears to have been the case with the AIG-Gen Re deal? The onus is on Berkshire to walk us through this, especially as Buffett has called for transparent financial statements in the past. The AIG transaction certainly doesn't look like an insurance deal because, although reserves and premiums were transferred from Gen Re to AIG, it doesn't appear any risk changed hands.

Berkshire would have to have made some book keeping entries for the AIG deal. It would also have recorded finite reinsurance fees -- $5 million in the AIG deal. If the finite deals are found to be improper, this might prompt restatements, which would be highly damaging to Berkshire and Buffett.

To hear and see Peter Eavis discuss Warren Buffett's travails on StreetWatch, click here.

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.

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