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Hard times come to the hedge funds

November 21, 2012: 11:48 AM ET

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Bears should have had a fine time in the 1969 market. But
some followers of the hedge concept got clobbered on their
shorts while being murdered on their longs. Worse than
that, the SEC is moving in.
By Carol Loomis

This story is from the January 1970 issue of Fortune. It is the full text of an article excerpted in
Tap Dancing to Work: Warren Buffett on Practically Everything, 1966-2012, a Fortune
Magazine book, collected and expanded by Carol Loomis.

The patriarch of the hedge-fund business, Alfred W. Jones, sixty-nine, had his worst year ever in
1969. He says the two Jones funds misread the market and will be run more conservatively from
now on. Jones himself is conservative and has done little to capitalize on his considerable fame.
Some people feel he missed the boat by not building a financial empire, but he says, "That's one
boat I never wanted to be on."

FORTUNE -- Atalanta Partners, Takara Partners, August Associates, Icarus Partners,

Grasshopper Fund, Lincoln Partners, Sage Associates, Rudman Associates, Tamarack

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Associates, Hawthorn Partners. Most investors would not find a single familiar name in that
collection or in a list of more than a hundred similar firms that could follow. Yet, all together,
these firms represent an investment force capable of moving more than $1 billion in and out of
the stock market. They are private "hedge funds," those unique investment partnerships which
operate almost completely out of public view.

Some 3,000 investors, however, can claim a special view, for there are now that many who are
limited partners in one or more hedge funds. Most of those investors are wealthy, many are
important businessmen, and some today are troubled about their hedge-fund investments. Their
misgivings are something new, for until lately the hedge funds looked like an investor's dream.
The records they produced were consistently lustrous, and it seemed as if their structure was
ideally geared to success.

That structure has three main features: first, the partnership arrangement itself, through which the
managers of a fund can be compensated in such a way as to leave them highly motivated to do
well; second, the use of borrowed money to obtain "leverage," a technique permitting the fund to
take maximum advantage of a bull market; and third, the use of short selling as a "hedge," or
protection against a bear market. The trouble that has now arisen is with the hedge, which simply
did not meet last year's stern test. In general, the hedge funds were clobbered by the 1969 bear
market, ending up in many cases with records that were worse than those put together by
aggressive mutual funds denied the luxury of short sales.

The 1969 experience has been a rude awakening for many hedge-fund investors, and has left
some of them with strong reservations about the whole concept. For the first time in their
relatively short history, the funds are not growing: in fact, some have suffered large withdrawals
of capital and a few have actually folded.

What remains, however, is still a big business, for in the last few years the hedge funds have both
proliferated in number and exploded in size. They are still, it is true, dwarfed by their public
cousins, the mutual funds, whose assets are in the $50-billion range. But the more than $1 billion
the hedge funds command is of quite special interest, since it is money that is inclined to
gravitate toward the more speculative stocks and, in steady pursuit of "performance," to move in
and out of them with exceptional speed. Furthermore, the last couple of years have seen the
formation of some twenty-odd mutual funds that are patterned after the private funds and that are
commonly also identified as "hedge funds." Their presence in the market substantially extends
the impact of the hedge concept.

The most interested spectator of all of this growth has been the Securities and Exchange
Commission, under whose yoke the investment partnerships, because of their private character,
do not now fall. For about a year, the SEC has been giving the funds a close new look, and while
the commissioners have reached no conclusions, certain SEC staff members have made it
supremely clear that they believe the funds should be brought under some form of regulation.
The managers of the hedge funds dislike that thought in every respect, but what they most dread
is the prospect of an SEC move that would prevent them from earning their compensation in the
traditional way -- i.e. by taking a share, usually 20 percent, of the profits earned on their limited
partners' money. The glories of this arrangement, given a reasonably good stock market, explain

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why so many money managers have been inspired to start hedge funds. But right now the threat
of SEC action -- and the threat must be judged very real -- is another deterrent to growth.

Why the crowds gathered

One man who never really wanted the growth to get this far is Alfred W. Jones, who started the
first hedge funds and for years had the business to himself. Jones, after a career as a sociologist
and a stretch as a Fortune writer in the early 1940's, established his first limited partnership, A.
W. Jones & Co., in 1952. He started a second one, A. W. Jones Associates, in 1961, by which
time he was celebrated among his investors for having compounded their money, over his nine-
year history, at a 21 percent annual rate. Because he was running private partnerships, Jones was
able to keep the dimensions of his success very quiet, and he had no imitators of any
consequence until 1964, when one of his general partners -- the first of several to do so -- peeled
off to start his own fund. Today three of the largest hedge funds, City Associates, Fairfield
Partners, and Cerberus Associates, each upwards of $30 million in size, are run by former Jones
men. These funds are sometimes jokingly referred to as "Jones's children," though Jones
apparently feels no paternal affection toward the defectors from his organization.

The real growth of the hedge funds did not begin until 1966, and it came then in the wake of a
Fortune article on Jones ("The Jones Nobody Keeps Up With," page 1 of Tap Dancing to Work).
That article pointed out that Jones's long-term record was better than that of any mutual fund,
that he had shown profits in most bear markets and pulled through even the 1962 collapse with
only a small loss, and that Jones himself had become rich. These items of news were enough to
create almost overnight a raft of would-be hedge fund managers, most of whom were convinced
that Jones had discovered the millennium. Some who then went on to start funds now
acknowledge that they paved their way into business by using the article about Jones as a sort of
prospectus, relying on it for help in explaining, and selling, the hedge fund concept to investors.

In the four years since, the number of hedge funds has grown to an estimated 150. The estimate
is Fortune's, and it is at best wobbly, for counting hedge funds is one of the harder jobs around.
Indeed, a look at some of the complications involved reveals a lot about the intriguing character
of these funds.

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A standout newcomer among hedge funds is Steinhardt, Fine, Berkowitz, whose $30 million is
run by (from left) Howard P. Berkowitz, twenty-nine, Jerrold N. Fine, twenty seven, and Michael
H. Steinhardt, twenty nine. In the fund's first fourteen months, its investors realized a gain of 139
percent. In the year since, they have just broken even.

First of all, there is some disagreement these days as to the definition of a hedge fund. Once it
was not so. Alfred Jones invented the hedge fund, and therefore his style of operation provided
the definition. Thus, a hedge fund was a limited partnership organized to invest in securities,
with the partnership structured in such a way as to give the general partners -- the managers of
the fund -- a share of the profits earned on the limited partners' money. Furthermore, Jones said -
- and still says -- that a hedge fund is always leveraged and always carries at least some short
positions. Fine, except that there are all sorts of limited partnerships around these days that have
obviously borrowed most of Jones's ideas, but not quite all. For instance, there are some
partnerships that feel no obligation to be leveraged, or to be short. In fact, some have actually
renounced one or both techniques, either because they have never felt them necessary or wise, or
because they have tried them out and bombed. On the other hand, there are also partnerships
around that are leveraged and do make short sales, but that have no provision for the general
partners to share in the limited partners' profits. The question, then, is which of these
partnerships, if any, should be thought of as "hedge funds"?

The question is plainly arguable, but it would appear that the key feature of a hedge fund is
neither the hedge nor the leverage, but instead the method by which the general partners are
compensated. Certainly it is this characteristic that has spurred the funds' growth and also helped
arouse the interest of the SEC. Therefore it seems reasonable to count as hedge funds those
limited partnerships that do not necessarily hedge and/or use leverage, but that otherwise are
constructed in the Jones mold.

This definition would exclude, for example, the funds set up by brokerage houses as vehicles for
commingling the accounts of several clients into a single account; the general partner, who is
typically a representative of the firm, runs the account on a discretionary basis, getting his
compensation from the commissions that it generates, not out of investment profits. It is not
unusual, furthermore, for a family to set up an investment partnership. Last year around twenty
members of the Rockefeller family and certain members of the Rockefeller staff organized the
Pocantico Fund, capitalized with around $4 million. Since the general partners, however, will get
no part of the limited partners' profits, this fund -- and others similar to it -- is not under
discussion here. Nor are the so-called venture-capital partnerships, whose emphasis on long-term
investments in new nonpublic companies makes them far different from the typical hedge fund.

A beacon in Manhattan

Armed with some definition of a hedge fund, the census taker next comes up against the
enormous problem of discovering the partnerships that might fit the pattern. Such help as there is
comes from certain state laws applying to partnerships. Typically, these laws stipulate that every
new limited partnership must file a body of information about itself, including the names of the
partners and the amount of their investments, at some specified county or state office.

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The great bulk of the country's hedge funds are located in New York's borough of Manhattan,
and, thanks to a provision of the New York partnership law, can be flushed out there with
relative ease. This provision requires every new partnership to publish the substance of its
official filing in two newspapers; in Manhattan, one of these is by custom always the New York
Law Journal, which thus provides the beacon by which essentially every Manhattan hedge fund
can be located.

After thirteen years of outstanding success in "value" situations, Warren E. Buffett, thirty-nine, is
closing down his $100-million Omaha operation, Buffett Partnership, Ltd. He wants to pursue
other interests, and has suggested that in the current market his investors may want to retreat to
municipal bonds.

What the records show is that, since early 1966, when there were only a handful of hedge funds
in existence, about a hundred new ones have been formed in Manhattan. Some of these have
folded, but their numbers are probably roughly balanced by the funds set up in certain New York
suburban areas. Inquiries in around twenty other major cities uncovered about thirty more funds,
and there can be no doubt that some were missed. In total then, an estimate of around 150 hedge
funds seems reasonable.

These 150 vary substantially in size and make-up. The largest are Jones' two partnerships, each
around $40 million in size. At the opposite end of the spectrum are a few funds capitalized with
less than $100,000. Some funds have more than sixty limited partners, but the average is closer
to twenty. There are even a few with only one limited partner. The most interesting of these solo
acts are funds in which the limited partner is a corporation, or an arm of a corporation. For
example, the NuTone division of Scovill Manufacturing Co. has invested $2,670,000 from its
pension fund, of all places, in Waterbury Associates, a one-year-old venture run out of New

Like the funds themselves, the 3,000 or so investors who populate them come in many varieties.
Their average investment works out to better than $300,000, and as the magnitude of that amount
might suggest, many have names that are immediately recognizable. A good number are
corporate executives: e.g., Laurence Tisch, of Loew's; Keith Funston, of Olin Mathieson;

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Leonard Goldenson, of American Broadcasting; Daniel Searle, of G. D. Searle; H. Smith
Richardson Jr., of Richardson-Merrell; Louis "Bo" Polk, formerly of M-G-M. Another well-
known businessman, Nathan Cummings, of Consolidated Foods, once held limited-partnership
interests, but has recently given them up. So has actor Jimmy Stewart. However, a passel of other
movie stars -- Deborah Kerr, Lana Turner, Rod Steiger, Jack Palance -- remain bunched in one
California fund, Taurus Partners. Gregor Piatigorsky, the cellist, Pete Gogolak, the pro-football
place kicker, and Thomas and William Hitchcock, scions of the Mellon family, are other
examples of the diversity that is to be found among hedge-fund investors.

A watchdog for Mr. Phipps

It becomes apparent, in discussions with limited partners, that many never had any idea that their
names, much less the size of their investments, were on file in some courthouse or state office
building. A lot are appalled at that news. Probably out of a desire to keep what information they
can confidential, the managers of some hedge funds have made their partnership filings very
difficult to find. For instance, though the managing partner of Cerberus Associates, Ronald
LaBow, has his office in downtown Manhattan and runs the partnership's portfolio from there,
the partnership's papers are filed in suburban Westchester County, where the partnership keeps
an address. In neither locality does Cerberus have a listed phone. When one finally lifts this veil,
a number of prominent names turn up on the fund's list of investors, including Howard Phipps
Jr., of the well-known Long Island family.

Limited partnerships are required to amend their filings whenever important changes, such as the
admission of new partners, take place. The latest partnership filing by Cerberus gives mid-1968
data and shows Phipps's investment to be $2,500,000. Cerberus' record since then has been more
up than down (it has been a star performer among the hedge funds) so it is likely that this
investment is now larger. As a footnote, it may be recalled that in mythology, Cerberus was the
three-headed dog who guarded the gates of Hell; the name, one dictionary says, also connotes "a
watchful and formidable or surly keeper or guard."

The comfortless cushion

After last year's bear market the words "watchful" and "surly" might also have been used to
describe certain hedge-fund investors. Fortune has been able to find only a very few funds --
most of them under $10 million in assets -- that were in the plus column for the year. Many of
the larger funds had dismal records: on the first of October, when the New York Stock Exchange
composite average was down by some 13 percent for the year, the two Jones funds and City
Associates were down between 30 and 40 percent.

Figures compiled by John M. Hartwell, who runs a large investment-counseling firm and who
has been managing two private hedge funds himself, also suggest the extent of the destruction.
During the month of June, when the market, as measured by the Big Board's composite average,
dropped by 6.9 percent, eight hedge funds on which Hartwell collected data (his own two were
included) dropped on the average by 15.3 percent. In July, when the market fell 6.4 percent, the
funds were down by an average of 10 percent. And in August, when the market bounced back

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briefly, the seven funds for which Hartwell had data averaged only a 4.2 percent gain, compared
to a 4.5 percent gain for the composite average.

Despite the weight of this and other evidence, some hedge-fund managers have attempted to
persuade their investors that 1969 wasn't really as deplorable as it might have seemed. Charles E.
Hurwitz, who runs three private hedge funds in Texas and also one of the largest public hedge
funds, Hedge Fund of America, reminded the shareholders of that fund a few months ago that
"the hedging feature is designed to reduce losses in a downturn, not eliminate them." He also
referred to the "cushioning" effect of the hedge concept during 1969. Some stockholders must
have shuddered to think where they would have been without the cushion. For at the end of
November, in a tabulation of 379 mutual funds prepared by Arthur Lipper Corp., Hedge Fund of
America's 24 percent decline for the year left it sitting in the 340th spot. Even then, it was some
distance ahead of the oldest public hedge fund, the Hubshman Fund, whose cushion had not
prevented it from losing 47 percent for the year and taking firm possession of the 379th spot.

Euphoric at sixty-nine

Alfred Jones, a candid and likable man, is one hedge fund operator who has not taken 1969
lightly. He has brooded about the year's catastrophes, and believes he can trace their causes. The
trouble began, he says, in the 1966-68 period when the craze for performance swept the
investment world and when all sorts of money managers, including those in his own shop, got
overconfident about their ability to make money. Jones's record for this period was excellent:
during his three fiscal years ending May 31, 1966, through 1968, the limited partners in A. W.
Jones & Co. realized gains -- after deduction of the general partners' 20 percent of profits -- of 29
percent, 22 percent, and 45 percent. In all three years, these gains (as well as those recorded by
Jones's other partnership) were far superior to those made by the broad market averages. As the
new fiscal year began in mid-1968, the profits continued to build up. Even Jones himself, despite
his sixty-nine years, was caught up in what he describes as the "euphoria" of the times. He says
he began to wonder -- for him, the very thought was heretical -- whether his hedging strategies,
which had always been aimed at softening the effects of a potential market decline and which
had therefore held back his gains in bull markets, might not have been misguided; perhaps it
would have been smarter, he told himself, to have run at full risk all the time, thus taking
maximum advantage of the general upward trend of the market.

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With money in eight funds, Laurence Tisch, chairman of Loew's, thinks the managers learned a
lesson last year. "The market," he says, "is a humbling thing."

It was in this frame of mind that Jones and his organization came into late 1968 and into a
market top, which, of course, could not at the time be easily recognized as such. Asthe market
slid, Jones and his portfolio managers gradually cut back their risk by building up short positions
-- but as he says, it was "too little, too late." By May 31, all of the early gains of the fiscal year
had been wiped out. The break-even performance that Jones was obliged to report to his
investors compared to a 4.3 percent gain for the Exchange's composite average, and so, for the
first time in his history, Jones had finished second to the market.

Jones's reaction, other than dismay, was to involve himself more closely with the business, which
in recent years had occupied less and less of his time. Included in his immediate problems was
some unrest among his limited partners. One of them, in fact, had written to complain that the
standard of living to which he had become accustomed was incompatible with break-even years.
Jones, while he can hardly view his limited partners as on the verge of destitution -- their average
investment is even now around $500,000 -- is nevertheless sympathetic to such problems; for his
funds, more than most in existence, include a large number of investors who had very little to
start with and whose partnership interests now represent virtually their entire wealth.
Acknowledging this, Jones now says that his funds will not in the future be trying for the big
swings, but will instead aim for moderate, steady growth. ("Moderate," to Jones, if not to most
people, seems to mean gains of 20 to 30 percent a year.) In his annual letter to his partners last
July, Jones spelled out his thoughts a little further: "Each money manager is now fully aware of
the necessity of running his segment as though the typical Limited Partner were retired and had
all of his capital, say $500,000, invested in our business."

Crowding up on the short side

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Jones's midyear decision to keep his short positions high, though it came at a time when the
market was still heading down, did not get him out of the woods. For, as almost any hedge-fund
operator can testify, it is one thing to assume short positions and another to make money on
them, even in a bear market. The alleged difficulties are numerous and have been recited so often
by battered short sellers that they are by now fairly well known. One is a procedural difficulty:
by an SEC rule, short sales in listed stocks can only be made on an "uptick" (i.e., the last change
in the price of the stock must have been upward); this restriction makes large positions hard to
establish. Another difficulty arises from the tendency of Wall Street's analysts to concentrate
mainly on developing buy recommendations, meanwhile ignoring the short side. Such few good
shorts as are then discovered tend to become overcrowded, and crowds tend to bring on short
squeezes. Still other difficulties have to do with the odds: the best short sale in the world can
produce only a 100 percent profit, whereas a long position offers the possibility of unlimited
gains. Flipping the situation, a short position, should the stock begin to rise, can lead to runaway
losses. Finally, and not by any means least, psychologically it is much easier to panic about a
short position than a long one.

In most years this litany would also include the complaint that there is almost no way to produce
short profits in a generally rising market. Last year that excuse was not available. The market
favored the shorts, and yet many hedge funds still lost money -- or, at the best, made only a little
-- on their short positions. Some hedge funds say that 1969 had its special problems, among them
the existence of too many hedge funds looking for shorts. In addition, the mechanics of a short
sale require that the seller borrow the stock to consummate his sale; last year the Street's back-
office difficulties greatly complicated the borrowing process and frequently impeded the short

Nevertheless, the hedge funds' main problem last year was of a more elementary kind: they
simply picked the wrong stocks to short. In particular, there were many funds which, figuring
that the market would go down, also figured that the drop would be led by some of the high-
multiple growth stocks, e.g., I.B.M. (IBM), Xerox (XRX), Burroughs. Actually, these stocks
came through the decline in first-class shape, and in early December were not far from their
highs for the year.

Bruises for puppeteers

The debris of 1969 has naturally prompted some hedge fund investors to ask just what it is that
the hedge-fund concept is doing for them. If short selling does not afford protection in a down
market, then why short at all? Why not instead retreat to cash when the market looks bad? In
taking this tack, these investors are, of course, leaning toward the views of those fund managers
who have never gone in for short selling or who have at some point given it up. Lately, this
group has been gaining some new supporters, among them John Hartwell, whose short-selling
experience comes not only from his private funds, but also from a public hedge fund he began in
1968. Hartwell, though he has not yet abandoned short selling, has come to doubt that it is worth
the effort put into it. "Hedging is vastly overrated as a concept. People argue that there is
psychological comfort in having a short position. I used to believe it, but I don't any more. I
stopped believing it after we got bloody and beaten from short selling."

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Decorating the list of investors in Los Angeles' Taurus Partners are actresses Lana Turner (top),
with a $50,000 investment, and Deborah Kerr, with $200,000.

They haven't capitulated in the Jones camp, however. Alfred Jones and most of the fund
managers who came out of his stable remain convinced that hedging is not only a desirable
strategy, but is essential if the portfolio manager is to keep the nerve he needs to operate
aggressively, and successfully, on the long side. Talk to the general partners of such funds as
City Associates and Fairfield Partners, and they will speak ruefully of 1969 and tell you they
should have been able to pull out of it with profits. They regard their failure to do so as a
reflection not on the hedge concept itself, but on their own ability to handle it properly. After all,
it is clear that the great majority of stocks went down last year, and, that there were innumerable
opportunities to clean up on the short side -- if only those opportunities had been seized. "The
marionette always works," one fund manager said recently. "It's the puppeteer who changes."

The debate about this particular marionette is likely to be prolonged, for a single bear market can
hardly settle matters, one way or the other. In the meantime, the hedge-fund business seems
certain to undergo extensive changes, some of which have already begun to materialize. In a
way, the business is at this juncture typical of those industries in which supply has at least
temporarily exceeded demand, and in which some casualties are the inevitable result. No one
knows exactly how many hedge funds have folded. But a fair number have. Two that have just
closed down are New York's Haymar Associates, and Los Angeles' Associates West, both of
which got their investment advice from HayWood Management Corp., a subsidiary of Hayden,
Stone Inc. Both also had poor records in 1969. So did Woodpark Associates, a New York
partnership that is now leaving the scene, albeit slowly. Although it has been trying to liquidate
for several months, it is stuck with more than $1 million in securities that are "restricted," i.e.,

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that cannot be sold until they are registered with the SEC. Various problems have delayed the
registration, and as of last month Woodpark's investors still had not got this money out.

The arrival of the new year will mark not only the demise of certain other unsuccessful
partnerships and the constriction of still others, but will also bring the liquidation of one of the
country's oldest, largest, and most successful investment partnerships, Buffett Partnership, Ltd.,
of Omaha. To call the Buffett operation a hedge fund is accurate only in the sense that Warren E.
Buffett, 39, the general partner, shares in the profits of the limited partners. (Under his quite
unusual arrangement, the limited partners annually keep all of the gains up to 6 percent; above
that level, Buffett takes a one-quarter cut.) Otherwise, he is set apart from the regular hedge
funds by the fact that he has invested almost exclusively in long-term "value" situations. Buffett's
record has been extraordinarily good. In his thirteen years of operation, all of them (including
1969) profitable, he compounded his investors' money at a 24 percent annual rate. Recently, the
partnership's assets stood just above $100 million.

But now, to the immense regret of his limited partners, Buffett is quitting the game. His reasons
for doing so are several, and include a strong feeling that his time and wealth (he is a millionaire
many times over) should now be directed toward other goals than simply the making of more
money. But he also suspects that some of the juice has gone out of the stock market and that
sizable gains are in the future going to be very hard to come by. Consequently, he has suggested
to his investors that they may want to take the "passive" way out, investing their partnership
money not in the stock market but instead in municipal bonds.

Happiness at tax time

If Buffett is right in his appraisal of future market conditions, a lot of hedge-fund managers are
going to be out looking for jobs that pay better than those they now have. Many could not at this
moment survive another losing year, for as one general partner puts it, "20 percent of nothing is
nothing." Lately, a few new funds have been set up with provisions that, in effect, endow the
general partners with salaries in those years in which profits are nonexistent or very small;
ordinarily, these salaries are then considered to be advances against profits to which the general
partners may become entitled in future years. This kind of arrangement, however, is not apt to
sweep the hedge-fund business. Most investors seem likely to feel that, in handing over 20
percent of their profits in such years as these exist, they are already doing plenty for their general
partners' welfare.

In addition, many of these investors are sophisticated enough to know that when the general
partners get around to paying their income taxes, there is something very wonderful about that 20
percent. It is not, in tax terminology, "compensation," and it is not, therefore, automatically
treated as straight income. Instead, the 20 percent is the general partners' share of the fund's
profits, and these, if the market has been kind and the management wise, may be totally or
largely in the form of long-term gains.

The results can be spectacular. Consider a fund of modest size -- say, $5 million. Assume that it
makes a gain of 20 percent in a year (most funds did that well, or better, in 1967 and 1968) and
that this $1 million is all in long-term gains. That leaves the general partners -- there will

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probably be only two or three of them -- with $200,000 in long-term profits to call their own. It
is a heady scenario. There simply are not many other businesses in which the entrepreneur can
hope to acquire, in fairly quick fashion, substantial long-term gains without necessarily putting
up a cent of his own capital.

It should be noted, however, that many hedge-fund general partners do have large amounts of
their own capital in their partnerships. The company of the general partners obviously works to
soothe their investors, since it reduces the possibility that the general partners will engage in wild
speculation, figuring that they have little to lose and lots to gain. If the talk on Wall Street is to
be believed, some of last year's hedge-fund failures involved funds whose managers put into
them little or no capital, and who were therefore able to shrug off the disasters that developed.

Repercussions from the Douglas affair

The next disastrous happenings may emanate from the SEC, which for years has been fretting
about the hedge funds and which lately has been trying strenuously to arrive at some decisions
about them. A year ago the SEC sent out an exhaustive questionnaire to some 200 investment
partnerships that it had spotted by one means or another. (Fortune's inquiries, however, turned
up a number of partnerships that had been overlooked by the SEC.) The Commission is now
compiling the answers to this questionnaire, and is virtually awash in facts about hedge funds.

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In the meantime, certain members of the
SEC staff have already concluded that the Commission must take steps to regulate these funds.
The staff rests its case on legal arguments, maintaining that two laws the SEC has long
administered, but has never interpreted as applicable to the hedge funds, do apply to the funds
and do require their registration with the Commission. Be that as it may, it also seems clear that
the staff thinks the hedge funds should be regulated and that the Commission must find a way to
do it. One staff member spoke recently of the "crisis numbers" to which the funds have grown,
and there has been much SEC talk about the "impact" of the funds on the market. Some hedge-
fund operators ask bitterly whether it is not premature to be forming opinions about impact, since
the questionnaires have not yet been analyzed. The question is apt, but it is also true that the staff
has seen a great deal of the hedge funds in various investigations. In addition, the staff has access
to the records of the public hedge funds, and these indicate "impact" in the form of vigorous
trading activity. Some of the public hedge funds have been turning over their portfolios at a rate
more than seven times the average for all mutual funds.

One investigation that brought the staff into contact with the hedge funds is that which led in
1968 to an SEC proceeding against Merrill Lynch, Pierce, Fenner & Smith and ten of its
important customers for their alleged misuse, in 1966, of certain bearish information relating to

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Douglas Aircraft. Merrill Lynch settled its part of the case, and so did one of the customers, City
Associates; but the rest of the customers are still fighting. Among these are the two Jones funds,
Fairfield Partners, John Hartwell's organization, and Fleschner Becker Associates, a hedge fund
formed in 1966. All are charged with having received "inside information" about Douglas from
Merrill Lynch, and with having then made sales and/or short sales of Douglas stock. The
outcome of this case is still in doubt, but meantime it represents the first official thrust of the
commission against the hedge funds.

Last year the American Stock Exchange also made its own move against the hedge funds, and in
so doing delivered some more ammunition to the SEC. Back in 1968, the Amex began to worry
about the heavy impact that hedge-fund trading seemed to be having on certain stocks. After
investigation, the exchange concluded that its rules applying to members and allied members
could also be construed to apply to hedge funds in which these members were partners.
Consequently, it decreed last spring that in the future such hedge funds would be obliged to
abide by certain existing exchange rules, including one prohibiting "excessive dealing" on the
part of members trading for their own accounts. (The key section of this rule bars members --
and now their hedge funds, too -- from making any trade that would accentuate the rise, or fall,
of any stock already engulfed by trading activity.) The Amex's new policy helped some of its
member firms (Goldman, Sachs for one) to decide that it just might be better if they stayed clear
of hedge funds in the first place. Subsequently, a number of brokers gave up hedge-fund

"Paris is worth a mass"

Like the Amex, the SEC may have to resort to some indirection if it is to take out after the hedge
funds. The commission's basic legal bother about the funds is that they are unquestionably
investment companies, but of a variety that is able to wiggle out from under the Investment
Company Act. The wiggle arises from a clause in the act that exempts an investment company
from registration if: first, it has fewer than 100 security holders (and all of the hedge funds are
within that limit); second, it does not engage in a public offering of its securities. There is no
hard and fast definition of a public offering, but it is clear that to avoid trouble a hedge fund must
be circumspect in its solicitation of investors, must supply them with much the same information
that would normally be included in a prospectus, and must restrict its limited partners to
investors who are sophisticated enough to understand what it is they are getting into. Some
hedge-fund managers are meticulously careful about that last point. Those advised by Kenneth J.
Bialkin, of the New York law firm of Willkie Farr & Gallagher, frequently take prospective
investors to him to be interviewed for suitability. Bialkin says he has turned down a fair number -
- "mostly women."

Since it cannot get at the hedge funds through the Investment Company Act, the SEC is thinking
of trying a couple of other routes. Its staff has advanced the opinion that the hedge funds are
"dealers" in securities, a term that, up to now at least, has mainly embraced those firms that
"make markets" in various stocks. The law, however, defines a "dealer" as "any person engaged
in the business of buying and selling securities for his own account," and the staff thinks that
definition fits a hedge fund. It might also, of course, fit a conglomerate that invests in the
securities of other companies, or, for that matter, a large individual investor who spends all his

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time whipping in and out of stocks. The staff, however, is not inclined to worry about such fine
points. It only knows that if it can establish that the hedge funds are "dealers," it can make them
register under the Securities Exchange Act and thus draw them into its jurisdiction. Lawyers for
the hedge funds shake their heads and say it's all ridiculous, but they also say there are worse
things that could happen to the hedge funds. "Maybe, if it would get the SEC off their backs,"
one lawyer said recently, "the hedge funds should confess to being dealers, although they
certainly are nothing of the kind. What is it Henry IV said? 'Paris is worth a mass.'''

In hedge-fund terms, "Paris" is the 20 percent of profits that goes to the general partners, and if
these were to follow another course open to it, Paris just might disappear. This course would lead
the Commission to claim that the general partners are in truth "investment advisers," a term
which, under the Investment Advisers Act of 1940, applies to "any person who, for
compensation, engages in the business of advising others [as to their investments]." The SEC
staff contends that anyone managing money on a discretionary basis, as the general partners of a
hedge fund clearly do, is inescapably also advising these investor.

Even the hedge funds' lawyers find this argument difficult to attack, but they have tried. They
say a number of investment partnerships existed when the Adviser Act was passed, and yet the
law ignored their presence. They say also that the unlimited liability that the general partners
assume in a limited partnership, and the capital which they usually contribute to it makes them
something more than advisers. Finally, they point to a clause in the law that exempts any adviser
with fourteen or fewer clients from registration; even if the general partners are advisers, their
lawyers say, their clients are not the limited partners as individuals but the fund as a single entity.
In other words, they do not have the number of clients that would require them to register.

Gunning for the goose

The whole argument has rather desperate overtones for the general partners, for they cannot
tolerate registration as investment advisers. The Advisers Act prohibits any kind of
compensation arrangement that relates the adviser's fee to the results he achieves with his client's
money. This prohibition was written into the act to discourage speculation, for the SEC believed
at the time -- and, in general, still does -- that advisers would be led to take undue risks with their
clients' money if they stood to rake in a share of the profits, but at the same time escaped any
liability for losses. It can be argued that the prohibition destroys any advisor's incentive, and is
therefore unwise, or at the least, too sweeping. Nevertheless, the prohibition exists and, in terms
of the hedge funds, surely threatens to kill the goose that laid the golden egg.

If the SEC were now to turn its thoughts into action, and were to tell the country's hedge-fund
managers that they are from this day forward to be identified as investment advisers, most would
still not register under the act. Instead, they would quickly turn their hedge funds into registered
investment companies. They would thereby subject their funds to certain restrictive rules
regarding short sales and leverage, and, saddest of all, would lose the glorious tax advantages
applying to partnerships. But registered funds are allowed to operate with performance fees, and
thus the managers could salvage some characteristics of their old life.

Tap Dancing to Work Page 15

It is hard to say what the SEC will do, and it is even hard to form an opinion as to what it should
do. Probably the hedge funds deserve to be regulated in some way, but whether they should be
ravaged is another question. If wealthy, sophisticated investors wish to pay 20 percent of their
profits for investment management -- or, as one dejected investor put it, are "foolish" enough to
pay 20 percent -- then quite possibly they should be allowed to do so. Anyway, it could be that,
after 1969, not so many will be in that magnanimous a mood. For as every hedge-fund manager
knows, without a good product at a good price, you don't get far in the market.

Posted in: Berkshire Hathaway, Tap Dancing to Work, Warren Buffett


Can you beat the stock market?

November 21, 2012: 11:47 AM ET

Email Print

By Daniel Seligman

This story is from the December 26, 1983 issue of Fortune. It is the full text of an article
excerpted in Tap Dancing to Work: Warren Buffett on Practically Everything, 1966-2012, a
Fortune Magazine book, collected and expanded by Carol Loomis.

These super-investors beat the market quite regularly and claim that others could too if they
followed the precepts of the late Benjamin Graham. Shown aboard the QE2 en route to England

Tap Dancing to Work Page 16

recently are (from left) Warren Buffett, Walter Schloss, Charles Munger, and William Ruane.
They meet with a small group of other stock market aficionados to exchange ideas every two
years, usually on land.

FORTUNE -- Most people interested in the stock market fall into one of three categories: (1)
academic scholars who doubt that anybody really knows how to beat the market; (2) professional
investors who indignantly reject this view of the matter; and (3) amateur investors who also
believe that you can beat the market but don't realize how controversial this assumption is. I have
long been a partisan of the first group, and until the last year or so had assumed that its case was

The professors seemed to have built an overwhelming case for the so-called efficient market
hypothesis (EMH). If you think of the hypothesis as a literal description of the real world, the
stock market cannot be beaten by mere mortals. Question: how close to reality is EMH? Having
now resurveyed the basic case made for it in the business schools, and also looked at some recent
findings that seem inconsistent with it, Ifindmyself still answering that EMH is extremely useful
for understanding the stock market -- but doubting that it's as close to reality as I had previously
assumed. It seems fairly clear that some superior investors are out there beating the market

The efficient market hypothesis says that stock prices always tend to reflect everything known
about the prospects of individual companies and the economy as a whole. This simple-sounding
academic proposition has some staggering implications. It implies first of all, that stock prices
cannot be predicted: if all current information is already imbedded in the prices, then they will be
moved only by events not now foreseen -- which are, by definition unpredictable. This means in
turn that all "technical analysis," and especially efforts to discern future stock price trends by
examining past trends, are futile. EMH also implies that no amount of fundamental research,
including the exhaustive and highpriced studies done by Wall Street for big institutional
investors, will give investors an edge. It implies that if you're in the stock market, you should
buy and hold rather than trade a lot; trading increases your brokerage costs without increasing
your expected return. It tells you to assume that professionals, or indeed any investors, who have
outperformed the market in past periods were probably just lucky, and that we have no reason to
believe they will have superior results in the future. In his textbook Foundations of Finance,
economist Eugene F. Fama of the University of Chicago asks "whether there are individuals or
groups -- for example, managers of mutual funds -- who are adept at investment selection in the
sense that their choices reliably provide higher returns than comparable choices by other
investors." Answer: "If prices always fully reflect available information, this sort of investment
adeptness is ruled out."

In the mid-Sixties, Fama probably did more than anyone to develop the efficient market
hypothesis. (Nobel laureate economist Paul Samuelson of MIT was also among those who
elaborated the concept then.) Asked recently how well he thought EMH has stood up over the
years, Fama replied genially: "It's done pretty well. Most economic models barely make it to the
next set of data." His perspective is that publicly available information (but not all inside
information) is almost certainly reflected in stock prices. This means that Fama, like most other
academics, believes in the "semi-strong" form of EMH. In the so-called strong form, all

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information known to anybody is said to be built into prices; however, I never did succeed in
finding anyone who accepted this proposition as literally true.

Even in the semi-strong form, however, EMH is hard for Wall Street to swallow. It implies that
much of what investors hear around them every day is nonsense. Fast example: Standard &
Poor's was presumably talking nonsense last June, when (like a lot of other advisory services) it
said the stock market would rise further because profits were improving; the efficient market
hypothesis tells us that prices in June would already be reflecting whatever was knowable about
future earnings

First Boston's trading room must contribute to market efficiency: 290 professionals get prices
and other data instantaneously.

Having somewhat different material interests from members of the investment community, I
have always found the efficient market hypothesis intuitively appealing and told myself that it
had tremendous explanatory power. Indeed, it explains the single most obvious mystery about
the securities business: how can it be that thousands of professional stock-pickers, including
many who are plainly intelligent and industrious, are endlessly confounded by the market and
embarrassed by their selection? Security analysis is one of the few lines of work in which we
take for granted that the recommendations of respected professionals will be wrong half the time
or more.

EMH is intuitively appealing on several other grounds. In a world where hundreds of thousands
of investors are endlessly scratching around in search of some advantageous risk-return
relationship, and where professional arbitragers on exchange floors stand ready to pounce on any
security that offers a marginal advantage, and where, furthermore, computers have enormously
multiplied the number of investors with access to instantaneous price quotations, it would be
hard to explain how market inefficiencies could last more than a few minutes or even seconds.
These armchair arguments have been buttressed by an avalanche of empirical studies that have
made EMH a solidly settled question on the campuses. Indeed, some scholars are concerned that
it may be excessively settled. Michael C. Jensen of the University of Rochester, who has no
doubts at all about market efficiency, nevertheless worried recently about the battle having been

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won so thoroughly, and added: "It's dangerously close to the point where no graduate student
would dare send off a paper criticizing the hypothesis."

Among the empirical findings that make EMH noncontroversial on the campuses are any number
showing that markets either anticipate or adjust instantaneously to published information and that
they repeatedly see through misleading accounting practices. Studies of mutual fund managers
disagree only about a minor matter: whether the managers are (a) unable to outperform the
market or (b) able to do so but not by enough to give shareholders an edge after subtracting
commissions and other costs. The studies agree that funds as a group do not enable investors as a
group to achieve returns higher than those of the market. In the course of researching this article,
I sat in on a lecture on EMH by Dean Burton G. Malkiel at the Yale Graduate School of
Management. Malkiel, a lucid and witty lecturer who is a former member of the Council of
Economic Advisers, had the students in stitches describing a study whose principal finding was
an utter lack of correlation between mutual fund rankings from one year to the next. In this
context he mentioned the Mates Investment Fund, which was ranked No. 1 among mutual funds
in 1968 but never got above No. 300 in subsequent years. Malkiel's throwaway line was that
Fred Mates eventually got out of the mutual fund business and took to running a singles bar in
New York called, appropriately, Mates. Evidently assuming that this was a made-up detail, the
Yalies groaned and hissed at the line; however, it happens to be true.

Naturally not wishing to give up on a theory that helps to explain life's mysteries, I have been
distressed by some signs in recent years that the efficient market hypothesis might be in trouble,
or at least in need of some updating. Like many other EMH fans, I have been shaken by the
proliferation of "anomalies" -- this being the professors' preferred term for stock market news
that seems to confound the hypothesis. News of this kind is taken very seriously indeed on the
campuses. Professor Stephen A. Ross of Yale's management school commented jovially the
other day that papers on the anomalies have become "a major growth sector of the academic

One disturbing anomaly centers on the extraordinary records compiled by certain high-visibility
investors. The records of one tightly knit group of investors, of whom Warren Buffett is the best
known, are printed on page 42 of Tap Dancing to Work. Buffett, chairman of Berkshire
Hathaway Inc. (BRKA) and the subject of a recent Fortune article ("Letters from Chairman
Buffett," page 34 in Tap Dancing to Work), is very much aware of the extent to which his
investment record constitutes a challenge to the efficient market hypothesis. He believes that
there are exploitable "pockets of inefficiency" in the market, and he has several times argued his
case in appearances at the Stanford business school, on whose advisory council he serves.
Speaking to the council, Professor William F. Sharpe of Stanford, one of the school's academic
stars and the author of a popular textbook solidly endorsing EMH, once referred to Buffett as "a
five-sigma event." In business school lingo, this superlative signifies that you should think of his
investment performance as being five standard deviations above the mean; if literally true -- no
one claims that it is -- this would tell us that there was only about one chance in 3.5 million of
compiling an investment record like Buffett's by chance.

The apparently superior long-run performance of the Value Line Investment Survey is another
anomaly that efficient-market fans must come to terms with. The professors have, in fact, been

Tap Dancing to Work Page 19

worrying about the survey since 1970, when Value Line Chairman Arnold Bernhard made a
presentation about its record at the University of Chicago.

Every week Value Line ranks about 1,700 stocks on a scale of 1 (most favorable) to 5.
Bernhard's most compelling detail: in the five-year period beginning in April 1965, the returns to
investors had corresponded precisely to the rankings. In every one of the five years, Rank 1
returns had been highest, Rank 2 returns had been next highest, and so on. For the five years as a
whole, Rank 1 was up 129% and Rank 5 was down 41%; this was a period in which stocks were
rising about as often as they were falling

Eugene F. Fama, 44, expounded the efficient market hypothesis in his 1965 doctoral dissertation.

Bernhard's methodology in getting to those figures was challenged by Professor Fischer Black,
now of MIT, a leading advocate of the efficient market hypothesis. However, Black ultimately
concluded -- reluctantly, I have to assume -- that Value Line had indeed done well over the five
years. His own figures showed annual risk-adjusted returns averaging 10% for Rank 1 during the
period and -10% for Rank 5. (A risk-adjusted return is one from which you have subtracted the
return expected on a randomly selected portfolio of comparable risk.) Reviewing matters three
years later, Black wrote in the Financial Analysts Journal: "If anything, the results have been
better since 1970."

However, Value Line was not yet home free. During the past decade or so, further refinements in
performance evaluation techniques have led to still more pulling apart of the organization's
results; the latest edition of Financial Theory and Corporate Policy, a textbook by Thomas E.
Copeland and J. Fred Weston, offers a "partial listing" of seven serious academic papers on
Value Line. The central issue in the most recent of these papers -- as in much other literature
about EMH anomalies -- is risk adjustment. Obviously, you cannot get agreement on Value
Line's providing superior risk-adjusted returns unless you first get agreement on how to measure

In examining Value Line's record, a 1982 paper by Copeland and David Mayers of UCLA
applied a measure of risk different from that used by Fischer Black; in addition, they extended
the period under examination out to 1978. The upshot: Value Line's edge now looked much

Tap Dancing to Work Page 20

smaller, and a strategy of going long on Rank 1 and short on Rank 5 would have yielded only
6.8% a year in riskadjusted returns, at which level profits would apparently have been wiped out
by brokerage commissions. In a final zinger, Copeland and Mayers noted that the abnormal
returns appeared to be sinking toward the end of the period. Still, any abnormal returns at all
represent a challenge to EMH. The CopelandWeston textbook concludes a detailed passage on
Value Line by proclaiming that it ''remains an enigma."

Several heavily studied anomalies concern the well-known discount on closed-end funds: many
of the funds, which are publicly traded, sold for years at huge discounts from their underlying net
asset values. After several of the heavily discounted closed-end funds went open-end a decade or
so ago, the discounts began to shrink; however, no one has satisfactorily explained why they
were so wide in the first place. "I've heard a hundred convoluted explanations of the discount,"
says Stephen Ross of Yale, "and not one that makes any sense."

In retrospect the discounts look especially disconcerting because an investor who had naively
told himself that he was outfoxing the market by buying his portfolio at a discount was outfoxing
the market, or at least outperforming it. Professor Rex Thompson of the University of British
Columbia has shown that during the 32 years beginning in 1940 an investor could have
consistently earned abnormal returns with a simple trading rule. The rule: maintain a portfolio of
discount funds, and weight the portfolio so as to emphasize those with the largest discounts. The
trading rule would have rather consistently given you a risk-adjusted rate of return of over 4%.
Conversely, an investor who had maintained portfolios of the funds selling at a premium (which
a few of the funds always did) would have racked up risk-adjusted losses of 7.9% a year -- also
an affront to EMH. Or, rather, an apparent affront. Thompson himself is inclined to think that he
was looking not at a market inefficiency but at still another situation in which risk wasn't being
measured properly.

Two other heavily studied anomalies pertain to the calendar. One, the "January effect," refers to
a distinct, statistically significant pattern of above-average returns to investors during that month,
with the gains heavily concentrated during the first five trading days of the month; in addition,
the gains are concentrated in the stocks of small companies. Such seasonal happenings are
supposed to be ruled out by EMH.

The other calendar-based anomaly seems even more bizarre. It is the "weekend effect," a
phenomenon on which Kenneth R. French of the University of Chicago appears to be the world's
leading authority. Analyzing daily returns from 1953 through 1977, French found a persistent
tendency for returns on Monday to be negative even though returns for the period as a whole
were positive. The data suggested the possibility of a profitable trading rule: load up on stocks on
Monday, just before the close, and then sell just before Friday's close. French's data said that if
you applied this rule to Standard & Poor's composite index of 500 stocks during 1953-77, you
would have had an average annual return of 13.4% (before transaction costs), vs. 5.5% for the

The weekend effect seems especially mind-blowing when you focus on another detail. Why
should Monday be a sick day on Wall Street? Instinct suggests that the below-average returns
must have something to do with the fact that the market had been closed during the two previous

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days. For example, you might wonder whether companies weren't more likely to release bad
news on days the market is closed. But this doesn't hold up. French found that when the market
is closed because of a holiday (and not just a weekend), the day after the holiday is not sick. In
other words, the weekend effect really does have something to do with weekends; and not closed
markets in general.

Stephen A. Ross, 39, has pioneered in developing new measures of stock market risk.

The discovery of these calendar effects is most ironic. Over the years the academics who have
developed EMH have been at pains to shoot down various Wall Street superstitions rooted in the
calendar, the principal ones being belief in a summer rally and a year-end rally. In the lecture I
attended at Yale, Malkiel explained why it was absurd to believe that the week between
Christmas and New Year's Day tends to be bullish. If there were any foundation to the belief, he
said, then investors would obviously load up on stocks just before Christmas and sell just before
the New Year. If they did that, the bullish period would be moved back a day or so, the investors
would then have to buy and sell still earlier, and they would be caught in an infinite regress.
Against this background, itis bothersome to the academics to be in the position of discovering
calendar effects that Wall Street hadn't heard about.

Furthermore, the calendar anomalies are not of the class that can be attributed to uncertainty
about measuring risk. Professor G. William Schwert of the University of Rochester, who is one
of the editors of the Journal of Financial Economics -- which can claim to have published more
articles about efficient market anomalies than any other periodical in the world -- commented
wryly the other day: ''I'm willing to believe that we're mis-specifying risk in some serious way,
but I have trouble believing that we only do it on certain days of the week."

The leading entry in the anomaly sweepstakes these days is none of the above. It is, instead, the
"small-firm effect." Schwert contributed an article on the small-firm effect to the June 1983 issue
of his journal, which also carried six other articles on the subject. Since small-company stocks
are in general riskier than blue chips, you would, of course, expect them to have higher returns
on average. The news on the small-firm effect is that even after adjusting for risk, small-
company stocks yield outsize returns. Marc R. Reinganum of the University of Southern

Tap Dancing to Work Page 22

California has found that for "very small capitalization firms," the risk-adjusted annual return has
been running at an incredible average rate of more than 20%.

How can this be? If small-company stocks -- or any other class of stocks, for that matter -- are
clearly identified as superior investments, you would expect the market to bid up their prices
until they reached a level at which risk-adjusted returns to future investors would be merely
normal. Why doesn't this happen?

In attempting to fathom the small-firm effect, the academics have come up with another startling
finding: the small-firm effect is in part a reflection of the January effect. Donald B. Keim of the
Wharton School has demonstrated that about half of that outsize return to small-company stocks
is accounted for by their superior performance during January, especially during the first few
days of the month. Whether this seasonal news reduces or magnifies the mystery of the small-
firm effect is somewhat unclear, but the finding has evidently encouraged academics to look
closely at some tax-related and other institutional explanations of the anomaly.

For example, what about the possibility that small-company stocks do well early in January
because they are rebounding from year-end tax-loss selling? Presumably they are especially
vulnerable tosuch selling because, as high-risk stocks, they are more likely than blue chips to
represent losses to investors. "This argument is ridiculous, of course," wrote Richard W. Roll of
UCLA in a now famous article in the winter 1983 Journal of Portfolio Management, and he
explained why: "If investors realized that such a pattern were persistent, they would bid up prices
before the end of the year and there would be no significant positive returns after January 1."
Roll nevertheless went ahead and ran some empirical tests of the ridiculous argument; for
example, he checked to see whether the stocks that did best early in January were in fact most
likely to be those with poor performances in the prior year. It turned out that they were, and for
this and other reasons Roll surprised himself and concluded that the tax-selling hypothesis had
something to it. (His mind-boggled attitude toward his findings is reflected in the article's
Teutonic title: "Vas ist das?") This left him having to explain why traders didn't bid up the prices
of small-company stocks in December and sell them in January. The likeliest explanation, he
decided, was high transaction costs, especially the huge bid-asked spreads on many small stocks.
Although Roll is one of the heavyweights of the efficient market fraternity, his explanation of the
small-firm-cum-January phenomenon has not been accepted by all his colleagues.

Even if it were universally accepted, we would still need an explanation for the half or so of the
outsize small-company returns that are not attributable to happenings in January. And we still
need explanations for the other anomalies -- investments that seem to have consistently offered
superior risk-adjusted returns in defiance of EMH. Hopes about resolving these mysteries center
on two possibilities: (a) that we will find new and better measures of risk that make the
anomalies go away, and (b) that we will find quirks in the marketplace that explain the anomalies
without requiring us to throw out EMH. Nobody in the academic world, so far as I know, is
responding to the anomalies by saying that maybe they mean markets are much less efficient
than previously supposed.

For the past 20 years or so, the preferred risk measure, both in the business schools and among
portfolio managers, has been the famous beta. The logic of beta derives from the Capital Asset

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Pricing Model (CAPM), developed in the early Sixties by William F. Sharpe and others. The
central insight of the CAPM is that not all kinds of risk affect return. The market does not
compensate you for bearing a risk associated with a given company -- the risk of a strike, say, or
a product failure -- because you can effectively eliminate such risks by diversifying. What you
cannot eliminate is the "systematic risk" that all investors share by virtue of the fact that stocks
tend to rise and fall together in bull and bear markets. Beta therefore expresses only the
systematic risk of a given stock and endeavors to do so by measuring the extent to which returns
on the stock have been more, or less, variable than those for the market as a whole. With the
market's own beta pegged at 1.0, a highly volatile stock that has historically offered extremely
variable returns might have a beta of 2.0. A defensive stock with minimum swings and not too
much dispersion in its returns might have a beta of 0.5. In principle, high-beta stocks have
correspondingly high rates of return. So if beta works as intended, and if markets are efficient as
believed, it should be impossible for scholars to find anomalies like the small-firm effect.

The fact that the anomalies nevertheless keep turning up is one reason why beta looks somewhat
shaky these days. Fama's crisp judgment on beta: "It's not adequate -- that's for sure." This risk
measure is not in trouble just, or even mainly, because of the anomalies. It has also been hurt by
(a) evidence that betas are not as stable over time as long assumed, (b) evidence that any
individual stock's beta will vary considerably, depending on which index one uses as a proxy for
the market as a whole, and (c) the bothersome finding of a decade ago that over one extremely
long period (1931-65) the risk-return relationship wasn't quite right: actual returns were
somewhat higher than predicted for low-beta stocks and lower than predicted for high-beta

The hottest current candidate to replace beta is a measure developed by Ross of Yale and Roll of
UCLA. They propose to replace the whole CAPM with their APT, which stands for Arbitrage
Pricing Theory. Like the CAPM, the APT assumes that only systematic risk -- the kind that can't
be diversified away -- needs to be measured. However, it also assumes that systematic risk
cannot be captured adequately in a unitary measure like beta. The research thus far tells Ross and
Roll that systematic risk needs to reflect several separate factors. The three mentioned most
often: unanticipated changes in inflation, in industrial production, and in interest rates. Efforts to
determine whether, and to what extent, the APT will get rid of the anomalies are still
preliminary, but Ross believes that his model will wipe out most of them.

In any case the APT clearly sends out messages about various stocks' riskiness quite different
from what beta tells us. The beta approach casts utilities, for example, as low-risk defensive
stocks, while APT shows them to be extremely risky in periods of unexpected inflation. One side
effect of APT's emergence has been to give utilities a useful new tool in arguing with rate
commissions about their appropriate returns. Revealing a utopian side to his character, Ross says
he hopes that utilities will use APT because it is a better model and not just because it happens to
serve their interests.

What about the possibility that some anomalies will ultimately be explained by quirks of the
marketplace -- by arrangements that might sometimes lead investors to be less rational than
EMH assumes them to be? Some proposed explanations look plausible. Dean LeBaron, president
of the rapidly growing Batterymarch financial management group in Boston, observes that

Tap Dancing to Work Page 24

institutional investors in general are apt to be unreasonably leery of high-risk situations because
the corporate treasurer, say, doesn't want to have to explain how come the pension fund portfolio
he okayed had a company in it that went bankrupt. LeBaron says that some of his institutional
clients were "not enthusiastic" about a high-risk portfolio that he was assembling early in 1982
and that included such subsequent big winners as Chrysler and International Harvester.

Another cluster of quirks has to do with the sizable transaction costs (mainly in the form of
outsize bid-asked spreads) and liquidity problems associated with companies that have small
capitalizations. A portfolio manager would have trouble loading up on such stocks without
sending their prices through the roof. Dimensional Fund Advisors, a hot new fund group, is
trying to solve this problem by assembling small-company portfolios and offering them to
pension funds and other institutional investors. Among DFA's advisers: Gene Fama.

On balance it seems likely that all or most of the anomalies will ultimately yield to further
academic findings about risk and institutional quirks. It seems most unlikely that the anomalies
will end up vindicating Wall Street. You have to keep reminding yourself that the Street would
never have heard of most of the anomalies but for business school research, and that the puzzles
still to be solved are puzzling only in relation to academic models that have long been scorned on
the Street. Anyway, if the market actually was inefficient in some fundamental way, the
professional stock-pickers of America wouldn't be in such chronic disarray.

The hard part is explaining the existence of such apparently superior investors as Buffett and
Value Line. An EMH hard-liner would argue that it's possible such investors are just being lucky
year after year after year; and since nobody knows how to run a controlled experiment decisively
differentiating between luck and skill in stock selection, that argument cannot be totally
excluded. But Buffett's view -- that in a basically efficient market it is nevertheless possible to
find occasional, exploitable pockets of inefficiency -- seems much more plausible.

What Buffett's view implies for the average investor is another matter. The professors make a
persuasive case for just buying and holding a diversified portfolio. And even if you accept that
superior investors do exist, it could be a mistake to act as though you and your broker are among

Posted in: Berkshire Hathaway, Tap Dancing to Work, Warren Buffett


Capital Cities' capital coup

November 21, 2012: 11:46 AM ET

Tap Dancing to Work Page 25

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Wall Street cheered as the 16th-largest communications

company prepared to swallow ABC. The outfit that will run
the combined operation is famously lean, but its cost-cutting
bosses know how and when to spend - and how to motivate
By Stratford P. Sherman

This story is from the April 15, 1985 issue of Fortune. It is the full text of an article excerpted in
Tap Dancing to Work: Warren Buffett on Practically Everything, 1966-2012, a Fortune
Magazine book, collected and expanded by Carol Loomis.

The winning team: Chairman Murphy (right) and President Burke of Capital Cities

FORTUNE -- When Capital Cities Communications, a medium-size New York company,

worked out a $3.5-billion takeover of giant American Broadcasting Cos., Wall Street paid a rare
tribute. Usually only the target company's stock price rises, impelled by whatever premium the
purchaser offers. This time ABC's share price skipped up 42% to $106 within a week, and
Capital Cities stock moved up too, rising 22% in the same period to $215 a share.

The market's thundering approval denotes an almost reverential confidence in the management of
Capital Cities, which will run the surviving company from midtown Manhattan offices with a
view of St. Patrick's Cathedral. Chief Executive Thomas S. Murphy, 59, is balding, cheerful, and
famed for his cost-cutting propensities and hands-off management. President Daniel B. Burke,
56, is more intense but philosophically much like his boss. They have been described by an
awestruck subordinate as ''one of the greatest Mutt and Jeff acts in business today.''

Tap Dancing to Work Page 26

Under Murphy and Burke, Capital Cities has turned in an exceptional performance in its
principal businesses: broadcasting, which produced 51% of the company's 1984 operating
profits, and publishing (48%). Without much show of effort, Capital Cities' per-share earnings
growth since 1974 has averaged 22% annually, compounded. Return on shareholders' equity, a
key measure of performance, averaged a splendid 19.2% during the period. In addition to seven
TV stations (four ABC-affiliated) and 12 radio stations, Cap Cities has publishing interests
ranging from the Kansas City Star Co. to such medical journals as Aches & Pains.

Leonard H. Goldenson, the magisterial chairman of ABC, has shown his admiration for Murphy
and Burke by entrusting them with the $3.7-billion-a-year TV, radio, and publishing empire that
he has ruled with ferocious independence for over 30 years. ABC, which is more profitable than
CBS or NBC despite a recent plunge to third place in prime-time audience ratings, has been
beset by suitors for decades. At 79, Goldenson is determined to protect the company he created --
''in perpetuity,'' as he puts it. He negotiated a deal that security analysts regard as highly
favorable to ABC's shareholders.

Warren E. Buffett, 54, chairman and 41% owner of Berkshire Hathaway (BRKA), a wonderfully
successful Omaha conglomerate with a large investment portfolio, says of Murphy, his friend for
almost 20 years: ''I think he is the top manager in the U.S.'' No slouch as a manager himself,
Buffett has placed a substantial part of his future in Murphy's hands. Berkshire helped bring off
the friendly acquisition by agreeing to buy about 18% of the merged company, Capital
Cities/ABC Inc., for $518 million. That stake should provide a buffer between the surviving
company and would-be acquirers. Buffett expects to make good money on the deal, and to get in
on it he agreed to sell his holdings in such media companies as the Washington Post Co. (WPO)
and Time Inc. (publisher of Fortune) if he's required to by the Federal Communications
Commission, which must approve the takeover. More extraordinary, Buffett agreed to vote with
management for 11 years -- on condition that either Murphy or Burke be in charge -- and
accepted severe limitations on his freedom to buy and sell the stock.

In Buffett's admiring phrase, Murphy and Burke are ''models of pleasant rationality'' who know
how to motivate managers without often brandishing bludgeons or setting specific financial
goals. Their low-key management style, grounded in decentralization and cost control, is imbued
with the notion that each manager has the confidence of superiors, and is expected to realize his
or her full potential. ''They implore us,'' says one newspaper publisher, ''they don't give us
mandates.'' Adds general manager Kenneth M. Johnson of Cap Cities' KTRK-TV in Houston:
''We have the opportunity to run our properties the way they should be run.'' Nonconformity
seems to work. The stations enjoy pretax profit margins as high as an estimated 70% of sales,
compared with a broadcasting industry average of 34%.

Murphy sometimes carries decentralization a long way. When in 1961 he hired Burke to replace
him as general manager of the company's first TV station, in Albany, New York, Murphy spent
only an hour introducing Burke around before returning to his own New York City office. Fresh
from General Foods' Jell-O division, where he was head of new product development, Burke
knew little about broadcasting. He sent off weekly memos to Murphy, many of them containing
questions about important operating matters. It was weeks before Burke heard from Murphy.
Says Burke, ''He just expected me to take care of things.''

Tap Dancing to Work Page 27

The great exception to the local-autonomy principle is a rigorous annual budgeting process that
Burke personally oversees. The company isn't miserly -- executives sometimes fly first class, and
capital expenditures last year amounted to $54 million -- but when Burke spots waste he doesn't
hesitate to intervene. Recalling one such intervention, Phillip J. Meek, publisher of the Fort
Worth Star-Telegram, says: ''The guys here still haven't forgotten his steely blue eyes.''

Cap Cities hires good people regardless of background -- Meek came from Ford Motor Co. (F) --
and keeps them. Few key executives have ever been fired, and many have served the company
for 20 years or more. Colleagues claim that Murphy finds happiness feeding other people's egos
instead of his own. He regards his job as managing the shareholders' assets; he concentrates on
acquisitions and leaves operating decisions to Burke. Managers who perform well get praise,
high salaries, and stock options. The result is an enduringly entrepreneurial enterprise. Cap
Cities' stock has appreciated at an average rate of around 23% a year since the company went
public in 1957. Burke and Murphy don't stint on themselves. Thanks to profits from stock
options, Burke's total take in 1983 amounted to $4.3 million, while his boss reaped $6 million,
putting them among the best-paid U.S. executives.

Murphy, who grew up in Brooklyn, is the son of a New York State supreme court judge and a
mother who always told him he was perfect. He attended a Jesuit high school and got a degree in
mechanical engineering at Cornell. After Navy service he applied to Harvard Business School,
but was rejected. He worked a year as an oil salesman for Texaco, finally got accepted by
Harvard, and stayed near the top of his class. ''They scared the death out of me,'' he explains.
Murphy's favorite course was called Control.

After graduation in 1947, he worked in advertising and then for Lever Bros. as a brand manager
(Chlorodent toothpaste and Dove soap) before joining Capital Cities in 1954. ''His greatest
intellectual gift is simplification,'' says James E. Burke, chairman of Johnson & Johnson (JNJ).
He is Dan Burke's older brother and a business school classmate of Murphy. Asked recently to
describe the network-TV business he is about to enter, Murphy offered one word: ''Competitive.''

The Burkes grew up near Albany, New York, sons of a New York Life Insurance Co. manager.
Their mother, a Wellesley graduate, encouraged stimulating dinnertime conversations. ''Dan was
the brightest in the family,'' says his brother. Of the close-knit pair that runs Cap Cities, Jim
Burke says, ''They don't have failure in them. They're conquerors.''

The conquerors' cost-cutting reputation is getting close attention at ABC, which has never
matched Cap Cities' operating efficiency. Many of the network's employees fear that they'll soon
be living lower on the hog. Plenty of heads may roll. ''Obviously there is some concern,'' says
one middle manager. ''I, for example, may be out of a job.'' But the deal isn't likely to close for
perhaps another year. Murphy says that once it does, Frederick S. Pierce, 53, Goldenson's No. 2
for the last two years, will run ABC autonomously, reporting to Burke. Presumably the
arrangement will last as long as Pierce gets results. He has shown himself to be tough. Some
employees fear that Pierce, with his ego bruised by Goldenson's decision not to pass him the
reins of an independent ABC, will throw himself into the new cost-control era with threatening

Tap Dancing to Work Page 28

Some security analysts have said the merger won't reduce Capital Cities/ABC's per-share
earnings even temporarily, but Murphy cautions, ''We'll have to see what the earnings are.'' His
chief financial officer predicts some dilution the first year. Earnings per share will be hit by
additional shares issued to Buffett, and in two other ways as well. Even with Buffett's $518
million, and after selling roughly $1 billion of what Murphy calls ''offending assets'' under FCC
rules (such as TV stations whose signals overlap with those of others owned by the company),
Cap Cities will have to borrow $2 billion from banks. That means big interest costs. There'll also
be large charge-offs for what accountants call goodwill -- the difference between ABC's net
tangible assets and the purchase price. The charge-offs could amount to $50 million a year. But
Warren Buffett says: ''It's a damn good deal. The company will do very well.'' Wall Street
obviously agrees.


Merger fees that bend the mind

November 21, 2012: 11:45 AM ET

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Executives fume at the tens of millions they pay top

dealmakers. But they shudder at the thought of swinging
deals without expert help. No early collapse of fees is likely.
By Peter Petre

This story is from the January 20, 1986 issue of Fortune. It is the full text of an article excerpted
in Tap Dancing to Work: Warren Buffett on Practically Everything, 1966-2012, a Fortune
Magazine book, collected and expanded by Carol Loomis.

Tap Dancing to Work Page 29

Companies are on the table as Bruce Wasserstein, director of First Boston Corp.'s merger group,
seated, consults with managing directors Charles G. Ward III, 33, center, and Bill G. Lambert,

FORTUNE -- On an ordinary workday morning last October, a chauffeur-driven limousine

pulled up outside the midtown Manhattan headquarters of First Boston Corp., an investment
banking firm. A yuppie in his early 30s alighted and disappeared into the building as an older
man on the sidewalk, passing by on the way to his own office, stared in astonishment. The
passer-by is treasurer of a major industrial company that is a First Boston client; he had just
witnessed the grand arrival of one of the middle-level merger and acquisition specialists working
on his company's account.

Corporate America is hooked on a very expensive habit -- paying huge fees to the handful of
investment banking firms that dominate the merger and acquisition business. The year just ended
has been the most lucrative in history for America's professional dealmakers. By some estimates,
the merger units at three leading firms, Goldman Sachs (GS), First Boston, and Morgan Stanley
(MS), each pulled in about $200 million in fees in 1985, not counting commissions for helping
raise the money to finance deals.

More than ever, an insistent question resounds through U.S. corporations: Are the dealmakers
really worth that kind of money? With customers willing to pay, the quick answer is yes. But
clients are muttering, and dealmakers are getting a bad image. You can't count on their loyalty,
grouse many chief executives; the merger maven who is your hired gun today may wind up in
the enemy camp next time around -- possibly armed with intimate details of your operation.
These fellows, it is further said, will stop at nothing to get a deal going. Merely calling a
dealmaker for advice may put your company in play.

Such grousing has not dented fee structures and isn't likely to anytime soon. But the fees clearly
rankle, and the issue is so charged that many senior executives who discussed it with Fortune
refused to be quoted for fear of the dealmakers' wrath. Many dealmakers, wary of inviting a
backlash, also insisted on anonymity.

Tap Dancing to Work Page 30

The dealmakers owe their huge take to the current merger wave -- some $200 billion worth in
1985, according to W.T. Grimm & Co., a Chicago research firm -- and the increasing dominance
of a few dealmaking firms. Like patients with a rare disease who demand the best doctors money
can buy, corporations turn to an oligopoly of investment firms that keep honing the latest
stratagems. Price is secondary, considering what can go wrong in a big deal. In bidding for an
acquisition, says the chairman of a company that made a large buy in 1984, ''I can screw up
badly. So I get the best people and pay what I have to pay. You pay investment bankers for
knowledge of the game. They're good at it; they created it.'' Says one young dealmaker at a major
firm, ''We always deal with the same players -- the same lawyers and bankers -- and there are
accepted protocols that guys from the sidelines just don't know.''

That's why interlopers and lesser fry have had a tough time winning a piece of the merger
business. According to statistics compiled by First Boston on more than 400 U.S. deals valued at
$100 million or more in 1985, corporations hired one of the top three firms in 35% of the cases
and one of the top seven dealmakers 57% of the time. Drexel Burnham Lambert has bulled its
way in by bundling dealmaking services with junk-bond financing. Commercial banks, on the
other hand, are still in the minor leagues. For years they have offered merger assistance,
sometimes at cut rates, but have landed none of the top deals.

The son of a steelworker, chief dealmaker Jay F. Higgins, 40, of Salomon Brothers has his arm
in a sling because of an old sports injury.

Faced with towering fees, some corporate chieftains play do-it-yourself. According to First
Boston's figures, that happens only 14% of the time, typically in situations where private
companies are being bought or sold. In deals between public companies, some executives have
learned the hard way that the do-it-yourself approach can be more costly than paying investment
bankers' fees. In January 1985 a Delaware court held the directors of Trans Union Corp. liable in
a lawsuit following the railcar-leasing company's acquisition by Marmon Group, a private firm
controlled by Chicago's Pritzker family. The plaintiffs were Trans Union shareholders who felt
the price was too low and the deal hastily done. They argued successfully that the board made an
ill-informed decision, which it could have avoided partly by getting an investment banker's
opinion of the price.

Tap Dancing to Work Page 31

Successful do-it-yourselfers tend to be financiers with extraordinary talent for sizing up a
transaction. When CBS was threatened with a takeover by Ted Turner, Loews Corp. (L)
Chairman Laurence Tisch rode to the rescue, taking a position in CBS stock that could go as high
as 25%.

Another do-it-yourselfer faced down two of Wall Street's most famous gunslingers. Warren
Buffett, the Omaha investing wizard and chairman of Berkshire Hathaway (BRKA), stepped in
last March on behalf of Capital Cities Communications in its effort to acquire American
Broadcasting Cos. Buffett, who is taking a 19% stake in Capital Cities in conjunction with the
deal, went into negotiations assisted by merger lawyer Martin Lipton of the firm Wachtell Lipton
Rosen & Katz. Across the table were Bruce Wasserstein, co-director of First Boston's mergers
and acquisitions department, and takeover specialist Joseph Flom of the law firm Skadden Arps
Slate Meagher & Flom.

As the two sides neared an agreement, the professional dealmakers held out for more. ''Buffett is
so smart,'' Wasserstein remembers, ''that you had to be careful to avoid being picked.'' As the
dealmaker tells it, he and Flom demanded that Capital Cities sweeten its cash offer for ABC with
stock; but Buffett, who was not to be pushed far, finally closed by throwing in some small
change -- a thin veneer of warrants that raised the deal's value by perhaps 3%. Buffett has
declined to comment.

Today's high fees reflect a fundamental shift in the relationship between investment bankers and
clients. Less important than a decade ago are long-term associations in which a corporation
depended on one Wall Street firm for discreet help and advice in a range of financial affairs, of
which mergers were only a minor part. Today's relationships are shorter lived, sometimes
breaking up after a single transaction, and the investment bankers must ceaselessly stalk new
business. Laments a well-known and powerful New York financier who deplores the dealmakers'
fat fees and fast moves, ''There are no investment bankers anymore, only brokers out to make a

One top dealmaker agrees. ''Investment bankers are independent,'' he says bluntly. ''We don't
serve anyone anymore.'' But he claims corporations have only themselves to blame. Ten years
ago the bulk of the bankers' income from corporate finance came from the cozy businesses of
underwriting securities and making private placements for those long-term clients.

Tap Dancing to Work Page 32

Morgan Stanley's merger boss, Eric J. Gleacher, 45, was almost acquired himself. He quit
Lehman Brothers before its merger with Shearson.

In this dealmaker's view, the old relationship went out in 1982. The Securities and Exchange
Commission, urged on by major corporations, instituted so-called shelf registration of new
issues. This allowed corporations to register large amounts of new securities at one time, issuing
portions whenever they chose. As a result, companies had less need for investment bankers'
services, and underwriting securities turned into an uninviting business with skinny margins.
''When major corporations pushed for shelf registration,'' says the dealmaker, ''they cut the
umbilical of the client relationship.''

Looking for other ways to make a buck, the Wall Street firms pushed dealmaking. By happy
coincidence, mergers and restructurings had taken a quantum jump by the time registrations went
to the shelf. In setting stiff fees for this growing part of their business, the investment firms took
full advantage of their new easy-come, easy-go relationship with corporations. ''When you had
client relationships,'' says an investment banker, ''it was sometimes hard to charge what you
wanted to.'' Today dealmakers make their money the old-fashioned way -- by charging what the
market will bear.

For those multimillion-dollar fees, clients get the services of such dealmaking virtuosi as
Wasserstein and Joseph Perella, who together run First Boston's mergers group; Geoffrey Boisi,
co-head of investment banking services at Goldman Sachs; and Eric Gleacher, head of mergers
and acquisitions at Morgan Stanley. They also get the services of merger departments -- which in
some firms have grown into deal factories employing scores of professionals. By standardizing
dealmaking techniques and recycling information churned up in earlier deals, these organizations
multiply the efforts of the gifted few who devise clever stratagems and think up new kinds of

Celebrated dealmakers still negotiate the biggest transactions, but the top firms insist that much
of their advantage today comes from teamwork and information technology. Deals incubate and
hatch in nests of printouts -- asset analyses, profiles of potential partners, and what-if scenarios.
Intelligence gets pulled into a deal from all over the firm. Corporate finance experts size up the

Tap Dancing to Work Page 33

details of offers, for example, and security analysts and arbitragers give readings about whether
investors will think a deal's price is right.

In courting clients, the big dealmaking shops trumpet such prowess. Over the past year, by
giving young dealmakers more leeway, buying more computers -- and aggressively selling its
services -- Morgan Stanley has quadrupled the number of deals its mergers unit handles. But the
archetypal deal factory is First Boston's. The unit's goal, according to managing director Bill
Lambert, is to make sure that First Boston becomes involved in every major deal -- even if the
original participants haven't invited it. Go-go marketing catapulted First Boston past old-line
names like Morgan Stanley and Lazard Frres (LAZ) to match Goldman Sachs as the biggest
dealmaker in 1985. First Boston did an estimated 175 deals worth roughly $60 billion.

The 120 professionals in First Boston's renowned deal factory work in squads, some in regional
outposts, some specializing in those industries where merger activity is hot, and some assigned to
push particular types of deals -- or ''products'' as First Boston calls them -- such as divestiture
plans and leveraged buyouts. By mixing and matching the experts from the various squads, says
Wasserstein, the unit can quickly analyze and structure transactions that otherwise would seem
unspeakably complex.

Goldman Sachs's dealmakers are led by Willard J. Overlock Jr., 39, and Geoffrey T. Boisi, 38.

Edward Hennessy Jr., chief executive of Allied-Signal Corp., is one of many corporate chiefs
who are avid users of the dealmakers' services. In five major deals since 1982, Hennessy has laid
out more than $20 million in dealmaker fees, transforming Allied from a poky oil and chemical
producer into a technology and automotive company. One investment banker says Hennessy
drives a hard bargain and chides dealmakers when they collect high fees from other clients on
foolish deals. The wisdom of his own moves has yet to be proved. On a split-adjusted basis,
Allied's stock recently sold 55% above its high in 1982, the year Hennessy began merging,
acquiring, and divesting. But the market has climbed more.

Another heavy patron of the deal factories is Donald Kelly. As chief executive of Esmark
between 1977 and 1984, he made over 50 acquisitions and divestitures and finally sold the

Tap Dancing to Work Page 34

company to Beatrice Cos. Now he is in line to run Beatrice after it is taken over by Kohlberg
Kravis Roberts & Co. (KKR) in a $6-billion leveraged buyout, the biggest ever attempted. Kelly
says he fought hard about fees a decade ago. ''I'd say, 'Whatever you charge is too much,' and
they'd say, 'You're too cheap,' '' he recalls. Now, he says, he has a ''gut feel for what's fair,'' and if
he underpays a firm on one transaction he lets it overcharge on the next.

Unlike a lot of corporate chiefs, Kelly is comfortable with the newly casual relationship between
dealmaker and client. Too many executives, Kelly says, are still counting on that old loyalty.
''The thing hardest for most people to understand is that one transaction does not create a lifelong
association,'' he says. ''You can find Bruce Wasserstein alongside you in one deal and on the
other side of the table in the next.''

When the modern dealmaking machinery of an investment bank works, it can warn clients away
from costly mistakes and deliver lots of money into shareholders' hands. Morgan Stanley and
Shearson Lehman Brothers, for example, kept Nabisco Brands from stumbling into shark-
infested waters on the way to its $4.9-billion acquisition by R.J. Reynolds Industries. The deal
initially planned by Nabisco chief F. Ross Johnson and J. Tylee Wilson, his Reynolds
counterpart, was a so-called merger of equals -- a friendly, cashless transaction in which Nabisco
shareholders would exchange their stock for Reynolds shares.

Mergers of equals were in vogue several years ago. But in today's frenzied merger market, they
often trigger competing tender offers that lure shareholders by offering cash premiums. Johnson's
investment bankers advised him that if he wanted to keep other acquisitors out of Nabisco's
cookie jar, he needed a much higher price, preferably in cash, from Reynolds. The Reynolds
chairman went off on a business trip, and on his return agreed to pay a hefty premium -- about
50% above the shares' market price before the talks began -- in cash, preferred stock, and notes.
The dealmakers' trophy: $10 million cash, divided between Morgan Stanley and Shearson
Lehman Brothers.

One of the most spectacular combinations to roll out of the deal factory in 1985 was Baxter
Travenol Laboratories' $3.7-billion acquisition of American Hospital Supply, the largest
distributor in the hospital industry. Baxter won after torpedoing a planned merger between AHS
and Hospital Corp. of America, the largest operator of private hospitals. The planned merger was
a $2.5-billion sweetheart deal that fell into the same sort of merger-of-equals trap that Nabisco
and Reynolds had avoided.

Convinced the sweetheart deal could be broken up, First Boston began a two-month search for a
customer willing to move in. Vernon R. Loucks Jr., Baxter's chief executive, had independently
decided he wanted AHS for himself. Loucks sought out First Boston after another investment
banker warned him not to proceed. That firm thought a bid too risky; it argued that AHS, much
the larger of the two, with $3.4 billion in 1984 revenues compared with Baxter's $1.8 billion,
might respond with a Pac-Man defense and swallow its suitor.

On June 20, only two weeks before AHS's shareholders were due to vote on the Hospital Corp.
merger, a First Boston plan won a go-ahead from Baxter's board. Baxter offered $50 per share in
cash and stock for AHS, far more than the estimated $35-a-share value of the Hospital Corp.

Tap Dancing to Work Page 35

deal. The offer was good until July 5 and for AHS's board raised the specter of a shareholder
vote against the HCA merger.

Loucks apparently intended to stick by his insistence that the bid be friendly. But when AHS
rejected the offer out of hand, Loucks changed his mind about withdrawing. AHS soon
discovered it was in a tar pit. Security analysts pronounced the Baxter merger a better fit than the
earlier accord, the media feasted on the story, and speculators snapped up AHS's stock.
Desperate to keep from losing the cherished Hospital Corp. deal, AHS postponed its shareholder
vote, and a storm of protest erupted.

Scott Mohr, the 31-year-old ''project director'' whom First Boston stationed in Baxter's offices for
the duration of the deal, remembers the four-week struggle as a blur of unbroken work. At times
15 First Boston staffers worked on the deal, many putting in 100-hour weeks. Days were
consumed in meetings with potential allies, bankers, and publicists, as well as in devising
securities to finance the deal and endless analytical drills. ''We had 20 strategic alternatives,''
Mohr remembers, ''and we kept developing more.''

AHS finally yielded to a sweetened $5-per-share offer from Baxter on July 15, and Hospital
Corp. agreed to accept a $150-million settlement. The deal was settled, after four days of nonstop
negotiation, during a three-hour phone call beginning at 1 A.M. between Wasserstein and
Goldman's Boisi, who had been belatedly brought in to represent AHS. First Boston earned $8
million on the deal, Goldman Sachs $7.5 million.

There is no way, investment bankers sometimes admit, to calculate the value of their services.
But they have a variety of rationales for charging a lot. Knowing how to structure a complex deal
without costly mistakes, or how to squeeze the last few dollars out of a suitor, they say, is worth
much more than dealmakers ever charge. ''We got one bid raised from $75 a share to $83,'' says
the head of one merger department. The investment firm's fee was the equivalent of 40 cents a
share. ''Ask yourself,'' says the dealmaker, ''whether we provided the equivalent of 40 cents a
share in value.''

The dealmakers like to cite their costs. A major transaction not only ties up the top dealmaker
and his harried assistants, but can also put heavy, unpredictable demands on senior colleagues
elsewhere in the investment bank. For example, Robert Scully, chief of the big capital markets
services group at Salomon Brothers, had to be pulled off the desk repeatedly over many months
when General Motors (GM) acquired Electronic Data Systems in 1984 and agreed to buy Hughes
Aircraft in 1985. Scully helped devise the new classes of common stock GM used in the deals,
on which Salomon collected more than $15 million.

Dealmakers also trot out the opportunity-cost argument -- the potential income they forgo when
doing deals. Whenever the firm's dealmakers are in on a transaction, for instance, the SEC
requires its arbitragers -- who speculate in stocks of companies involved in takeovers -- to sit on
their hands. ''Fees help make it worth our while when we can't arbitrage a deal,'' says an
investment banker. The events leading up to Du Pont's (DD) 1981 acquisition of Conoco, for
example, threw Salomon's arbitragers into a dither. They were stuck on the sidelines on a deal in

Tap Dancing to Work Page 36

which several big arbitragers made over $10 million each, while Salomon's dealmakers collected
a mere $500,000 for representing Texaco, a loser in the bidding contest.

Egos and precedent play big roles in how fees are set. Dealmakers often negotiate with a
customer by pulling from a briefcase a printout showing what bankers have received for
comparable deals. ''I give the comparison sheet to the chief financial officer, the financial
policeman who wants to chisel anything he can,'' confides a veteran dealmaker. ''Then I negotiate
the fee with the chief executive, whose company is on the line or who is about to make the
biggest purchase of his career. The sheet keeps the chief financial officer from objecting too

The prevalent practice among dealmakers is to peg fees to the total amount of the deal, using a
sliding scale of percentages that drops as the deals grow larger. For some dealmakers, the
touchstone is Morgan Stanley's fee scale, which occasionally turns up in proxy material. In an
early 1984 version, Morgan charged 1% for a $100-million transaction and 0.5% for a $500-
million deal. A $1-billion megadeal will cost you 0.4%, or $4 million; a $4-billion deal 0.23%,
or $9.2 million. Later in 1984, Morgan Stanley hiked its prices for deals between $100 million
and $900 million by about 15%, citing heavy demand.

Whether the client is an acquirer or acquiree makes a difference in how the bills pile up. When
Goldman Sachs represents a buyer, the fee is fixed so that the client won't pay more if the deal
price goes up -- and Goldman won't earn less if it negotiates a bargain. The fee is negotiated
beforehand in two parts: an ante the client must pay even if nothing happens, and a success fee if
the deal goes through. Morgan also offers a different, racier arrangement to customers who want
to be acquired. The seller pays a fee slightly below the regular schedule until the bidding reaches
the price he expects, and then a whopping 5% of the amount by which Morgan can get the buyer
to raise his price.

Unless they are helping a besieged client stay independent, Morgan and other dealmakers almost
always agree to take a relative pittance if no deal is brought off. When Lazard helped sell
Houston Natural Gas to InterNorth in a $2.3-billion transaction, its contract called for $7 million
if the deal closed, and only $1 million if not. In a recent bank merger, Morgan was scheduled to
collect $3 million upon completing a deal that turned out to be worth $900 million, but only
$200,000 if it fell through. The latter sum, interestingly, was Morgan's estimate of actual hours
worked on the deal.

Dealmakers always make sure they're paid and out of the picture if a deal goes wrong. Fees are
spelled out before a transaction takes place, in detailed, confidential engagement letters that
cover all foreseeable eventualities. Goldman Sachs right now must be sighing with relief that
Getty Oil signed such an agreement in January 1984 while Pennzoil was bidding to take Getty
over. The single-spaced, four-page agreement came to light in Pennzoil's recent lawsuit against
Texaco for outbidding Pennzoil and breaking up the deal.

The fees were munificent as usual. Goldman was guaranteed $6 million no matter what the
outcome. If Getty voted to accept Pennzoil's bid, which Pennzoil contends Getty did the day after

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the letter was signed, Goldman's cut would work out to $10 million. When Texaco swooped in
and snatched Getty away, Goldman was able to collect $18.5 million.

But it is the agreement's boilerplate indemnity clause that could turn out to be worth all the gold
in Goldman Sachs. It is designed to insulate the investment bank from paying damages in
lawsuits, even though a lawyer for Pennzoil says it scarcely considered suing the Wall Street
house. Texaco, on the other hand, has hell to pay for Goldman Sachs's success at peddling Getty

According to jurors, testimony from Goldman's Boisi and merger lawyer Lipton helped swing
the case against Texaco. Their accounts of frenetic 11th-hour efforts to get more for Getty than
Pennzoil was offering reinforced the jury's impression that Getty had welshed on a deal. Juror
James J. Shannon Jr., a city of Houston employee, derides Boisi's attempt to play down his role:
''Boisi said he didn't shop the deal, he made 'courtesy calls' -- that was totally unbelievable.''

For the time being, dealmakers are basking in a happy status quo. Most corporate executives
regard them as necessary evils -- necessary for their skills and connections, evil for their fat fees
and opportunism. But merger mania could fade, cutting their fee income; Morgan Stanley
expects a dropoff in deals in 1986. Two principal reasons: higher stock prices and a diminishing
supply of conglomerates ripe for busting up.

Posted in: Berkshire Hathaway, Tap Dancing to Work, Warren Buffett


The inside story of Time Warner

November 21, 2012: 11:44 AM ET

Email Print

The year's fiercest takeover tangle sparked elation, despair,

fury, and accusations in the courts and three boardrooms
before its surprising conclusion. Here's what happened.
By Bill Saporito

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This story is from the November 20, 1989 issue of Fortune. It is the full text of an article
excerpted in Tap Dancing to Work: Warren Buffett on Practically Everything, 1966-2012, a
Fortune Magazine book, collected and expanded by Carol Loomis.

Steve Ross: He demonstrated once again that in the music of deals -- for his shareholders and
himself -- he has perfect pitch.

FORTUNE -- Around six o'clock on the evening of June 6, Time Inc. CEO J. Richard Munro
walked into the office of President N. J. ''Nick'' Nicholas Jr. holding a fax message in his hand
and a blank stare of disbelief on his face. Munro is normally outgoing, excitable, and expressive,
but his stunned look told Nicholas all he needed to know. ''He did it,'' Munro said to his friend
Nicholas. ''Martin Davis did it.''

Davis is the CEO of Paramount Communications. And what he did was waltz by Time's dream
house with a pail of gasoline and a flame thrower, torching the company's long-planned merger
with Warner Communications and touching off one of the most ferocious corporate clashes in a
decade chock-full of them. The battle provoked tremendous controversy and touched every bare-
wire business issue of the age: long-term vs. short-term value, shareholder rights, the
significance of corporate culture, executive compensation, business ethics, management practice,
and merger and acquisition tactics. The full story of it, revealed through interviews with most of
the drama's major actors and in 12,000 pages of sworn depositions, many not made public
before, shows the extraordinary way in which one mammoth deal was conceived and carried
through. It may prove a fitting sign-off to a decade in which both the Dow Jones average and
corporate hostility reached new heights -- for while it typified the Eighties takeover by being
huge and vicious, it also suggested a new battle plan for the Nineties by refuting the accepted
wisdom that a cash offer is curtains for a target company.

Paramount's offer to buy Time for $175 a share in cash hit barely two weeks before Time
stockholders were set to vote on the planned merger with Warner, the diversified entertainment
and media company run by Steven J. Ross. To hold off Davis and hold on to its independence,
Time instead acquired Warner for $13.1 billion in cash and securities.

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Time's decision to change the transaction from merger to acquisition without a shareholder vote -
- one the management almost certainly would have lost -- added a new page to corporate law that
may affect some future mergers and acquisitions. When Paramount sued Time in Delaware's
Court of Chancery to undo the deal, the outcome held the potential to kill stock-for-stock
mergers, the kind Time and Warner originally attempted. The M&A business froze in its tracks
until the courts decided that in this case Time directors, not the shareholders, retained
responsibility for determining the firm's direction. That ruling looks to some like a short circuit
in shareholders' ability to have the ultimate voice in the corporations they own.

No one disputes that Time and Warner are an excellent fit. The combined company is an
American giant in an age when global behemoths rule the media planet. Time Warner (TWX)
makes movies, television programs, records, tapes, books, and magazines, including this one,
and can sell virtually all of these things around the world. It sells pay TV through Home Box
Office and Cinemax to 23 million subscribers, and owns cable TV systems serving six million
households across the U.S. ''It is awesome how impressive this company will become,'' says
Munro, now co-CEO of Time Warner with Ross. Sales in 1989 will approach $11 billion, and
the underlying assets are worth some $25 billion. All that and Bugs Bunny, too. Awesome

But agreement about the combination ends there. Davis too wanted to walk in the land of the
giants and saw a combination with Time as a perfect way to get there. In launching his bid Davis
acknowledged Munro's logic but chose as a weapon a rather basic fact of arithmetic: $175 is
more than $120. The first figure was Paramount's initial offer for each share of Time; the second
was the maximum value Paramount and its investment adviser, Morgan Stanley, figured Time
Warner's stock would reach if the original merger went through. Davis assumed that given the
choice, shareholders would take the cash. He was probably right. They generally do. He was
definitely wrong in assuming that they would get the choice.

Dick Munro: Less than a year before retiring, Time's CEO says, "I did not work here 33 years to
bust the company up."

Time and Warner managers view the acquisition as a perfect combination that would have sailed
through in its original form had it not been for that spoilsport Davis. But he couldn't let it sail
through, they say, arguing that the debt-free, tax-free merger would have left Paramount too

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small to compete with a media and entertainment powerhouse such as Time Warner. In this view
Davis looked at a no-lose situation and jumped in: He might succeed in buying Time cheaply, or
he might break up the deal, or he would at least saddle the new company with debt, making it
less competitive. Davis says that notion is ridiculous.

Davis declined to be interviewed for this article. But Paramount's lawsuit to prevent Time from
buying Warner alleges that Munro and Nicholas sold the shareholders out to preserve their own
empire. He said they did this on the pretense that Time's editorial independence and culture
demanded it. Munro and Nicholas insist that notion is ridiculous. Says Munro, 58, who will
retire as co-CEO next year after ten years of running Time: ''This is my legacy. I did not work
here 33 years to bust the company up.'' He and Nicholas, 50, own loads of company stock, he
points out. If they had just wanted to get rich, they would have sold the company to Davis or the
highest bidder -- and cleared many millions of dollars each.

Steve Ross, 62, Warner's affable, high-profile chairman and CEO, demonstrated once again that
in the music of deals he has perfect pitch. Ross orchestrated a great short- and long-term bargain
for his shareholders and flattened a persistent boardroom antagonist. He now will share the
CEO's job for five years at a company twice the size of Warner. He also retains a compensation
package so abundant in dollars that, should the oilman fail to show this winter, Ross can shovel
money into his furnace and have plenty left over in the spring.

The strategy emerges

Publishing is a wonderfully profitable business. Basically it comprises a bunch of people and a

bunch of trees that eventually run into each other at a printing press. The product of this union is
sold to readers and to advertisers who wish to communicate with them. Publishing can offer a
high return on assets and terrific margins. Time's magazines, which include Time, Fortune, Life,
Sports Illustrated, Money, and People, plus a score more wholly or partly owned, are doing just
swell, thank you.

But over the past decade Munro, Nicholas, and Time vice chairman Gerald M. Levin came to
believe that the magazine division was not growing fast enough. Revenue gains in the division
have averaged about 5.7% a year since 1985, and when the Warner deal was announced in
March Time's investment bankers could not project anything beyond 6% for the future. Time
already has about 22% of the U.S. magazine advertising business, more than twice the share of
its nearest competitors, and 33% of magazine profits. Says Munro: ''We have two huge engines
that drive that division, People and Sports Illustrated. So I would say that the growth there is a
little bit limited.''

While Time's soul is in publishing, the company tried for decades to find another leg to hold up
the financial body. Magazine publishing is a cyclical business hitched to the U.S. economy, and
Time Inc. has suffered through several profit swings. The corporation has bought and sometimes
sold newspapers, television stations, and forest-products companies in several unavailing efforts
to diversify profitably.

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Nick Nicholas: Without much debate, Ross and Munro agreed to make him their successor at the
top of the merged company.

Successful diversification did not come until the company happened on cable television and pay
channels early in the game, and lo and behold, they took off. Time had picked up a few cable
systems in the Sixties, and in the early Seventies a free-spirited entrepreneur named Charles
Dolan had briefly joined the company and started something called the Green Channel, soon
renamed Home Box Office. By 1974, after years of losses and frustration, these ventures were
about to start spouting money, and the executives in charge happened to be three young men
named Munro, Nicholas, and Levin. With less than ten years' TV experience among them, they
faced the best problem a manager can have: struggling to handle all the growth. Time's future
was getting tuned in to a new channel. Today the video side and the magazine side are
approximately the same size, $2.1 billion and $1.9 billion, respectively, in sales.

That was terrific, but as of the mid-Eighties Time's top executives still saw three large problems
with the corporate structure.

Problem No. 1: Time didn't own any significant copyrights in the fastest-growing sector of the
media business, video. Copyrights are a central concept in media. When a film, book, or
magazine is produced, distributed, and sold, the copyright owner makes a big chunk of the
money. With its cable and pay TV operations Time owned entertainment distribution channels,
but it didn't own any entertainment. That stuff had to be bought on the open market, and prices
were getting steep.

Problem No. 2: The media industry is increasingly diversified and global, and as Munro and
Nicholas saw it, Time was sufficiently neither. While foreign companies such as Bertelsmann,
Hachette, and Rupert Murdoch's News Corp. (NWSA) inhaled properties through the mid-
Eighties, Time's management thought of these companies as collectors paying crazy prices.
Gradually, as prices continued to spiral and Time watched from the sidelines, another thought
took hold.

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Nicholas understood that not only would the prices continue to increase, but the very mass of
these new empires also offered security from business risks. In addition, mass offered more
protection from the appetites of the acquisitive. In a rapidly consolidating media industry, it was
eat or be eaten -- and Time sincerely, intensely wished to avoid being eaten.

In pursuing this wish Time lacked a powerful weapon available to most of America's other great
publishing enterprises: a separate class of nonvoting stock, which a company's founding family
would sell to outside investors while retaining control of the voting stock. New York Times Co.
(NYT), Dow Jones, Washington Post Co. (WPO), Times Mirror, all had created these two
classes of stock, and all had remained independent. Failing to create such stock was, Nicholas
says, one of founder Henry R. Luce's few big mistakes.

Besides being tough to take over, the newly forming media empires had another advantage, a
capacity for laying off risk. Says Nicholas: ''The idea is a very simple one. You get some
businesses where you can spread your overhead. You've got to be able to control or have
relationships with enough distribution channels to know you've got a great shot at amortizing the
fixed costs.'' In other words, the $35 million price tag of a movie like Batman looks less chancy
when a company knows it can get its money back by showing the movie in the U.S., then
showing it abroad, selling the videocassette, selling the soundtrack on records, compact discs,
and tapes, showing it on pay TV, and perhaps selling related books or producing related TV
programs, all using the company's own resources. This year Warner's Batman opened the way
for sales of videos, record albums, books, and even comic books (where the character originated)
-- all owned by Warner.

Martin Davis: He wanted to walk in the land of the giants and saw a combination with Time as a
way to get there.

Problem No. 3: Wall Street was not in love with Time Inc. and traded the stock at a fraction of its
theoretical breakup value. Investors didn't like the variability of Time's earnings. With increasing
frequency the stock would rise on rumors that Time was about to be taken over, but this was not
Munro's idea of good news.

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In the mid-Eighties Munro saw a way to attack all three problems: Hook up through merger or
acquisition with another media giant. Allen Neuharth, chief of Gannett Co. (GCI) and self-
described S.O.B., came calling in 1985. Gannett's newspapers and broadcast division might have
fit well with Time, but its management wouldn't. Munro had a cast-iron condition for any
potential combination: Time Inc. would run the show or would share top-level authority equally.
Neuharth scoffed at the idea.

CBS chief Tom Wyman also chatted with Munro about a merger in 1985, when Ted Turner was
quixotically attacking CBS (CBS), but the talks led nowhere. In the fall of 1988, Warren Buffett
came by with his friends from Capital Cities/ABC, in which he was a major investor. Munro and
Nicholas met with Buffett and Cap Cities CEO Thomas Murphy and President Daniel Burke.
The meetings continued into December, until, according to Nicholas, Murphy mentioned that in
any deal there should be one or two more Cap Cities directors than Time directors. Munro says
he told Murphy, a good friend, thank you very much but Time Inc. is not for sale. A Cap Cities
source says the two men couldn't agree on who would be boss.

Time had rebuffed Buffett before. In 1984 he had asked Munro informally about acquiring up to
10% of Time Inc.'s stock, enough to frighten a raider. Buffett's practice with other large
stockholdings is to hang on to them for years or decades and become a trusted board member and
adviser. But when Munro took Buffett's feeler to the board, the directors -- to Munro's regret --
discouraged him from pursuing it.

Munro and Nicholas in 1987 began speculating about combining with a film and video producer.
Disney (DIS) had an excellent studio, but 60% of its revenues are from theme parks, a business
in which Time had no expertise. Columbia Pictures, MCA, Fox -- each had charms but lacked
size, strategic fit, or management. Only two companies looked right: Paramount (then called
Gulf & Western) and Warner.

Warner was more profitable and a better strategic match than Paramount. Importantly, at a time
when foreign markets offer the brightest growth opportunities, 40% of Warner's revenues come
from overseas, vs. less than 10% of Time's (and only 16% of Paramount's). In movies and
television both Warner and Paramount produced outstanding returns, but only Warner owned
100% of its movie distribution business. Additionally, Warner had 1.6 million cable subscribers
who could combine nicely with the 4.3 million of Time's American Television &
Communications, already America's No. 2 cable company (after Tele-Communications Inc.).
Paramount's publishing division, Simon & Schuster, would also have fit well at Time, but the
company wasn't looking to expand in book publishing. Instead Time got big eyes for Warner's
wildly profitable record business, which accounts for about half the company's operating income.

Nick drops a dime

One day in May 1987, Nick Nicholas found himself with an unexpected free afternoon. Citizen
Nick had planned to spend the day on jury duty in state supreme court in Manhattan but was
dismissed early. From the courthouse lobby he punched the digits for Warner Communications
and asked for Steve Ross. Did Ross have some time that afternoon to discuss a couple of things?
If Ross didn't have time, he soon made some available.

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Oded Aboodi: An investment adviser and Steve Ross's confidant, he negotiated the deal for

Nicholas knew Warner's cable operation well -- he had once negotiated, unsuccessfully, to sell
Time's Manhattan Cable to it -- and he was interested in a joint cable venture. Ross was also
interested because Warner was at a crossroads in cable -- "too big to be small and too small to be
big,'' says Ross. In 1986 Warner had bought its partner American Express (AXP) out of joint
ownership in a cable television company that held systems Time coveted. A joint venture offered
a way for Time to get co-ownership of those systems.

Ross took the idea one step further. During several subsequent meetings that summer he
developed the notion that Time should throw in its HBO unit, while Warner would contribute its
Warner Brothers studio. Such a combination would create a vertically integrated entertainment

The egos in the media corporations that cluster around Manhattan's Sixth Avenue are as big as
the buildings, and that was the problem the two sides grappled with in a sit-down at the Helmsley
Palace Hotel on November 4, 1987. From Time came Munro, Nicholas, Levin, and HBO
Chairman Michael Fuchs. The Warner group included Ross, Deane F. Johnson from Warner's
office of the president, and Warner Brothers studio bosses Robert A. Daly and Terry S. Semel.
There were no Indians among these chiefs, making the subject of just who would report to whom
a touchy one. Ross wanted Warner Brothers left alone; Time felt the same way about HBO. Both
sides agreed the cable systems could be jointly run.

Even before they reached those matters, the two groups had to figure out if they could stand each
other. And Ross left the meeting apparently smitten. The Time side left the meeting impressed
by the Warner people but not willing to rush into anything. Levin wrote to Munro: ''The key here
is to keep our options open with Warner, cool Steve's ardor somewhat, but maintain a deepening

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relationship.'' The joint venture idea intrigued Time's team, but Levin wanted a month or so to
think about it.

As the talks progressed a number of hurdles sprang up. There were questions of how much
money each partner could take out of the venture, serious tax problems within the new company,
and a need to develop a divorce agreement should the two parties, like those in so many other
joint ventures, decide they didn't like each other after all. Against that formidable stack of
problems a simple solution occurred to several of the people involved: Just merge the companies.

Nicholas, with Munro's agreement, popped that merger question in early June 1988, after a year
of trying to work out a joint venture. Ross thought about it for a week and agreed to begin
negotiating. In the original joint venture proposal, Munro and Ross would have been co-CEOs of
the enterprise, with HBO reporting to Munro, Warner Brothers reporting to Ross, and the cable
companies reporting jointly. This structure carried over into the merger talks. The two sides
spent the better part of the summer divvying up the reporting relationships and hammering out
the roles of the chief executives.

The concept of a co-CEO is not foreign to Ross. He shared the title at Warner with William
Frankel from 1967 until Frankel's death in 1972. At one meeting he brought along a Fortune
article that discussed Unilever, invariably described as the ''Anglo-Dutch consumer products
company.'' Unilever is essentially two companies and has two CEOs, one in the Netherlands
(UN) and one in Britain (UL), who run what Ross called a staple corporation. The two are joined
at the bottom line.

Without much debate, Ross and Munro agreed to make Nicholas their successor. Ross had no
logical No. 2 to compete for the spot, and over the months of negotiations he had become
increasingly impressed with Nicholas. Ross says, ''If he weren't with Time I would have made
overtures to have him with us. I think he is extremely capable and very knowledgeable. So we
never had a problem.'' A culture clash, however, has the makings of a problem.

The culture

Above all other considerations in any merger, Munro felt compelled to defend the Time culture.
He sincerely believes, as do many employees, that working for Time isn't like working for, say,
Amalgamated Spark Plugs. The executives and employees consider Time Inc. a kind of public
institution and believe working for it confers special status.

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Jerry Levin: A lawyer turned strategist and Time's vice chairman, he sat across the table from

The most famous feature of Time's culture is the separation, both psychic and structural, of
church and state. Time founder Luce decreed that the editorial side of the business (church)
would report directly to the editor-in-chief rather than to the publishing side (state), as it does in
nearly every other journalistic enterprise in the world. The arrangement gives editors freedom to
report and analyze the news without influence or interference from the business side and its

The benefits of separating church and state are obvious: It attracts top journalists, it increases a
magazine's value to readers, and it makes a magazine more valuable to advertisers, even though
they may occasionally take their licks in the editorial pages. But the idea of dual hierarchies
reaching all the way to the board is unknown at most companies, including Warner. Jason
McManus, 55, Time Inc.'s editor-in-chief and church's high priest, took a philosophic view
toward Warner. He was part of the tradition -- he had worked for Luce -- but believed that if
Time didn't merge it would be taken over, with who-knows-what effect on the magazines'
independence. ''There was a nostalgia for Time Inc. as it was imagined to be,'' he says, ''but the
people who felt 'Gee, if we hadn't done anything we'd have been fine' were living in a dream

In style, Time was long a classic Ivy League preserve, particularly on the business side of
publishing. The management approach was restrained, the process collegial, the meetings
frequent and primly structured. An investment banker for Time calls it ''the preppiest company I
have ever seen in my life.'' The Warner style, by contrast, is streetwise New York and
entrepreneurially driven. Problems are solved family-style -- in frequent scream fests.

Warner behaves more like a partnership than a corporation. Under Ross, division managers have
total autonomy in operations. This policy proved expensive in 1983 and 1984, when the Atari

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videogames division pulled the entire company into the red after managers failed to anticipate
the cooling of the videogames fever. In general, however, Ross picked extremely able division
heads, including Daly at Warner Brothers and Morris ''Mo'' Ostin of Warner Brothers Records.

The two companies' cultures do not clash in respect for creative independence. Just as Time's
publishing managers leave the editorial types alone, so Warner's film, record, and book
producers create free of the company's corporate overseers. Time executives say Warner's
attitude was an important reason they preferred to join with it instead of with Paramount.

To preserve the church-state structure, Warner acknowledged -- not that Time considered the
matter negotiable -- the corporate hands-off policy regarding Time's magazines. Editorial
operations would report only to editor-in-chief McManus, who is one of Time's four inside
directors (the others: Munro, Nicholas, Levin). McManus reports only to the board. It exercises
its responsibility for editorial operations through a committee of six outside directors, with four
seats going to people who were on Time's board before the merger. Warner demanded the same
protection for its creative output. Time agreed to an entertainment committee, controlled by
directors who had been on Warner's board, to oversee Warner's movie and record businesses.

The Time directors came up with another method to ensure cultural survival: They authorized
Levin, 50, to negotiate long-term contracts for Munro, Nicholas, and himself. Says Munro: ''We
told the board that we didn't want contracts, but they insisted.''

Jason McManus: The editor-in-chief believed Time had either to merge soon or be taken over.

Munro had long said that by age 60 he would step aside both as CEO and as a director. Working
out the merger terms, he changed his mind in order to smooth the transition and be available
should Ross be incapacitated. Munro's contract makes him co-CEO with Ross until he steps

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down next year. After that he will be chairman of the board's executive committee until 1994 and
an adviser for five years more. He will be paid at least $1.5 million annually in salary and bonus
as co-CEO. From 1990 until 1999 he will be paid at least $750,000 a year. He will later get
another $4,275,000 in deferred compensation. Nicholas also signed a roughly comparable ten-
year contract, making him co-CEO with Ross as soon as Munro resigns, and sole CEO in five

In theory the board could undo these arrangements, subject to restrictions in the contracts. But to
the extent it was possible, Time had ensured that its cherished culture would have advocates at
the top of Time Warner for a decade. The contracts put Munro in the position of explaining to
employees, including hundreds of journalists, that he and Nicholas accepted the extraordinarily
handsome agreements to protect them.

As for the differences in corporate style, Ross advised his guys not to worry. ''They were upset,
but I told them once this deal was concluded the company would be Time Warner,'' he says. ''We
would be unable to distinguish between Time executives and Warner executives. The question is
then: Who are the people who are going to lead us into the next century?'' He assured his
executives that he would be around to take care of them, and that Time Warner would grant the
same kind of autonomy he had given them.

Jerry's deal

The task of negotiating the merger's financial terms fell to Levin from Time and to Oded Aboodi
for Warner. Aboodi, 48, is neither a Warner officer nor a director, nor an investment banker in
the usual sense, though he is sometimes called one. But Ross wouldn't make a move without
him. A Jerusalem-born accountant, Aboodi handled some Warner transactions while a partner at
Arthur Young & Co. Technically astute, he loves the creative aspects of dealmaking, and in
Steve Ross he found a soul mate. Says Levin: ''He reads the psychological set of the people he
deals with.''

Levin, an attorney by training and Time's chief strategist and planner, insisted from the
beginning of negotiations in early 1988 that Time had to be the acquiring entity. Says he: ''There
was never a discussion of the acquisition of Time by Warner. We were interested in an
acquisition -- where the Time culture, the Time institution, the Time tradition prevails.''

That was fine with Aboodi. He had an imperative of his own: Ross's demand that the deal be
erected not as a cash buyout but as a merger in which only stock changed hands. Ross wanted
Time to issue millions of new shares with which to buy Warner from its stockholders. Time
executives had hoped to borrow billions in good old cash and buy Warner that way, preserving
greater assets and earning power for each Time share. On this issue Time gave in early. Says
Ross: ''They threw in the sponge because they knew finally that I wasn't going to do anything but
a stock deal.''

One reason Ross insisted on this form of merger was that it would let the merged company treat
the deal as a pooling of interests, a now rarely used accounting method that combines the assets
of the merging enterprises as if they were never apart. Most mergers use purchase-price

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accounting, a technique with an insidious cost. Acquired companies are generally worth far more
than the value of the hard assets shown on their balance sheets. The difference between the price
paid and an acquired company's updated asset value is called goodwill. Under purchase-price
accounting this amount is amortized over a long period, with the amount amortized each year
deducted from reported profits, even though no cash loss is involved. In the Warner deal
goodwill amounts to $10 billion to $12 billion, or something like $300 million to $400 million a
year for 30 years. Ross did not want such a hit to earnings.

Henry Luce: Time Inc.'s father willed that the company continue to be "principally a journalistic

So the deal would be an exchange of stock -- but at what ratio? By the end of June 1988, the
talks focused on that question. Aboodi was in the driver's seat because Warner had a better
bottom line and a higher market value than Time. In 1988 Warner earned $423 million after
taxes on sales of $4.2 billion. Although Time had sales of $4.5 billion, its net profit was $289
million. Main reason: Warner enjoys a lower tax rate resulting from accumulated tax credits.

Warner's sales and earnings growth were outpacing Time's. Had the two companies remained
independent, Warner's sales would have overtaken Time's this year. Aboodi argued further that
Warner's stock price would rise faster and carry a higher earnings multiple because Wall Street
liked its business mix better. He also noted that Time was supporting its own stock price, having
bought back 10% of the shares, while Warner was not. Finally, and most important, Warner had
to be accorded a takeover premium.

Time indicated it was willing to pay a premium for the right to take Warner out. The price of
Warner's stock had been about 35% of Time's over the previous 12 months. Adding to that a
premium of around 10 percentage points, Levin figured to get a deal at a ratio of 43% to 45% --
or, as the negotiators say, .43 to .45. He started at .40; Aboodi talked .50. They would not get any
closer that year.

The $193 million man

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A far more delicate challenge also awaited Levin, Munro, and Nicholas: how to sell Steve Ross
to the Time board. Money and controversy have followed Steven J. Ross like stray cats in search
of a meal. Ross's contract was as lush as that of any CEO in America. In 1987, following a wild
board meeting ending in a 9-to-6 vote, Ross took home a ten-year employment contract that
guaranteed him base pay of $1.2 million a year. That's not unheard of, but the contract included a
bonus that would pay an average $14 million a year for ten years if Warner stock appreciated
10% a year. It has.

Under his amended ten-year contract with Time Warner, Ross is due $193 million at the close of
the deal for stock-based compensation he had coming at Warner: $70 million in cash and $123
million in deferred payments. He also gets the same $1.2 million annual salary and deferred
compensation he did at Warner plus a minimum bonus of 0.4% of Time Warner's earnings
before taxes and some amortization and depreciation. And he receives options on 1.8 million
shares of stock at a minimum price of $150 a share. After 1999 he will collect $750,000 a year
for five years as an adviser.

Time's management convinced the board that Ross's contract was his reward for founding the
company in the 1960s and successfully nurturing it. Curiously, Ross owned only about 1% of his
baby's stock, which is where most founders get their reward. Very few Time directors liked
Ross's contract, but they viewed it as part of Warner's price. Says director Donald S. Perkins, a
former CEO of Jewel Cos., a supermarket chain: ''It just comes down to a cost of doing business.
It was part of the price of the deal.'' Says another, who prefers to remain nameless: ''I've made a
lot of guys rich who didn't deserve it. The deal is what's important.''

Ross patched Warner together initially by grafting a rental car business onto his father-in-law's
funeral parlor business. He added parking lots and took the company public as Kinney National
Service in 1962. In 1969, Kinney bought Warner Brothers-Seven Arts, then a broken-down relic
of a Hollywood studio, for a reported $400 million in stock. But Warner also had real estate, a
film library, a great record company, and good executives, such as Ahmet Ertegun of Atlantic
Records. Warner is the ultimate people business, and it fit Ross's schmoozing style. A big guy's
big guy, Ross lives the high life and makes no excuses for it. His longstanding friendships with
Hollywood glitterati -- Clint Eastwood, Barbra Streisand, Steven Spielberg -- are counted as
corporate assets.

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Henry Luce III: Seeking to uphold his father's philosophy, he urged Munro to forget about
Warner and go after McGraw-Hill. Eventually he voted for the Warner deal.

Ross combined an uncanny sense of the future, a genial manner, and shrewd dealmaking skills to
lift Warner onto the Fortune 500 in 1971. He put someone he could trust in charge of each
business, left him alone, and paid handsomely if the division performed. The pay included stock
appreciation rights. The deal with Time will enable about 700 Warner employees to cash in
options totaling more than $600 million.

Retired Time president James Shepley, who died in November 1988, made no attempt to hide his
belief that Ross and Warner were unsavory partners. In the early Eighties, Time lost three cable
television franchise battles to Ross in Pittsburgh, Cincinnati, and the New York City borough of
Queens, and Shepley was sure Warner had played dirty. Dick Munro had led the battle in
Pittsburgh. He remembers: ''We had the champagne all ready to pour. And then the word came
that Warner had been picked. We couldn't believe we'd lost. They must have paid somebody off.''
Time sued Warner and the city of Pittsburgh, charging improper bidding procedures. The two
sides eventually settled out of court.

Prosecutors had won several indictments and one conviction involving Warner. In 1973 Warner
invested $250,000 in a new stock issue floated by Westchester Premier Theatre Inc., a
performing arts center in Tarrytown, New York. The amount was a piddling part of Warner's
$200 million investment portfolio, but it came out later that Premier Theatre was controlled by
the mob, according to federal authorities.

When Premier Theatre went bust five years after Warner made its investment, a subsequent
federal investigation led to Jay Emmett, a member of Warner's three-person office of the
president. Emmett was indicted and pleaded guilty to defrauding Warner by approving invoices
for nonexistent services not rendered by one Leonard Horwitz, a broker enlisted by Premier to
sell the new stock issue. Horwitz later worked for Warner as a consultant. The feds ''flipped''
Horwitz and Emmett, getting them to rat on Warner's then assistant treasurer, Solomon Weiss, in
exchange for leniency. Weiss was convicted of mail fraud and racketeering in connection with
Warner's purchase of the stock. Emmett and Horwitz got suspended sentences. Weiss appealed,
lost, and got five years of probation tied to performing community service.

During the trial, Assistant U.S. Attorney Nathaniel H. Akerman told the jury Ross was the
mastermind, alleging that he put Weiss in charge of a secret cash fund to use at his discretion.
Ross was never charged with any offense and was not called to testify at the trial. By agreement
between his lawyer and the federal attorney, Ross, under oath, denied all allegations to the

Ross knew the issue would come up again when the Time merger was announced. He says, ''I
just don't let it bother me. I've made the right decisions.''

Time executives were also well aware of the issue. Levin raised it in a memo to Munro, and
Time sources began to ask around. Says Munro: ''We must have talked to 100 people about Steve
Ross, and not only did we not find anything [bad], we found just the opposite.'' Another Time

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executive says: ''We do have some pretty good investigative resources around here. And we
came up empty.''

Time's board hops on

Munro told Time's board in June 1988 that his team was talking to Warner about a merger, but
he gave no details. The directors also received copies of a new report by a group of fast-track
Time executives charged with recommending a corporate strategy. One of their conclusions:
Focus investment on video programming, ''an area where we are underdeveloped and
underleveraged.'' During the next few weeks Munro, sometimes accompanied by Nicholas, spoke
with each director privately to explain his vision of Time Inc.'s future and ask for approval.

Mike Dingman: A key Time director, he persuaded Ross to set a date for his retirement, keeping
the merger alive.

Events of the Eighties had affected several of Time's 12 outside directors in various ways that
would directly influence their view of any deal. After he retired, Donald Perkins watched
American Stores take over his Jewel Cos. and unhinge the organization he helped create. Edward
S. Finkelstein, chairman of R.H. Macy & Co., had taken the retail merchandiser private when it
became raider bait. James F. Ber, chairman of Borg-Warner, took his company private in a
leveraged buyout to fend off raids by Irwin Jacobs and GAF.

A key player was director Michael D. Dingman, who is chairman of Henley Group, at least this
year. An astute shuffler of corporate assets, Dingman had done more deals in a few years than
most executives do in a career. He knew leverage, he knew shareholder value, he sure as hell
knew mergers and acquisitions -- and he knew as of late July 1988 that among Time directors
Munro's merger plan with Warner was dead. Says he: ''It was damned controversial. If you ran a
board vote on it, it would have failed.''

Levin was also keeping score, and it wasn't looking good. His handwritten notes revealed the
tally: Ber was unenthusiastic, Perkins lukewarm, ditto Clifford J. Grum, CEO of Temple-
Inland. Another director, Henry C. Goodrich, former chairman of Sonat, an Alabama energy
company, was down as a flat no. John Opel, chairman of IBM's (IBM) executive committee, was
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skeptical but open- minded. David T. Kearns, chairman and CEO of Xerox (XRX), was signed
on, as was Finkelstein. Levin had no read on the board's two academics: Matina S. Horner,
president of Radcliffe College, and Clifton R. Wharton Jr., former chancellor of the State
University of New York and now chairman of Teachers Insurance & Annuity
Association/College Retirement Equity Fund.

Director Arthur Temple's name did not appear on the list. Nor did that of director Henry Luce III,
son of Time founder Henry R. Luce. There was no need.

Arthur Temple would no sooner get in bed with Hollywood than he would climb a loblolly pine
naked. Temple joined the board in 1973 after his family's pulp and paper company, Temple
Industries, was acquired by Time in an ill-considered diversification foray. (''By whom are you
currently employed?'' a lawyer asked him in a deposition for Paramount's lawsuit. Replied
Temple: ''I'm not employed by anyone. I'm chairman.'') Time later bought Inland Container, a
containerboard maker, and merged the two subs. Temple-Inland was a voracious consumer of
capital, as was cable TV, and the two branches competed for the company's cash. But Temple-
Inland was a commodity business, quite unrelated to Time's basic enterprises. Money spent on it
could have been much more profitably invested in Time's media and entertainment properties.

At the urging of Nicholas, Time spun Temple-Inland off to shareholders in 1983. But the effects
of opportunities missed lingered on. Nicholas believed that had Time never acquired Temple and
Inland, Time last year would have earned not $5.01 a share but $10.

Temple-Inland is headquartered in Diboll, Texas, miles from nowhere, but close to Jesus, in
Bible belt country. Temple holds the Hollywood crowd responsible for the moral breakdown of
America, and he regularly encouraged Munro to sell HBO and the cable companies while the
market was hot. Buy more magazines, he said.

Temple isn't trying to be a moral grandstander. He believes that in the next decade the phone
companies will use fiber optics to usurp cable television. Temple was close to James Shepley,
the former Time president, and Shepley was filling his ear with nasty tales about Ross and

Director Henry Luce III wasn't wild about Hollywood either, but more fundamentally he did not
yet buy the strategy. He had worked at Time for 30 years, including tours as publisher of Fortune
and Time, then retired in 1981 to run the Henry Luce Foundation, which controls about 3.5% of
Time's stock. For years he had approved company expansion into other media with mixed
emotions. He accepted that Munro's strategy might be valid but felt it was not necessarily the
only effective one. Says he: ''I expressed disagreement to Dick and his colleagues. They made all
their points that it was an important strategic move, but they left me unpersuaded.'' And like
Temple, Luce was appalled by the rich employment contracts for Munro, Nicholas, and Ross.

Luce also believed that his father, Harry, would not have approved the Warner deal. In late July
1988, he sent Munro a note that quoted his father's will: '' 'Time Inc. is now, and is expected to
continue to be, principally a journalistic enterprise, and, as such, an enterprise operated in the
public interest.' '' Luce III continued: ''In the spirit of the above, and in view of many other

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specific factors, I don't believe I could vote for the proposition ... '' Luce instead urged Munro to
go after McGraw-Hill (MHP), the undermanaged publishing house two doors down Sixth
Avenue from Time.

Out of courtesy Munro told retired Time executives about the deal and sought their approval.
Andrew Heiskell, who as CEO had more or less wandered into the cable business, recognized the
logic in the Warner merger. But he was unenthusiastic. Retired director Hedley Donovan, Luce's
personally chosen successor as editor-in-chief, did not hide his disappointment when Jason
McManus informed him: ''I disapproved unless I was convinced that all other reasonable
alternatives had been explored, and I hadn't been. I told Jason, if Time had to get bigger to avoid
takeovers, then to do so by buying other print.''

Nicholas and Munro spent the summer on the stump, presenting their strategy to the directors in
a series of one-on-one meetings. They developed strong allies. Donald Perkins became intrigued
by Warner's international business. He had on several occasions warned management that Time's
lack of significant global business was a major problem.

Dingman had come to believe that Time was right to be expanding in TV. Says he: ''I had been
skeptical from day one of cable, HBO, and the broad entertainment business. It has a propensity
to vaporize. If left to our own devices, we [the board] would have sold those assets. But Dick and
Nick convinced us that cable was tied to the future. It was real vision, and they never wavered.''
The Warner deal, Munro persuaded him, was the capstone to this strategic vision.

Dingman served as an antidote to Temple. The two had been friends for 20 years, and Temple
served on the Henley Group board. Munro and Nicholas presented their merger case to them
together at Dingman's headquarters in Hampton, New Hampshire. Dingman and Temple spoke
often on the subject, sometimes heatedly, but Temple would not be swayed. In one talk Dingman
discovered that Shepley had been denigrating Ross to Temple. Dingman passed the information
to Munro.

Although Temple remained unconvinced, he acknowledged that the deal would work out
financially. He did not make a commitment then, but eventually voted for the deal. Temple quit
the board last April and since January has been liquidating the Temple Foundation's holdings of
Time stock.

There was no antidote to Luce, and none was needed. Luce may have been the walking legacy of
Time's creator, and also an intelligent, thoughtful man who did not hesitate to offer his opinion.
But as neither a Time executive nor a heavy-hitting CEO or former CEO on a board that was full
of them, his views carried relatively little weight.

In the summer of 1988 Munro probably could have campaigned for the merger and mustered the
votes to win approval. But giant mergers almost always upset someone and attract lawsuits.
Because of the probable legal challenges, Munro believed obtaining a unanimous vote was

Ross takes a hike

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If anyone held fears of a boardroom showdown, they were dispelled on August 11, 1988, when
Ross pulled out of the talks after an emotional meeting at his Park Avenue apartment with
Munro, Levin, Nicholas, Aboodi, and attorneys. (No meetings were held in the Time & Life
Building. As Ross noted, ''They were a magazine company, filled with reporters.'')

Some Time directors felt relieved. Although many of the so-called governance issues had been
worked out, the Time board had insisted that Ross accept a finite term as co-CEO and the
assured succession of Nick Nicholas as sole chief. ''We didn't want another Armand Hammer,''
explains one director. Lawyers for Time kept referring to Ross's tenure as transitional. The
language grated on Ross. He felt unwanted and unloved by the Time board, and worse yet feared
being locked into a lame duck status, which would undermine his authority.

The last thing Ross wanted was another contentious board. At Warner he was living with an
archenemy in Herbert J. Siegel, the Chris-Craft Industries chief who as a director controlled 17%
of Warner stock and who often clashed with Ross over strategy. But Ross usually got his way.
Says he: ''The way Warner survived and achieved its goals was that the board and I understood
each other. The disagreements we had stayed in the boardroom, and we all came out of the
boardroom with one goal in mind -- to use the best ideas.''

Once again Dingman stepped into the deal, this time to explain to Ross how things work in the
Time & Life Building. Toward the end of 1988 the two met for dinner at Ross's apartment, and
Dingman told Ross that he had put Munro and Nicholas in a bad position with the Time board
over the governance issue. The Time executives had talked up Ross, but if the merger was ever
to get back on track the Time directors needed to know that Ross had no designs on a power
grab, and they needed it in writing.

Ross relented. He says, ''I realized that I've got to decide what I want to do -- take off those deal
blinders and say, Okay, Steve, you've been guiding the company, enjoying working with your
people. You enjoy long range planning, you enjoy dreaming of tomorrow and seeing what you
can do. But there's one thing you don't enjoy doing, and that's running a business on a day to day
basis ... So I said to myself, Maybe this is an opportunity.'' He told Dingman he would agree to
retire as co-CEO in 1994 and retain the chairmanship another five years, through 1999, to give
Nicholas whatever strategic help was necessary.

Dingman reported back to Munro that Ross was ready to deal again. Time's directors had viewed
his reluctance to set a date for his retirement as the last roadblock to an agreement in principle.
Levin and Aboodi resumed negotiations in January 1989, and over the next month closed the
gap. On March 2 Ross was summoned from a Warner board meeting to a session with Aboodi,
Levin, and Nicholas. They had a ratio: .465 shares of Time to be exchanged for each Warner

Felix and Herb

Felix Rohatyn, the renowned investment banker with Lazard Frres (LAZ), was a longtime
friend and adviser to Ross, and he sold the merger hard to the Warner board. The thought of
combining Time and Warner would not have crossed his mind ten years earlier, and deals cross

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Rohatyn's mind the way cars cross the George Washington Bridge. To Rohatyn the cultures were
vastly different. So were the businesses. But with Time's growth in television, that situation had
changed. Says he: ''In its original form I think this was the best merger I had seen in decades -- a
combination of dominant businesses in fields that lent themselves to global expansion in a
financial structure that was a powerhouse.''

Lazard partner Jonathan O'Herron told the Warner board that any exchange ratio higher than .40
was a fair price, and anything over .45 was a ''hell of a deal.'' Rohatyn assured the directors that
even though Time would be the surviving corporation, ''in no way could it be considered'' that
Time was buying Warner. That was because at the agreed exchange ratio, Warner shareholders
would own the majority of the stock. In the Paramount suit to stop the deal, Paramount's attorney
would use Rohatyn's statement to bolster its claim that Time was being sold.

When Rohatyn extolled the deal to the Warner directors, he was perhaps trying especially to
convince Herb Siegel. Ross and Siegel hooked up in 1984 when Ross was trying to shake the
takeover grip of Rupert Murdoch. Warner issued new shares to Chris-Craft in exchange for
42.5% of Chris-Craft's broadcasting subsidiary, BHC Inc. The move shut out the Australian
(Murdoch had not yet become a U.S. citizen) because U.S. law forbids foreign ownership of
American broadcast properties.

The relationship between the two men soon disintegrated. Siegel believed Ross was greedy and
ran an expensive operation. Siegel manages Chris-Craft with a corporate staff that would have a
hard time fielding a softball team. He travels by limo but pays his own way. Siegel also believed
Ross was structuring deals to dilute Chris-Craft's stock and thus Siegel's power on the board.

In board meetings Siegel said very little about the Time deal, but he had his own view of
shareholder value. He's the buy and hold type, while Ross doesn't like to sit still. Says Ross:
''Herb's a very astute, very smart investor. We [at Warner] are operators. Those are two very
different and distinct worlds, and that's something I should have realized up front.''

Warner's strategy for dealing with Siegel, as one high Time executive explained it, is to figure
out a reasonable position and then be totally unreasonable about it. The company's theory is that
in any event Siegel will just ask for more. Siegel owned Series B and C Warner preferred stock,
securities that could be converted to common shares and that carried rights to an independent
appraisal in the event of a merger or buyout. Through a legal complexity, Siegel's requesting an
appraisal would disallow the pooling of interest accounting that Ross so coveted in the merger.

No one knew if Siegel intended to seek the rights. But Time and Warner hated knowing that
Siegel could in effect push a button and blow up the merger. Martin Payson, Warner's general
counsel, fired a warning shot across Siegel's bow. In a board meeting Payson said that if Siegel
should seek appraisal rights, Time and Warner were ready to restructure the deal as an
acquisition of Time by Warner, thus denying him a payoff for his stock. This was untrue.
Whatever Warner's desire, Time had no such intention. More important, under accounting rules
Siegel could have scotched the pooling of interest anyway by selling Warner stock.

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Eventually the parties settled the extraordinarily complex problem. Warner distributed its BHC
shares to its own stockholders as part of the merger deal. Siegel took some new nonvoting Time
Warner stock in exchange for his Warner preferred. Chris-Craft's profit on its five-year
investment in Warner: at least $2.1 billion.

Warner's board approved the merger on March 3. Siegel abstained. Across Sixth Avenue, Time's
board gave its unanimous approval.

A sensitive issue remained: how to announce the deal. Warner insisted that the word
''acquisition'' not be used by itself. Ross didn't like the connotation, preferring to call the
combination a hybrid, a merger/acquisition. ''He didn't want people to think Warner would be
operated like some subsidiary,'' says Aboodi. To Time, using the word acquisition shouted the
news that Time was the successor company. Ultimately, the six-page press release announced
that the companies would ''combine'' and noted only once that Time would ''acquire'' Warner.

Time for a counterattack

Dick Munro felt certain that Martin Davis would not move against Time. He believed he had
secured a firm promise that Davis would respect Time's independence. A few days before Davis
announced his bid, Munro found out that Davis was to lunch with Joseph Flom, the famous
M&A lawyer from Skadden Arps Slate Meagher & Flom who is a Time attorney. Munro, not
exactly thrilled to learn that one of his attorneys was breaking bread with a potential enemy, sent
word to Flom to feel Davis out one more time. According to depositions, Flom asked Davis if he
knew anything about a raid on Time. Davis said something on the order of ''Time? It's 12:30. I'll
have the soup.'' Munro understood that the road to the deal wasn't mined.

Neither of Time's investment advisers, Bruce Wasserstein of Wasserstein Perella and J.

Tomilson Hill of Shearson Lehman, was all that surprised by the Paramount raid. From the
beginning they considered the all-stock merger a risky piece of dealmaking because it could be
easily upset by a higher cash bid like Davis's. Neither Wasserstein nor Shearson was willing to
recommend the deal without a commitment that Time would complete it for cash if the merger
fell through.

Despite their concerns, Time's investment bankers had believed it was an auspicious time to try
the merger. With the market set to digest the huge amounts of junk bonds being floated in early
May in the RJR Nabisco takeover, buyers for newer issues might be scarcer, and the political
environment was growing increasingly anti-buyout. These factors could discourage potential
raiders, who might try to finance their attacks by issuing junk. Says one ''Wasserella'' staffer:
''We thought the usual crazies would lie low. We went down the roster. We all knew these people
and their predilections.''

Still, Time's stock had begun to climb, from $110 in early March to about $135 by May 30, in
anticipation of a raider's play. The investment bankers picked up Paramount's trail in late March,
and it led to Morgan Stanley, the investment banking house. Morgan Stanley had marked Time
for two years before the Warner merger, occasionally sharing its information with Paramount.
Soon after Time and Warner announced their merger, Morgan sent Paramount a business-by-

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business analysis of Time Inc. with an estimate of what a potential acquirer might expect to pay
for the company. And incidentally, if Paramount was interested, Morgan was ready and able to
assist said potential acquirer to make the purchase. Morgan wasn't alone. Salomon Brothers
smelled blood, too, and made a similar presentation to Paramount.

Charles Dolan, founder of HBO, was also nosing around in March with A. Jerrold Perenchio, a
former boxing promoter, television producer, and theater owner. Jerry Levin phoned his friend
Dolan -- who had hired him at Time Inc. in 1972 -- to catch up on old times, and uh, by the way,
you wouldn't be thinking about making a bid, would you? Dolan was noncommittal.

Time's executives, their antennae up, tried to track down other rumors. Munro called General
Electric (GE) chief Jack Welch to flesh out a story that GE Capital would fund Dolan's effort. He
also asked Welch about GE's designs. Welch wasn't talking. Munro next called Robert Bass,
another rumored bidder, and asked his intentions. Bass said he wasn't active in the Time

That Paramount was talking to Morgan Stanley did not seem all that threatening. Time's
investment bankers assumed Davis was lining up a partner should someone else try to break the
Time-Warner deal. He might then step in as a white knight, or buy one of the pieces. In fact,
Paramount was getting calls from Bass and other interested parties about making a joint run at

Davis, Munro, and Nicholas had circled one another for years. HBO signed a deal long ago to
show Paramount movies and renewed the arrangement last year. The three men chatted
occasionally, and several times they gathered for breakfast at the Ritz-Carlton Hotel on Central
Park South, between Time's and Paramount's headquarters. Says Nicholas: ''The discussions
about doing things together probably lasted no more than five minutes, and they were initiated by
Martin Davis, and he made comments like, 'You know, we're a great fit.' And then he would say,
'Gee Dick, you're retiring and then I can run it, and then Nick, you're younger and you can
eventually run it.' That's about as substantive as it got.'' Davis also shared a lunch with
Hollywood-hating Arthur Temple to get to know such an influential Time director a little better.

It is Munro's distinct recollection that Davis told him several times that Paramount would never
attack Time. ''I never asked Martin if he would make a hostile attempt to take over Time,'' says
Munro. ''He volunteered that on at least two or three occasions -- that he would never do
anything hostile, period.'' In testimony for his lawsuit, Davis agrees with Munro on one point:
They did meet. Memories diverge after that. Davis says Munro told him that Time Inc. was not
interested in the motion picture business and wanted to remain just as it was.

By the end of May Paramount had hired Morgan Stanley to prepare for a raid on Time, with
Paramount wheeling in the financial ammunition. Paramount paid Citibank to issue a ''highly
confident'' letter stating that Paramount could secure the credit needed to take Time over.

Davis decided on Friday, June 2, that he would pull the trigger, and he sent relevant information
to his directors so they could consider the matter over the weekend. He sounded out a small
group of lieutenants but spent hours thinking by himself. Paramount's board met the following

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Tuesday, June 6, and Davis got the go-ahead then. The merger that had been all wrapped up and
ready for delivery suddenly wasn't.


The Time-Warner-Paramount battle brought together a monsoon's worth of Wall Street

rainmakers. The Time lineup included Cravath Swaine & Moore, one of the company's law firms
for more than 60 years, led by senior partner Samuel Butler and merger ace Allen Finkelson.
Takeover titan Joe Flom was also on hand, as were Bruce Wasserstein, who has had a finger in
nearly every big takeover pie, and Tom Hill, Shearson Lehman's top merger mogul.

Some of the bills were shocking. Cravath and other law firms jacked up their normally stiff
hourly rates because of the difficulty of the assignment. Time's bill for Cravath and Skadden is
$14 million and rising. Warner's fees, to be paid by Time Warner, include well over $25 million
due the firm of Wachtell Lipton Rosen & Katz.

As the tense days progressed, the Time executives began to meet in ever smaller groups,
sometimes without outside help. Says Munro: ''We had some meetings that were just crazy,
where one rainmaker says go to the mountains and another says go to the valley. We managed a
lot of it ourselves.'' That chafing cut both ways. ''Time doesn't use its advisers too well,'' notes
one of the highly paid lawyers in the case.

Warner's legal team included Arthur Liman of Paul Weiss Rifkind Wharton & Garrison. Liman,
a legendary litigator, last made headlines as one of Ollie North's interrogators in the Senate's
Iran-contra hearings. Warner also had Herbert Wachtell and Martin Lipton of Wachtell Lipton,
the firm that virtually created all modern corporate defense strategies. As investment adviser,
Ross had another old friend, Rohatyn of Lazard, assisted by three partners.

Paramount was outmanned but not outgunned. Davis's team included his inside counsel, Donald
Oresman, a former partner at Simpson Thacher & Bartlett, Paramount's outside counsel and the
law firm that represented Kohlberg Kravis Roberts (KKR) in the RJR fight. Paramount often
worked with Lazard and Wasserstein, but their dance cards were obviously filled. So Davis went
with Morgan Stanley. Stephen Waters, ex-Shearson merger specialist and no stranger to the
takeover wars, led Morgan's group. The M&A experts are like the Pharaohs: few, rich, powerful,
and incestuous. They are also hired guns, and many of them had met a few months earlier at the
battle for RJR, or in even more recent business. Rohatyn had worked for RJR's special
committee of the board, prominently including Martin Davis. Shearson had banked Ross
Johnson's losing hand in the RJR game. Wasserstein's was one of four banking houses employed
by KKR; Morgan Stanley was another. Paramount retained Wasserstein for a year, until
February, 1989, to review acquisition strategies. Lazard had represented Paramount in the recent
sale of its Associates subsidiary; a Lazard partner sits on Paramount's board.

The sides chosen, the gang was ready to play again, and for big money: $16 million each for
Shearson and Wasserella. Morgan signed on for pocket change, $2.5 million, but stood to gain
more than $100 million in fees if Paramount's bid succeeded.

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The acquisition solution

''We will not make a decision this week.'' Time's board convened on Thursday, June 8, to those
words from Munro. The decision not to choose a response to Davis's hostile offer had several
purposes, the first being to see if any other players were going to jump out of the wings. The
second was to take some heat off the board and minimize the chance of committing a tactical
error under pressure. The third and most important was to give the board time to carry out its
strict legal duty of carefully deliberating over its next step.

Munro, livid and convinced that Davis had snookered him, sent the Paramount chief a so's-your-
old-man letter flooded with invective and hyperbole. ''You've changed the name of your
corporation but not its character: it's still 'engulf and devour,' '' he wrote. ''Hostile takeovers are a
little like wars: it's impossible to tell where they may end.''

If Munro wanted the head of Martin Davis, an in-your-face, Pac-Man counterattack could deliver
it. Just buy Paramount. Director John Opel asked the advisers for a detailed analysis of the pros
and cons of Time making a counterbid for Paramount, the so-called Pac-Man defense. The
company was, after all, No. 2 on Time's short list of merger-acquisition candidates, and it would
be cheaper to buy than Warner.

The problem with Pac-Man attacks is that they seldom succeed, and the tactics are messy. There
was, however, one intriguing potential outcome: Once Time turned the tables on Paramount,
Davis might be amenable to a mutual disengagement. But then again he might not, and the
strategy would be a step removed from the real goal of merging with Warner. So Time
renounced Pac-Man.

Instead, Time attacked Paramount's bid on two fronts, price and conditions. Mack Rossoff of
Wasserstein Perella appraised Time's value at $238 to $287 a share, a range some directors
thought far too low. Later, however, Wasserstein lowered it a bit.

Even by that measure, Paramount's $175-a-share offer didn't get into the ballpark. The Time
board cited the low bid as a reason for refusing to negotiate with Paramount. The advisers
figured that if Paramount owned Time, Paramount's stock price might double in a year.
Wasserstein and Shearson's analysis of Paramount indicated that it could afford at least $225 a

Paramount attached a large number of conditions to the deal. Time had the usual poison pill
defenses that Paramount wanted rescinded. As part of the original merger deal with Warner, the
two companies had also agreed to exchange a small amount of each other's stock. Such a swap
would increase the price Paramount would have to pay, and Davis wanted the obstacle removed.

Davis's offer had a standard ''financing out'' condition, a technical way of saying, ''If we can't get
the money, the deal's off.'' More important, the offer was contingent on Paramount's obtaining
approvals from cities and towns across the U.S. for the transfer of cable television licenses from
Time to Paramount. ''If theirs was such a great offer,'' asks Ross, ''why were there 27 conditions
to it?''

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Rossoff, Levin, and ATC Chairman Joseph J. Collins argued at one Time board meeting that
Paramount's bid had to be discounted because the company needed at least three months and
more likely a year to get approvals for the cable franchise transfers. Cable franchises generally
carry a right to renewal, but Collins explained that it goes out the window in any change of
ownership that is not first approved by the governing municipality. Furthermore, he said, no
hostile acquirer had ever asked for franchise transfers; maybe some wouldn't be granted at all.
Wasserstein noted that at a discount of 1% per month compounded -- the rate of return Time
shareholders expect on their investment -- $175 four months down the road is worth $170 today.
If the payoff is a year away, the present value is only $155.

In addition to the franchise transfers, Paramount also had to obtain license transfers from the
Federal Communications Commission for such things as microwave relays and radio operating
permits associated with cable transmission. That too would take a while. So Paramount asked the
FCC to let it establish a voting trust, run by former Defense Secretary Donald Rumsfeld, that
would hold Time shares while the company pursued the license transfers. Since Paramount's
offer prevented the company from buying shares until it got FCC license and cable transfers, the
company planned to have the trust pay Time's shareholders immediately. Collins told the Time
board the trust was probably illegal.

In response, Time launched a guerrilla attack to delay the transfer approvals. Lawyers for Time
and ATC told officials in many cities and towns that Paramount's plan to set up a trust for the
shares violated franchise agreements. Should city fathers be as horrified as Time Inc. at this state
of affairs, Time would help them sue Paramount for illegally interfering with the franchise. Time
sent to officials of about a dozen large cities all the legal papers necessary to file suit -- just fill in
the blanks -- and told a couple of cities it would even pay the legal costs and indemnify the
plaintiffs against countersuits by Paramount. The company also challenged Paramount's
application to the FCC to set up a voting trust. ATC sued Paramount in Connecticut for illegally
interfering with its business.

Such civic-mindedness is hardly the type of behavior that usually characterized the preppies of
Time Inc. This is big league, sharpen-your-spikes-and-slide-in-high type stuff. Asked by
Paramount's lawyers if the legal ambush was an ethical business practice, Munro was clearly
uneasy: ''I would have a little trouble with that. I'm not sure it's right or it's wrong, but it's
marginal.'' (Not to director Finkelstein. He says: ''One pursues the tactics that one thinks are in
one's own interest. Both sides do that.'')

During meetings on June 8, 11, 15, and 16, the Time board debated options. It could do nothing
and risk the shareholder vote on the Warner merger. It could take on debt and pay out a big
dividend to the shareholders, enough to induce them to reject Paramount's bid. Or it could
change the deal. Wasserstein told the board that by selling off 1.5 million cable subscribers (out
of Time's 4.3 million) plus Scott Foresman, a Time textbook publishing subsidiary, and
borrowing against the remaining assets, management could in theory raise enough cash to pay
the stockholders $185 to $200 a share in a restructuring or leveraged buyout.

Only remotely did Time's board consider selling the company and delivering cash to the
shareholders. The directors were convinced the Warner deal would pay off down the line. Only if

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the company lost Paramount's suit would they consider a sale. The lawyers assured the board
there would be plenty of time to do that.

Having eliminated a sale, buying Paramount, or an LBO, the board focused on Warner. Says
Finkelstein: ''In looking at a variety of options that [the advisers] presented, including what
shareholder value would be two, three, four years down the line on the merger, and various other
approaches ... I came to the conclusion Time's a very valuable company, and it's my own
judgment that the acquisition of Warner will magnify that value.''

During the meeting on the 15th, advisers took the board through a variety of scenarios in which
Time would buy Warner for $70 a share, either in cash or in combinations of cash and securities.
The advisers favored a deal they had worked out with Warner: Time would tender for about 50%
of Warner's stock in cash, with payment for the rest -- the so-called back end of the deal -- to be
considered later.

Warner's stock was then selling for $55.63. Directors peppered the advisers with questions about
why the back end was left so vague. The answer was straightforward: The back end was open
because Warner negotiated it that way. Steve Ross was leaving himself some room to make a
deal within a deal.

On the 16th the board voted unanimously to acquire about 50% of Warner for $70 a share in cash
and to pick up the rest for cash or securities or some combination. The board then postponed the
shareholders' meeting scheduled months earlier for June 23 to vote on the original merger.

The directors debated little whether to ask Time shareholders to approve the new proposal. Time
executives later explained that it would take too long to mount the educational campaign to
persuade them of the deal's long-term advantages. By that time Warner might have dropped out,
and the overriding concern was getting the deal done. Even though most shareholders would
have preferred to take Davis's cash, Time's board was persuaded that in the long run the Warner
acquisition would be more valuable to them. Says Finkelstein: ''Once you believe you are acting
in the best interests of the shareholders, you can continue on until you have a better argument,
and I don't think we were presented with a better argument.''

When Munro explained the new deal to sometimes skeptical employee groups over the next
couple of days, a number of them asked about the shareholder vote. He told them bluntly: ''We
are going by the law.'' Shareholder approval was not needed. It would not be asked for.

Even as the Time board was moving forward with an acquisition, Ross tried desperately to save
the merger. According to Arthur Liman, he was even willing to consider lowering the exchange
ratio in light of the rise of Time's stock. Although a creative dealmaker, Ross still carried the
baggage of many Depression-raised executives -- he didn't like leverage one whit.

With Time stockholders almost sure to vote down the original all-stock merger in the face of
Paramount's offer, Ross focused on doing that deal without them. He had a problem: The New
York Stock Exchange then required a vote when a company wants to increase its shares by
18.5% (now 20%) or more in an acquisition, as Time would have done under the original terms.

Tap Dancing to Work Page 63

Ross set out to persuade the stock exchange that the rules didn't really mean what they said, that
a shareholder vote wasn't necessary. The idea was farfetched but worth a try.

Ross had no contacts on the NYSE. Munro did, and Ross asked him to try to arrange a meeting
with NYSE Chairman and CEO John J. Phelan Jr. Alas, he was traveling. Warner lawyer Martin
Lipton then drafted a letter to the Exchange -- cosigned by Sam Butler of Cravath -- that
explained, through a variety of contortions, why a shareholder vote really wasn't necessary.

Time viewed the letter with decidedly mixed feelings. The top executives preferred a cash or
cash-and-debt acquisition and always had, because it would not dilute the stock. Time had agreed
to the original merger only because Ross wouldn't do the deal any other way. Butler may have
signed the letter knowing the NYSE was nearly certain to reject the plea. Ross suspected as
much: ''I had a feeling that if we did get approval there would have been one hell of an
argument'' between him and Munro over how the deal would be structured. As the Warner
directors met on June 16 to consider Time's $70-a-share offer, they got word that the NYSE had
rejected any waiver of a shareholder vote on the merger. They voted for the acquisition.

After the meeting Ross told Time he was triggering the stock swap that the two companies
negotiated as part of the original deal. The swap put 11% of Time's shares in Warner's hands and
9% of Warner's shares in Time's, an exchange that rendered a raid more costly and difficult to
execute. Ross was playing defense: If Time did get taken over by Paramount, Warner would at
least get a sweet going-away gift when Time's price rose. On June 23 Davis turned up the
pressure by increasing his bid to $200 a share, a maneuver the Time directors fully expected.
They held firm.

Davis wows 'em

Martin Davis won the media battle with startling ease. As a former movie publicist he
understands how the press works. And as CEO of a once wide-ranging conglomerate he knows
many industries and the reporters who cover them. Davis also happens to be a terrific source:
knowledgeable, articulate, and unafraid to tackle tough questions.

On this issue Davis delivered a simple message: Here's the offer, it's cash, we don't plan to sell
assets, and yes, we expect to have all the approvals we need just as quickly as we can get them.
Clearly Paramount's deal was not that simple, but why complicate the issue?

Davis defused Munro's charge that Paramount would violate Time's editorial integrity. Why
would he want to interfere with such great magazines? He told Fortune he would put in writing a
pledge not to meddle with the magazines' editorial operations.

Munro told everyone who would listen that Paramount's offer was illusory, inadequate, and
highly conditional, and that Davis was a lying so-and-so who would have to sell huge pieces of
Time to finance his debt. His protestations did not get him far.

Some Time executives and Wall Street bankers had naively assumed the press would rally
around a brother media company to repel such a raid. Instead, much of the press slammed Time.

Tap Dancing to Work Page 64

Davis framed the issue in black and white and left Munro to struggle with a dozen shades of
gray. The media do not write much about gray.

Directors were disappointed by the cynicism shown their efforts to make an American institution
into an international one. The cancellation of the shareholder vote, the rejection of a $200-a-
share cash offer without negotiating, the high-paying, long-term contracts for top executives --
there were answers on all these issues, but explaining them took time and more willing ears, and
Munro didn't find enough of either. Time could not even begin talking about Davis's bid until the
board had fully considered all options -- and that took days.

The Time Inc. magazines (including Fortune) drew fire for their coverage. McManus had to
defend Time magazine's failure to cover the initial merger announcement, a decision he made
because he wasn't sure Time could do a story sufficiently complete -- the announcement came on
the day the magazine goes to press -- to avoid allegations of favoritism. And in a bizarre editorial
the Wall Street Journal chastised Time for trampling shareholder rights -- bizarre because
common shares of Dow Jones, the Journal's owner, have one vote, while the Class B shares,
controlled mostly by insiders, have ten votes each.

The whole extravaganza headed for a rock'em sock'em showdown at Time's annual meeting June
30 to elect four directors. The combatants would be management and the shareholders, by now
perhaps one-third arbitragers, who were in to make some fast money and wanted the company to
deliver. The showdown never occurred.

The dippy gadfly Evelyn Y. Davis (no relation to Martin S.), attired in a Batman hat and T-shirt,
broke the tension. She nattered endlessly about her pet topics and offered words of advice to
management. CEOs value Ms. Davis's attendance about as much as they do an SEC
investigation, but Munro and Nicholas couldn't have asked for more. Dissenters, perhaps thrown
off stride by the babbling batwoman, did not materialize. Quite the opposite: A few Time
shareholders and employees swore their fealty to the cause. Munro was elated. It was one of the
few pleasant moments he had had in the past month.

War in Delaware

The day was July 11, and members of the Delaware bar said it was the damnedest thing they had
ever seen. The 1989 Super Bowl of corporate litigation, Paramount Communications v. Time,
was under way. A mob of photographers and TV cameramen, reporters tethered to them by
microphone cables, waited on the steps of the Court of Chancery in Wilmington. At 9 A.M. men
and women began wheeling huge cartons of documents up the steps. The gang with the cameras
followed en masse, a media mummers' parade capturing for posterity what appeared to be an
office move.

About 85 stultifying degrees of thermal energy and twice that many lawyers, arbitragers, and
reporters crammed into the corridor when courtroom 301 opened. An ugly scramble for seats
forced the bailiffs to call for order. This being Wilmington in July the heat would have shown up
anyway, but the crowd might have been thinner had everyone known what Robert D. Joffe knew.

Tap Dancing to Work Page 65

Cravath's Joffe, lead counsel for Time, was going to argue before Chancellor William T. Allen.
Joffe knew that Paramount's lawyers had deposed 13 Time and Warner executives, directors, and
advisers. He knew they had copies of the minutes of board meetings, handwritten notes of phone
conversations, and presentations made by Time's and Warner's bankers. And he knew they didn't
have the case they went looking for.

Joffe knew even before Paramount deposed Munro on July 1. Paramount had chosen to depose
Munro last, and by then Joffe figured there was no way it could make its case. He told Munro
just to answer the questions and not screw up. Says Munro: ''Going into my deposition we were
sure we had an 80% chance of winning the case. And we were certain that if we lost at the lower
level we'd win on appeal.''

Delaware law has always given directors wide latitude in determining corporate conduct. Only in
recent years have the courts tightened the reins on them, and only in a few narrow cases. In
Revlon v. MacAndrews & Forbes Holdings, a 1986 case now known as Revlon, the Delaware
Supreme Court ruled that if the directors decide to sell a company, they must sell it to the highest
bidder. No favorites. In a 1985 case, Unocal Corp. v. Mesa Petroleum Co., called Unocal, the
court ruled that directors defending their company from a raider may respond only in a
reasonable way. ''Reasonable'' did not necessarily mean ''fair'' to the raider. To prevail,
Paramount would have to demonstrate clearly that Time had broken the Revlon or Unocal mode

Paramount built its case on two foundations, the first being that Time put itself up for sale when
it agreed to merge with Warner on March 3. The argument was largely technical: When Time
acceded to a swap at a .465 ratio, 60% of its shares -- a majority -- would have gone to Warner
stockholders, and Paramount said that's a sale. If it was, then Time was in the so-called Revlon
mode and had to sell to the highest bidder. The second and more complex argument charged
Time managers with entrenching themselves at shareholder expense and responding
unreasonably to Paramount's bid, violating the Unocal rule. Time's plan to acquire Warner
without shareholder approval was Exhibit A.

Paramount's attorney, Melvyn L. Cantor of Simpson Thacher, tried to string together a cohesive
tale of entrenchment. In a calm though faintly sardonic voice he led Allen through the
negotiation of the merger ratio, the management contracts, the governance provisions, the refusal
to negotiate with Paramount, the cancellation of the shareholder vote, and the new plan to
acquire Warner. He also suggested that Time didn't really believe that preserving the editorial
culture is vital to the company. After all, he asked, ''Who is going to preserve this culture, your
honor? Nick Nicholas, a man who has worked 20 years in cable television.''

The closest Paramount got to a smoking gun was a memo written by Time vice chairman Levin
in August of 1987. Levin, Time's Big Thinker, outlined the logic for combining with Warner and
Ted Turner's TBS. (Time then owned about 12% of TBS; Time Warner owns 18%.) He sketched
what he believed would be the relative positions of Time's other businesses in the future. Levin
also noted, ''An overriding question would still be: Have we secured the company? Is sheer size
sufficient protection, or will we still need a large block of stock in friendly hands?'' To
Paramount, the statement was direct evidence that Time's executives desired the company for

Tap Dancing to Work Page 66

themselves. But Levin closed the memo by saying, in effect, he was just thinking out loud, a
postscript that may have been vital to Time's defense.

Cantor was terrific, but his argument didn't have much law behind it, and Joffe attacked it head
on. Time's decision to merge with Warner was more than two years in the making, he pointed
out. If that isn't thoughtful corporate planning, what is? Warner attorney Herbert Wachtell asked
the court: Had Paramount not appeared on the scene, would any court have prevented the
original Time-Warner combination? The answer, as Wachtell knew, was no -- the proposed
merger was clearly legal. Just because Paramount decided to make a bid for Time a day late and
50 bucks short, he argued, that was no reason for the court to stop the Time-Warner deal.
Besides, for all Time had done, it had in no way prevented any future bids for the company. If
Davis wanted to buy the new Time Warner, Wachtell noted, nobody was stopping him.

Chancellor Allen agreed wholeheartedly. In a slam dunk opinion he gave full support to the Time
board as the corporation's caretakers in this matter. It didn't matter that the shareholders might
well have preferred to accept Paramount's bid. ''The corporation law does not operate on the
theory that directors ... are obligated to follow the wishes of a majority of shares,'' he wrote. ''In
fact, directors, not shareholders, are charged with the duty to manage the firm.''

Allen said Time's directors acted reasonably in rejecting Paramount's bid because they were
pursuing a major strategic plan in acquiring Warner. That suggested that a long-range strategy
might join the poison pill in U.S. corporations' defensive arsenal. (Who knows, it may even help
the business.) Allen added another potential new factor to future takeover fights when he cited
the board's concern for preserving Time's culture. ''I am not persuaded,'' he wrote, ''that there may
not be instances in which the law might recognize as valid [in a defense against takeover] a
perceived threat to 'corporate culture.' '' Most of the Fortune 500 are already incorporated in
Delaware, and Chancellor Allen's granting of such broad authority to directors is a powerful
reason to stay there.

On appeal the Delaware Supreme Court upheld the decision unanimously. Justice Randy Holland
asked Cantor, ''Do you agree that Time and Warner is a good deal?'' ''Yes,'' Cantor agreed, but
before he could add that Time Paramount was a better one, Holland shot back: ''Then don't you
lose?'' You do.

The raid on Time cost Paramount more than $80 million pretax. But it resulted in Time's having
to borrow $12 billion, an enormous debt load. As a result Time Warner paid $451 million in
interest and financing fees in this year's third quarter and took a $40 million earnings hit for
amortization of goodwill, contributing to a loss for the quarter of $176 million. The question is
inevitable: Is this the reason Davis pulled the raid? ''Just look at the depositions,'' says Davis.
''You'll see that there isn't a shred of truth'' to the charge.

A better question might be: Assuming Paramount really wanted to own Time, did it choose the
right tactics? A lawyer involved on the Time side says, ''Morgan Stanley had to know that Time
was worth at least $225 a share. Why give the board a reason to reject you by coming in so low?''
Court documents show Morgan Stanley valued Time at a minimum of $217 a share. Some

Tap Dancing to Work Page 67

investment bankers wonder why Davis didn't play the last card: bid for the merged Time Warner
after prearranging a deal with some third party to take Warner off his hands.

After losing in court Davis said he was not interested in further pursuit of Time Warner. He did
not say he was not interested forever. But now Paramount has another set of variables to deal
with. Sony's (SNE) pending buyout of Columbia Pictures Entertainment for about $3.4 billion
(plus the assumption of $1.4 billion of debt) has revalued the entertainment business once again.
That sale makes Time's deal a little better looking, and it puts the spotlight back on Paramount.
Selling its Associates financial business has made the company even more attractive: a media
play loaded with cash. Paramount's stock, around $55 when it attacked Time, rose to about $65,
apparently in anticipation of a buyout.

Is bigger better?

Dick Munro, Nick Nicholas, and Steve Ross have their dream come true: Time Warner is the
largest media empire on earth. Now these three men have some substantial promises to keep in
the face of considerable uncertainty. They must show that an important premise of the deal was
valid -- that the companies can enhance the value of print, video, and music and create new profit
opportunities together. They must pay off at least some of Time Warner's $12 billion debt
without divesting the core businesses of magazines, pay TV, cable systems, and film and record
production -- though a rise in interest rates could poleax their repayment forecasts.

Munro must show that he was right to spend $13.1 billion for a company that depends
enormously on one man. For now he acknowledges that ''If I'm wrong about Steve Ross, it will
be the biggest mistake I've ever made.'' Nicholas will eventually have to show that he was worth
signing up as CEO five years in advance. All three executives will have to demonstrate that they
merit their extraordinary long-term contracts.

Perhaps most important, Munro and Nicholas will have to show that their fundamental act of
stewardship in this deal -- repulsing a highly conditional offer for Time shares in favor of a
highly leveraged acquisition -- was sound. Remember that at one point they discounted the value
of Paramount's offer by assuming Time investors demanded a 12% annual return. They also
argued that their deal might not look as good as Paramount's in the short term but would be far
more valuable in the long term. Fair enough. The $200 a share Time stockholders didn't get, at
12% a year, will be worth $352 in five years, $621 in ten years. The stock was recently around
$140. The managers of Time Warner must now demonstrate that bigger is better. And in a big

Posted in: Berkshire Hathaway, Tap Dancing to Work, Warren Buffett


Buffett to Disney: All thumbs up

Tap Dancing to Work Page 68

November 21, 2012: 11:43 AM ET

Email Print

By Carol Loomis

This story is from the April 1, 1996 issue of Fortune. It is the full text of an article excerpted in
Tap Dancing to Work: Warren Buffett on Practically Everything, 1966-2012, a Fortune
Magazine book, collected and expanded by Carol Loomis.

Warren Buffett and wife Susie ham it up at a February Cap Cities management meeting, weeks
before Disney's Eisner (left) and President Michael Ovitz learned of his plans.

FORTUNE -- Just in from Omaha and making a do-it-yourself delivery, Berkshire Hathaway
(BRKA) Chairman Warren E. Buffett strolled into the downtown Manhattan offices of Harris
Trust on March 5 and handed two envelopes to a Harris officer. In envelope No. 1 was stock
worth, gulp, $2.5 billion: Berkshire's 20 million shares of Capital Cities/ABC, being delivered to
that company's purchaser, Walt Disney Co. (DIS)

In envelope No. 2, sealed and marked "Do not open until 4:30 P.M. on March 7," were Buffett's
wishes -- kept secret from even the managements of Disney and Cap Cities -- as to how he
wanted Berkshire to be paid for the contents of envelope No. 1. Like any ordinary Cap Cities
shareholder, Buffett had the choice of taking the standard package, which was Disney stock plus
cash, or of requesting all stock, or all cash.

And the envelope, please? Giving Disney a huge thumbs up, Buffett asked for stock only.
Talking to Disney CEO Michael Eisner late on the 7th, Buffett said he'd paid the company and

Tap Dancing to Work Page 69

its boss his ultimate compliment by entrusting them with Berkshire's money. Eisner assured
Buffett he'd work to make the decision right.

Because Berkshire's allotment of Disney stock will depend partly on the choices made by other
Cap Cities shareholders, its exact stake in Mickey Mouse & Co. wasn't immediately known. But
even 20 million Disney shares -- the minimum Berkshire will receive -- would give it about a 3%

In Berkshire's 1995 annual report, due out momentarily, Buffett will acknowledge that he is
returning to the scene of an investing crime. Attracted to Disney in 1966 by its film library, its
burgeoning theme-park business, and its peanut-gallery stock price -- the market capitalization of
the entire company was less than $90 million -- Buffett invested a large chunk of Buffett
Partnership money in the stock at a split-adjusted price of 31 cents a share. The stock recently
sold for $65 -- but did Buffett hang around for the ride? No. He sold out in 1967 at 48 cents a
share. "Oh, well," Buffett says, with surely a wince, "it's nice to be back."


Beating the market by buying back stock

November 21, 2012: 11:42 AM ET

Email Print

A company just isn't in the swim today unless it's buying its
own shares. Are buybacks a fad - or do they pay off for
investors? A ground-breaking Fortune study shows that
buybacks have made a mint for shareholders who stuck with
the companies carrying them out.
By Carol Loomis

This story is from the April 29, 1985 issue of Fortune. It is the full text of an article excerpted in
Tap Dancing to Work: Warren Buffett on Practically Everything, 1966-2012, a Fortune
Magazine book, collected and expanded by Carol Loomis.

Tap Dancing to Work Page 70

The sultan of buybacks is Henry E. Singleton, 68, chairman of Teledyne, which over the years
has repurchased 85% of its shares for about $2.7 billion. A model of flexibility about his stock,
Singleton used it as currency when Teledyne was a 1960s highflier, issuing bundles of shares to
acquire companies and build his conglomerate. But when Teledyne's price-earnings multiple
dived, he switched to repurchases. The first was in 1972 at a price (adjusted for splits and stock
dividends) of $8 a share, the last at $200 in May 1984. The shares then leaped to $300 and were
recently at $250.

FORTUNE -- Does it pay a company to buy its own stock? A world of companies have come
around to thinking that it does. Last year, according to a Merrill Lynch count, about 600
companies announced programs to repurchase their stock -- a record, by a mile. Salomon
Brothers estimates that $26 billion went into repurchases during the year, another runaway
record. The list of companies in the game includes the large and elite, many among the Fortune
500: Exxon (XOM), Standard Oil (Indiana), American Home Products, Coca-Cola (KO),
General Foods, on and on.

This burst of activity, however, has taken place in a certain statistical vacuum. No one could say
how good stock buybacks have been over the long run for shareholders who stayed with the
repurchasing companies. Anyone might marvel at Teledyne, the most celebrated buyback
company over the years, whose shareholders have made out smashingly -- achieving a gain,
since the buybacks began in 1972, of more than 3,000%. But that standout performance hardly
serves as a testimonial to buybacks in general. How about all the other companies that over the
years, with somewhat less verve and certainly much less public attention, were buying large
chunks of their own stock?

To that question, Fortune now has an answer. Working with the 1,660 stocks covered by the
Value Line Investment Survey, we identified companies that bought significant amounts of their
own common stock in the ten years from 1974 through 1983. Next we reduced this list to
voluntary repurchasers -- cutting out, for example, companies that had bought the shares by
paying "greenmail" to get rid of a threatening shareholder. Then we measured the total returns
(stock appreciation plus dividends) earned by shareholders from the approximate dates of each
repurchase "episode" to the end of 1984. For exactly the same periods, we compared the results

Tap Dancing to Work Page 71

with total returns earned on Standard & Poor's 500-stock index, a generally accepted indicator of
"the stock market."

The outcome is spectacularly decisive. The shareholders in the buyback companies earned
superb returns, far exceeding those accruing to investors as a whole. For all episodes measured,
the buyback companies showed a median total return, expressed as an annual average,
compounded, of 22.6%. The equivalent return for the S&P 500 was only 14.1%. That difference
of 8.5 percentage points is enormously significant to an investor: at 22.6%, a stake of $1,000
grows to $7,670 in ten years; at 14.1%, it grows to only $3,740. Clearly, the managers of the
buyback companies, in aggregate (though certainly not in every instance), added heroically
during these years to the wealth of shareholders who remained in the fold. (For a list of
companies that have been big buyers recently, see box at the bottom.)

These findings cannot cheer the critics of buyback programs, who tend to regard them as close to
unpatriotic. Why, some skeptics ask, should tax breaks be granted to corporations in the name of
"capital formation" when so much money is flowing lazily and unproductively into repurchases?
Why, especially, in an age of gigantic government deficits?

Eugene M. Lerner, professor of finance at Northwestern's Kellogg Graduate School of

Management and a critic of buybacks, wishes for corporate actions more "socially useful." It's
discouraging, he says, to see managers spending so much time "screwing around with the
market, instead of finding good business opportunities, competing against the Japanese, and
minding the store." Lerner thinks the market should view the announcement of a buyback as a
negative signal -- an admission that a company has run out of constructive things to do with its
money. But the market, he concedes, doesn't see things that way, and he is unsurprised to hear
that the buyback crowd has achieved superior results. He is also unimpressed: "You make a lot
of money peddling drugs too, but I'm not in that business either."

Under examination, the arguments against repurchases lose much of their force. If it is wrong for
companies to channel money to shareholders instead of retaining it for corporate use, dividends
as well as repurchases should be under a cloud. But few people go that far in their criticism --
certainly not Lerner, who regards dividends as "a glorious discipline" to which corporations
definitely should be subject. The money paid for repurchases, moreover, does not vaporize once
it reaches stockholders and lose its capacity for doing constructive work. Some of it goes for
taxes -- assessed at preferential capital-gains rates, rather than the full rates paid on dividends.
Once the Internal Revenue Service gets its due, the rest of the money trucks back into the
economy, with a part of it unquestionably round-tripping into stocks.

The big positive point about repurchases is that they have showered benefits on stockholders
who stayed aboard the buyback companies. For the period covered by Fortune's study,
repurchases were an intelligent use of money by managers who had, as they always do, a range
of alternatives. If the rate of return looks attractive, they can plow funds into the development of
new products or into plant and equipment. A second alternative is to buy other companies. A
third is payouts to shareholders through dividends or repurchases.

Tap Dancing to Work Page 72

Liking leverage for the boost it can give return on equity, Tandy Corp., home of the Radio Shack
chain (see Selling), has been a big buyer of its stock. The man in charge of purchasing, Garland
P. Asher, 40, director of financial planning, says Tandy has bought at "horrible times" that
initially made it look like "a chump." But the buying done in the 1970s eventually produced rich
payoffs. Since late 1983 Tandy has been back in its chump mode: Asher has bought while the
stock has sunk. "But that's the point," he says. "You don't want to buy your stock when it's

If a company's stock is undervalued -- as many managers believe theirs is -- a repurchase may

offer the best payoff of all. Approaches to determining stock values vary but fundamentally each
company judging itself undervalued is saying that its future stream of earnings justifies a higher
price than the stock market is willing to accord it. To capitalize on this situation, a company will
normally have to expend cash or other assets for its shares, thereby shrinking its total wealth. But
because each $1 spent will buy more than $1 of value, the stockholders who retain their shares
will emerge with more wealth per share than they started with.

Imagine, for example, a company with this financial profile: $200 million in assets, including
$38 million of spare cash invested in commercial paper; $120 million in shareholders' equity;
projected earnings for the next year of $20 million (after taxes), including about $2 million in
interest to be earned on the commercial paper; ten million shares outstanding, which means
earnings per share are expected to run $2; and a stock market valuation of $160 million, or eight
times expected earnings. But the company's executives are quite sure that the company is worth
more like $300 million -- to, say, a private buyer. In other words, they believe the true value of
the company to be around $30 a share, rather than the $16 a share that is the stock market's

So the company makes a tender for two million of its shares at $19 each, thereby spending $38
million (leaving aside costs for lawyers, investment bankers, and the like). That strips $38
million from assets, which fall to $162 million, and from stockholders' equity, which falls to $82
million. The company thus shrinks and also becomes more leveraged. That is, each dollar of
equity is now supporting $1.98 in assets vs. $1.67 previously.

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The value of the company to a private buyer also drops, we may assume, by $38 million (to $262
million), and expected earnings fall by the $2 million that will no longer be earned on the
commercial paper. But only eight million shares now exist to split the corporate wealth. The
forecast for earnings is revised to $2.25 per share, up 12.5%. The true value per share, based on
the $262 million the company might bring in a private deal, rises to $32.75, up 9.2% from the
original $30.

The stock market will be coping with all these facts in its own independent, unpredictable way.
While the tender is in progress, at that premium price of $19 a share, the stock price will
undoubtedly rise from its former $16. But it can be argued that if the market remains consistent
in its appraisal of the company, its total market value should drop by $38 million -- the shrinkage
on both sides of the balance sheet -- once the tender is completed. Were that to happen, the
market price of each of the eight million remaining shares would be only $15.25 and their price-
earnings multiple less than 7. That multiple could even seem logical because of both the
premium paid for the repurchased shares and the added leverage injected into the company.
Though leverage can be wonderful in prosperous times, it can be terrible in bad. Bond-rating
agencies, in fact, sometimes lower the ratings of repurchasers, as Moody's did recently with both
Teledyne and Holiday Inns. Both are among the many companies that have not only pumped up
leverage by buying in stock, but have also raised cash to do it by adding debt.

As it turns out, neither the leverage created by buybacks nor much else about them appears to
have bothered the stock market. Various academic studies of tenders have shown that the stock
seldom slips to $15.25 (to stay with our example) when a tender is completed and instead stays
well above the old price of $16. Say the post-tender price is $18. That would mean the market
had knocked only $16 million from the company's total market value -- less than half the amount
expended to buy shares.

The results of Fortune's study are consistent with the academic findings. But they add a whole
new body of information about the long-term effects of buybacks. Furthermore, Fortune's
results, good as they are, present a conservative picture of how well the buyback companies did.
For one thing, the study covers only companies still public at the end of 1984. It omits
companies that repurchased large quantities of their stock but later were acquired at prices far
above the market (Norton Simon, for example) or that bought in all their shares at premium
prices and went private in the ultimate buyback (like Metromedia). Were these winners added in,
the returns would surely look even more superlative. Second, we did not assume that investors
jumped into a buyback situation early. Instead we assumed that they bought in only after a
company's repurchases had become a matter of public record -- and after the share prices, in
many cases, would have moved up.

To begin with, we identified Value Line companies that, in one or more years from 1974 through
1983, repurchased enough shares to reduce those outstanding by at least 4% (or that, in a few
cases, repurchased convertible securities and warrants that are common stock equivalents). The
4% standard limited the study to hard-core buyers. The soft-core sort would be the many
companies that buy relatively small amounts of their stock for housekeeping reason -- for
example, to supply shares for option and other employee-purchase plans.

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Glenn W. Bailey's managerial stripes were earned at ITT under Harold Geneen, whose burning
ambitions never included stock buybacks. But after Bailey began running the company now
called Bairnco Corp., a maker of lighting fixtures and electronic components, he watched its
stock collapse in 1974 to 25% of book value and three times earnings. "Very interesting,'' he
said, and bought until the price hit book seven years later. The stock is up 4,300% since the 1974
low. Bailey, 59, has an 11% stake, recently worth $33 million, that keeps his attention on what's
best for stockholders.

The search for 4-percenters turned up about 360. But we wanted only the companies that seemed
to be buying on their own initiative, simply because they saw unrecognized value in their stock.
So besides weeding out greenmail repurchasers, we excluded other companies that may have
been buying because they felt an obligation to do so. For example, purchases made from a
former officer or director, or from estates and foundations linked to the buyback company, were

In this weeding, we looked at all the companies among the 4-percenters big enough to have made
the 1983 Fortune lists of the 500 largest industrials and the 500 largest service companies. Of
136 such companies, 87 appeared to be voluntary buyers meeting our criteria. Wanting also to
examine the experience of smaller companies, we added a random sample of 100 that seemed to
be buying voluntarily. So the total number of buyers included in the final survey was 187. Many
of those met the 4% standard in more than one year, and returns to their shareholders were
measured, through 1984, for each purchase. In all, the 187 companies accounted for 312 "years,"
or episodes, of buying.

The result for shareholders had to be measured from a logical time within or after each episode.
Fixing that point was easy in the case of cash tender offers and offers to exchange senior
securities for common stock. These events are always announced and therefore we began
measuring returns from the end of the month in which the announcement was made. By that time
the news of the tender or other offer would already have caused the price of the stock to jump in
recognition of both the premium to be paid and any other pluses investors saw in the repurchase.
Because we began measuring only after such jumps had occurred, the results of the study don't
include them.

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An after-the-fact procedure was also used for open-market purchases, which are commonly
strung out over months and even years. Many companies announce these repurchase programs
when they begin. But the Securities and Exchange Commission does not require an
announcement and some companies never make one. Word of their repurchases, however, is
generally passed along by Wall Street traders and analysts. Quarterly reports to shareholders may
confirm that buybacks have taken place. At the latest, a shareholder can discover that a company
has bought a significant number of shares when its annual report is published.

Taking all this into account, Fortune adopted a compromise approach for openmarket purchases,
beginning to measure returns at the end of a fiscal year in which the company experienced a
reduction of at least 4% in its outstanding shares. This delayed start means that any help a
company's buying gave its stock in that year was disregarded in the returns we measured.

But some companies kept on buying their stock. Does that mean their presence in the market
could have boosted investors' returns later? The point is important because many people suspect
the basic purpose of repurchase programs is to "prop" the stock -- to push up its price or, at the
least, keep it from falling. Some companies own up to such intentions. In a 1983 study conducted
by the Conference Board, a business research group, 72 companies that had been big
repurchasers of stock ranked their reasons for buying. Eleven said one of their objectives was to
support their stock's market price, and nine of the 11 ranked that objective first, second, or third.
But the Conference Board also asked the 72 companies what impact their repurchases appeared
to have had on market prices of their stocks, and only a relative few saw a positive effect. More
than 80% discerned no impact at all.

As that suggests, propping is difficult, in part because of an SEC rule, 10b-18, that deals with
repurchasing. In the SEC's language, the rule is not "prescriptive." Rather it describes a code of
conduct that, if followed by corporations, will provide them a "safe harbor" against charges of
manipulating their stocks. The code suggests that companies should: (1) stay out of the market in
the early and late moments of the trading day, so as to avoid having an influence on opening and
closing prices; (2) follow the market up rather than lead it; and (3) limit their trading volume in
any one day to no more than 25% of the average daily volume in their stock over the preceding
four weeks. If repurchasers follow those guidelines -- and Wall Street traders say most do -- their
opportunities for propping are not bigger than a breadbasket.

Furthermore, a company buying its own stock is simply a single force in the market, seldom
more powerful than a large institutional investor, and no more able to stem a tide of selling. Says
Kevin M. Gately, a vice president of block trading at Kidder Peabody: "If everybody wants to
bail out of a stock at the same time, the company can't hold it up."

Fortune's survey results, in fact, include buybacks that boomeranged. Not many, to be sure --
there were only 32 negative returns in the 312 episodes of buying -- but enough to prove Gately's
point. When business in the oil patch began to sag, a good many oil and oil field service
companies stepped up to buy their stock, among them Consolidated Oil & Gas, Northwest
Industries, and NL Industries. Sellers whipped them. Says a disgruntled NL executive: "Buying
our stock is not something we'd be likely to do again." Suave Shoe Corp., a Florida manufacturer
that repurchased large quantities of stock in fiscal 1982 and 1983, also stumbled badly. The

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company began running losses partly attributable to competition from importers helped by the
strong U.S. dollar. Following the 1982 episode of buying, Suave's shareholders suffered an
annualized loss of 27%, and after the 1983 episode, 38% -- the worst result in the survey.

Exxon has spent more than $3.5 billion since mid-1983 buying 10% of its stock, and it shows no
sign of stopping. Architect of the program has been Jack F. Bennett, 61, senior vice president,
who has paid an average of $41 a share (against a recent price of $50). Since an average of
around 18 barrels of oil and of natural gas equivalents underlay each Exxon share during this
period, Bennett in effect bought reserves at $2.28 a barrel -- approximately half the company's
worldwide finding costs. Exxon has nevertheless maintained a huge exploration program.

On the other hand, the star performer was Charter Medical, a Macon, Georgia, owner and
operator of psychiatric and conventional hospitals. In 1977 Charter twice offered shareholders
preferred stock in exchange for common, reducing its common shares outstanding by about 42%.
The shareholders who held on to their common -- they include founder and Chief Executive
William A. Fickling Jr. -- have since realized average annual returns of 71% (from the date of
the first tender) and 79% (from the second).

The exchange offers were obviously classy business decisions -- except that Fickling and Charter
have recently been sued by two former common stockholders who accepted preferred stock in
the exchanges and think they got taken. They charge that Charter withheld bullish information
from the common shareholders (which the company denies doing) and therefore induced them to
accept the preferred. Other buyback companies have been sued on similar grounds.

Charter Medical was one of the smaller companies randomly chosen for Fortune's survey. The
small companies as a group, however, lagged somewhat in performance, racking up a median
total return of 21.3% for all episodes measured, vs. 24.1% for the bigger companies studied. And
despite Charter Medical's success with exchange offers, one-shot deals -- tenders and exchange
offers -- generally brought smaller gains than openmarket purchases. More numerous as well as
more successful, the open-market episodes of buying resulted in a median return of 24.1%
against 19.6% for the tenders and exchanges. Score one more for the tortoise.

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All that, though, is trivia compared with the big general conclusion that buybacks, regardless of
who did the purchasing or how, worked superlatively for shareholders. The natural question is
why. The most likely answer is that a lot of managers were smart twice over. First, they correctly
judged their stock undervalued. Second, they were willing to commit capital to that proposition.

Some managements do not even think of buybacks as an option. The idea of shrinking their
equity base repels them. Their inclination instead is to get bigger, and this often leads them to
pay rich prices for acquisitions that never earn their keep. Part of the reason for the superior
returns of the buyback companies, no doubt, is that they simply did not make as many bad
acquisitions. Says Garland P. Asher, director of financial planning at Tandy, a buyback
company: "You can argue that at the very least a share-repurchase program keeps people from
making mistakes."

A buyback is itself a special kind of acquisition, made at prices that are typically a bargain
compared with those a company must pay for an outside purchase. Thomas S. Murphy,
Chairman of Capital Cities Communications, has for many years weighed outside acquisitions
against the inside variety, sometimes buying other companies, sometimes buying Cap Cities by
repurchasing its stock. In the company's 1983 annual report, Murphy describes acquisition
opportunities as too highly priced and noted that the company had been a buyer of its own stock
during the year. But in March he found an outside megadeal he couldn't refuse, agreeing to
acquire ABC for $3.5 billion.

Other companies have seen hard-to-resist advantages in repurchases. Says an executive of a

Midwest company:"We looked at what we could buy and decided our own shares were the best
value. We know our own company. We didn't know others as well."

His thinking parallels that of investment banker Goldman Sachs (GS), which in a 1983
presentation to client Getty Oil reeled off a string of reasons the company should buy its own
stock. Said Goldman, paraphrased: "You will be purchasing crude oil and gas reserves
substantially below fair-market value and below what you would pay in a competitive
acquisition of another company. The price will also be below finding costs for new reserves. The
risks of Getty's business are already well known to management. Repurchases do not disrupt
operations. Management time will not be spent on the reallocation of people and resources."
Because Getty Oil was then caught up in a fight with the man who controlled 40% of its stock,
Gordon P. Getty, the company did not follow Goldman's advice. Texaco, showing no appetite at
the time for its own stock, subsequently bought Getty Oil in one of those competitive
acquisitions Goldman was talking about, spending more than $10 billion to do so. Later, Texaco
got suddenly interested in its own stock as well spending $1.28 billion to buy out the Bass
brothers in a greenmail deal.

A buyback enthusiast, Bernard A. Edison, president of Edison Brothers Stores, a chain retailer of
shoes, says that its repurchases reflect the wish of those running the company to "manage the
stock from the point of view of the stock holder, not that of management." He and other insiders
control 37% of Edison's stock which undoubtedly helps them to think like stockholders.
Substantial holdings by insiders are, in fact, a feature of many of Fortune's buyback companies,
and surely a reason these companies substitute repurchases for richly priced acquisitions.

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Another buyback enthusiast is Warren E. Buffett, the noted Omaha investor. The company he
controls, Berkshire Hathaway (BRKA), is due to acquire 18% of Capital Cities in the ABC deal,
and that will become his biggest investment. But right now his four largest commonstock
holdings are in corporations that have also repurchased substantial amounts of stock: Geico,
General Foods, Exxon, and Washington Post (WPO). The Exxon investment is new, built up
only after the company started acquiring its shares in 1983. "A big reason I got in," Buffett says,
"is that the company has recognized the value in its stock and been smart enough and pro
shareholder enough to repurchase it." On the other hand, Buffett has sold the stocks of certain
companies because they would not make repurchases.

He is convinced, in fact, that the market discounts the prices of companies that should be making
repurchases and don't, instead frittering their money away on acquisitions or other investments of
far less value. The corollary, he says, is a markup in prices for companies that do repurchase
shares, because investors identify the buybacks as a sign that management will be consistently
inclined to act in the interests of shareholders. "All managements say they're acting in the
shareholders' interests," he observes. "What you'd like to do as an investor is hook them up to a
machine and run a polygraph to see whether it's true. Short of a polygraph the best sign of a
shareholder-oriented management -- assuming its stock is undervalued -- is repurchases. A
polygraph proxy, that's what it is."

A major question for the future is whether buybacks will serve investors as nobly as in the past.
Fortune's figures suggest they may not. The evidence is in the 1983 data: for episodes of buying
that took place in that year, the returns to shareholders have been terrible -- well below results for
the S&P 500. That may be because the buybacks need time to bear fruit. It may be also because a
large batch of wrong companies -- those whose shares are not really undervalued -- have jumped
into the game.

They could be making buybacks simply because these are in fashion. Or perhaps because they
fear takeover. Some companies acknowledge that they are buying today to get the price of their
stock up, hoping to discourage attacks from raiders looking for cheap merchandise. Though
propping doesn't work well, companies that buy shares use up spare cash or untapped debt
capacity and thereby presumably make themselves less appealing as takeover candidates.

That whole proposition, however, is controversial, since certain other companies believe that
buybacks increase the purchaser's vulnerability by shrinking its size, concentrating stock in the
hands of institutions, and making the company generally an easier prize to grab. Harry S.
Derbyshire, chief financial officer of Whittaker Corp., is of that persuasion, though Whittaker
has nevertheless bought back about 10% of its stock over the past four years. Derbyshire says his
company, a Los Angeles-based conglomerate, simply believes itself underleveraged and is
buying to cure that condition. The investor relations director at another buyback company says
he's sure that repurchases increase the risk of takeover. But his company, he says, is buying its
stock anyway "because we're worth more than we're selling for." He might be claiming that even
if he didn't believe it. Nevertheless, that's the right kind of reason for repurchases, and it is also a
distinct warning to the wrong companies buying for the wrong reasons. The purchase of
overvalued stocks won't work any better for companies than it does for investors. But if the

Tap Dancing to Work Page 79

players in this game are companies sensitive to values, buybacks may continue to deliver
sensational returns to shareholders who hang in for the ride.

Tap Dancing to Work Page 80

Posted in: Berkshire Hathaway, Tap Dancing to Work, Warren Buffett


Should you leave it all to the children?

November 21, 2012: 11:41 AM ET

Email Print

If you do, you may not be doing them a favor. But if

you want to, there are sensible ways of passing on
what you have without depriving the kids of a feeling
of achievement.
By Richard I. Kirkland Jr.

This story is from the September 29, 1986 issue of Fortune. It is the full text of an article excerpted in
Tap Dancing to Work: Warren Buffett on Practically Everything, 1966-2012, a Fortune Magazine
book, collected and expanded by Carol Loomis.

Tap Dancing to Work Page 81

Travel magnate Curt Carlson, left, asks, "How the hell do we keep our money from destroying our girls?" He and wife Arleen
will leave most of their estate to their daughters, right, with their husbands.

FORTUNE -- Warren Buffett, 56, the chairman and guiding genius of Berkshire Hathaway (BRKA),
the phenomenally successful holding company, is worth at least $1.5 billion. But don't bother being
jealous of his three children. Buffett does not believe that it is wise to bequeath great wealth and
plans to give most of his money to his charitable foundation. Having put his two sons and a daughter
through college, the Omaha investor contents himself with giving them several thousand dollars
each at Christmas. Beyond that, says daughter Susan, 33, ''If I write my dad a check for $20, he
cashes it.''

Buffett is not cutting his children out of his fortune because they are wastrels or wantons or refuse to
go into the family business -- the traditional reasons rich parents withhold money. Says he: ''My kids
are going to carve out their own place in this world, and they know I'm for them whatever they want
to do.'' But he believes that setting up his heirs with ''a lifetime supply of food stamps just because
they came out of the right womb'' can be ''harmful'' for them and is ''an antisocial act.'' To him the
perfect amount to leave children is ''enough money so that they would feel they could do anything,
but not so much that they could do nothing.'' For a college graduate, Buffett reckons ''a few hundred
thousand dollars'' sounds about right.

How much should you leave the kids? Agonizing over that question is a peculiarly American
obsession. In much of the world custom and law dictate that children, unless they have committed
some heinous crime, automatically receive most of the parents' wealth when they die. Only Britain
and her former colonies -- common-law countries all -- give property owners the freedom to leave
their children whatever they want.

And nowhere is the feeling about inherited wealth so ambivalent as in the U.S. No country so readily
celebrates the self-made man, no culture is more suspicious that the silver spoon contains
something vaguely narcotic. Says Curtis L. Carlson, 72, the Minnesota travel and real estate
magnate (Radisson Hotel Corp., TGI Friday's restaurants, and the Ask Mr. Foster travel agency),

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who has a net worth of $700 million and two married daughters: ''There's nothing people like me
worry about more -- how the hell do we keep our money from destroying our kids?''

Certainly nowhere else in the world do so many parents enjoy the privilege of grappling with this
dilemma. The Federal Reserve Board estimates that some 1.3 million U.S. households enjoy a net
worth of at least $1 million. The vast majority of millionaires inherited their wealth or built it on a
business they founded. Plenty of corporate careerists have also racked up seven-figure estates by
taking advantage of profit-sharing and pension plans. But concern for how best to provide for the
offspring is not exclusive to the millionaires' club. Estate planning is fast becoming a major concern
of the middle class.

Leaving nothing to his children, $50-million man Eugene Lang, middle, lets his family help decide which worthy causes to

Whatever their misgivings about inheritance, most Americans -- rich, poor, and somewhere in
between -- keep the bulk of their estates in the family. Once formed, a chain of inherited wealth is
rarely broken -- until the money runs out. It has pretty much run out for some of the great names of
U.S. business: the Dodges, Reynoldses, and Vanderbilts. The sons of Texas oil tycoon H. L. Hunt,
whose fortune was once estimated at $8 billion, have just filed for bankruptcy protection for the
family's corporate jewel, Placid Oil Co.

Of 30 multimillionaires recently surveyed by Fortune, six say their children will be better off with only
minimal inheritances. Almost half plan to leave at least as much to charity as to their heirs. In an
area where almost no research exists, Alexander Sanger, a partner with the law firm White & Case
in New York, offers a revealing statistic. Of 20 wills Sanger has drawn up for newly wealthy parents
with net worths of $20 million or more, 16 left at least half the estates to charity. Of 12 comparable
old-money estates, only one gave so much away.

Old money tends to keep its wealth in the family. ''After a generation or more, inheritance becomes a
stewardship kind of thing,'' says Alexander Forger, head of estate law at the New York firm Milbank
Tweed Hadley & McCloy. Sometimes, as in the case of one of the firm's clients, the Rockefeller
family, the progenitor already fattened some foundation with a big endowment years ago.

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MORE: A tale of the rich and infamous

Even inheritors who want to give their money away feel duty-bound to pass on some of their wealth
to their children. George Pillsbury Jr., 37, a scion of the Midwestern baking family, inherited more
than $1 million while still in college. He has spent his adult life building and bankrolling a network of
foundations that tap young inheritors for a variety of liberal causes. ''Robin Hood was Right,''
declares one foundation pamphlet. Pillsbury believes in ''much, much higher'' inheritance taxes. Yet
despite his politics, he says ''it seems unfair'' not to leave his two young children at least a few
hundred thousand dollars.

Why shouldn't parents leave it all to the children? Newspaper headlines shriek the more lurid
reasons -- drugs, derangement, even murder. In July a Pennsylvania judge ruled Lewis du Pont
Smith, 29, heir to $1.5 million of the Du Pont (DD) fortune, ''mentally incompetent'' to manage his
affairs; Smith had been handing over thousands of dollars to political extremist Lyndon H. LaRouche
Jr. This month a Florida judge sentenced Steven Benson, 35, heir to a $10-million tobacco fortune,
to 72 years in prison for killing his mother and her adopted son with a car bomb.

Investor Warren Buffett says leaving children a lot is "harmful."

What usually troubles successful entrepreneurs and executives, however, is the mundane but far
more likely prospect that large inheritances will encourage their offspring to do nothing useful with
their lives. They worry that Commodore Vanderbilt's grandson William, heir to some $60 million in
1885, was right when he declared that ''inherited wealth ... is as certain death to ambition as cocaine
is to morality.'' (An indifferent businessman and dedicated bon vivant, William suffered a fatal heart
attack at a fashionable French race track in 1920.) Says centimillionaire Curt Carlson: ''I know one
extremely wealthy Minnesota family that has 63 heirs in the fourth generation, and none is gainfully
employed. I think that's terrible.''

One self-made multimillionaire wants to ensure that his heirs are leading productive lives before they
get a share of his estate. He has set up trusts for each of his children -- a sound estate-planning
practice even for middle-income families (See How to - and not to - give it away). None of the

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trusts pays a penny until the child reaches 30. Until then, the entrepreneur says, he expects his sons
and daughters, all still under 30, to ''live on the salaries that young adults who are college graduates
can make.'' The terms of his trusts also allow him or his executors to withhold the kids' patrimony in
certain situations. Says he: ''I believe you've got to be doing right, or you don't get anything. If I end
up with a 30-year-old who's not worth a plugged nickel, all his money goes to my personal

Encouraging rich children to be self-supporting can be good for them. John L. Levy, executive
director of the C.G. Jung Institute of San Francisco, has spent the past five years studying the
effects of inherited wealth on 30 families. He concludes that many wealthy children experience
considerable suffering and deprivation'' because they have little self-respect. ''It's hard for them to
take much satisfaction in their accomplishments since they always suspect that their successes are
at least partly the result of the wealth and position they have inherited.''

To let children grow up free of their parents' long shadows is the main reason rich individuals choose
to withhold or limit their legacies. New Yorker Eugene Lang, 67, for example, built a fortune of more
than $50 million by founding REFAC Technology Development Corp., a high-tech licensing
company. Lang paid for the education of his three children and after college handed each a ''nominal
sum'' -- he won't say how much. Since then he has given them nothing but encouragement. Says
Lang: ''To me inheritance dilutes the motivation that most young people have to fulfill the best that is
in them. I want to give my kids the tremendous satisfaction of making it on their own.'' Now in their
30s, his children are a lawyer, an actor, and an investment analyst. They will get nothing from their
father's estate. Lang plans to provide ''adequate security'' for his wife and bequeath the rest to a
charitable foundation. He has already given away more than $25 million to hospitals, colleges, and a
scholarship program for Harlem schoolchildren.

Oilman T. Boone Pickens, with wife Beatrice, will give half his estate to charity.

Californian Gordon Moore, 57, who co-founded semiconductor maker Intel (INTC) and is worth $200
million, agrees that ''children ought to have a sense of accomplishment for what they've done.''
Moore set up small trusts for his two sons when they were young -- ''the sort of thing that let my older
boy make a down payment on the house" -- but does not plan to do much more. He expects to leave
''almost everything'' to charity.

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Still, the urge to heap most of the wealth upon the family continues to be powerful. ''I'd rather give
my money to my kids than do anything else with it,'' says Jackson T. Stephens, 63, chairman of
Stephens Inc. of Little Rock, Arkansas, the largest investment bank outside New York. ''If my heirs
want to clip coupons, that'll be their business. I can't control the future, and I'm not going to worry a
whole bunch.'' Stephens, who has four children, and his older brother Wilton, who also has four
children, share a net worth of at least $500 million.

Some entrepreneurs and their heirs argue that rather than being a disincentive to work, an
inheritance can give a child a target to outstrip. ''I feel I've got to make my mark equal or better than
my father,'' says Warren Stephens, 29, Jackson's son. California real estate developer M. Larry
Lawrence, 60, who has three children and a fortune worth more than $200 million, concurs. Says he,
''If the children have been brought up right, they end up attempting to outdo the parents.''

Inevitably those who hand on their wealth see proper upbringing as the ultimate safeguard against
potential problems. Says Katharine Graham, 69, chief executive of the Washington Post Co. (WPO)
and head of a family whose fortune totals some $350 million: ''My instinct would be to just pass the
money on and hope that in doing so you also pass on your values -- how to use it, the life to lead,
the standards to have.''

Besides, some rich individuals argue, not giving it to the children can cause problems too. Says one:
''If you're the child and you see your father with all this dough and you get some but not much, I just
can't help thinking resentment will enter in.'' Susan Buffett, who works in Washington as an
administrative assistant to the editor of U.S. News & World Report and is married to a public interest
lawyer, admits her father's position is tough to live with. ''My dad is one of the most honest,
principled, good guys I know,'' she says. ''And I basically agree with him. But it's sort of strange when
you know most parents want to buy things for their kids and all you need is a small sum of money --
to fix up the kitchen, not to go to the beach for six months. He won't give it to us on principle. All my
life my father has been teaching us. Well, I feel I've learned the lesson. At a certain point you can

Leaving something to his two children seems only fair to George Pillsbury, scion of the baking family. But he also believes in
higher inheritance taxes.

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Parents who disinherit not on principle but because they disapprove of their young heir's behavior
face a troubling prospect -- they might be making a mistake. Just days before committing suicide in
1963, R. E. Turner Jr., the father of maverick television mogul Ted Turner, arranged a quick sale of
his Atlanta billboard business to Curt Carlson. Recalls Carlson, who had no idea that the elder
Turner was planning to kill himself: ''He told me he wanted to have some money to leave his wife
when he died, but that everything he had was tied up in his business. He said he was sure if Ted got
his hands on the business, he would run it into the ground.'' Within days of Turner's death, Carlson
got a call from his widow, Florence, and a visit from Ted, then 24. Says Carlson, ''His mother wanted
Ted to have the business back, and Ted, who can be very convincing, talked about how this was his
one chance to get going in life.'' Persuaded, Carlson sold the business back to Ted, who has been
going fast ever since.

Estate planning is particularly tough when the legacy is a family business. Most entrepreneurs do not
plan to sell out, as R. E. Turner did, but try to keep the business in the family. Says Curt Carlson,
whose privately held Carlson Cos. brought in revenues of more than $3 billion last year: ''You think
of your company as your own baby. You hate to think of someone buying it and then the name is

But leaving it to the children will not guarantee that the business stays in family hands. Because of
fraternal fights, the Bingham family's Louisville newspaper and broadcasting empire went up for sale
last January. Destructive squabbles are most likely to break out when family members try to sell
company stock to outsiders, an act viewed as disloyal by those desperate to keep control. In St.
Louis the heirs of legendary Joseph Pulitzer staged a noisy row this year over the attempted sale of
some Pulitzer Publishing Co. stock. The family members who wanted to sell backed a takeover bid
by Alfred Taubman, a Detroit-based real estate developer. Chairman Joseph Pulitzer Jr., his half
brother, and a cousin struck a deal to buy out the dissidents' shares at three times the pre-feud
price. Taubman is still fighting in the courts.

Chicago centimillionaire Lester Crown, 61, worries that mercenary motives among family members
could one day force the breakup of his very private business empire. The Crowns' holdings range
from building materials, hotels, and real estate to 23% of General Dynamics, one of the largest U.S.
defense contractors. Over the years, says Lester, he and his father, Henry, 90, have ''always treated
our operations as a common pot.'' They have handed out voting shares and limited partnerships in
the various businesses to Lester's uncles, cousins, brothers, nieces, and nephews, as well as his
seven children. Lester predicts that ''one of these days we're going to get hit in the back of the head
because we did this.'' If he could do it over again, he would still give the family ''the ability to enjoy
the good life'' by setting up a single trust to pay out a guaranteed income to everyone. But he would
make sure that control of the companies was ''retained by those who operate the business.''

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Ross Perot, with part of his family in 1982, says children should not grow up in "fairyland."

The Coors family of Colorado has kept its brewery bubbling with just such an arrangement since
1969. All the company's voting stock sits in a trust, whose trustees can only be family members
active in the business. Says Bill Coors, 70, chairman of Adolph Coors Co. and grandson of the
founder: ''We've minimized family feuds by concentrating control in the hands of those most
dedicated to preserving the family values.''

Warren Buffett argues that most proprietors should forget trying to keep the management of their
beloved companies in the family; he assumes current nonfamily management will continue running
Berkshire Hathaway after he is gone. He grants that occasionally an heir may be the most suitable
candidate to manage a company but believes the odds are against it. Says Buffett: ''Would anyone
say the best way to pick a championship Olympic team is to select the sons and daughters of those
who won 20 years ago? Giving someone a favored position just because his old man accomplished
something is a crazy way for a society to compete.''

Buffett especially admires how fellow Omaha businessman Peter Kiewit solved his legacy problem.
Kiewit arranged his affairs so that when he died in 1979 his 40% stake in the family's enormously
successful construction company was sold to employees. The proceeds from the sale then went to a
charitable foundation that he had established to promote education and social services in Nebraska.
Kiewit left approximately 3% of his $186-million estate to his widow, his son, Peter Jr., 60, and other
relatives. Peter, a successful Phoenix lawyer, was surprised by the $1.5-million legacy he received
at age 53. Says he, ''I was raised to expect nothing, and supported myself all my life. In the end, I
think my father was saying from the grave that he approved.''

For wealthy parents, and even for those with more modest estates, the question of how much to
leave the kids is a highly subjective matter. But here are a few points worth keeping in mind.

Don't play hide-and-seek. Forget locking your will away in mystery like some 19th-century miser.
Bring the family finances into the daylight, so the children will know what they are getting and where
it came from, and will have some idea how to hold on to it. They should also, of course, know if they
are not getting anything. For example, George Pillsbury knew that he would get more than $1 million
when he turned 21 -- ''It's tough to be unaware of your wealth when you have a brand name,'' he

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says. But many of his friends had no idea what was coming to them. ''A lot of them were shocked,''
he recalls, and some had trouble coping with their new fortunes.

Phoenix lawyer Peter Kiewit Jr. received only $1.5 million of his father's $186-million estate.

John Train, whose investment firm claims to be the largest in New York City serving rich families,
recommends that talks about money, like those about sex, begin as early as possible. These can
evolve into full-scale sessions on the family finances. Lester Crown is a big booster of this idea: ''We
started when the kids were young and put the dollar signs in as they got older.''

Former Treasury Secretary William Simon, who has made tens of millions in leveraged buyouts
since leaving Washington, says that at one of his family's regular meetings, his seven children had to
read and discuss 19th-century steel magnate Andrew Carnegie's essay ''The Gospel of Wealth.''
(Carnegie argued that by giving away their great fortunes, rich men would produce ''an ideal state in
which the surplus wealth of the few will become, in the best sense, the property of the many.'')

Though the children of Eugene Lang will not share in his estate, they and Lang's wife are trustees of
his private foundation and join in deciding where to give. Says Lang: ''In a way they're spending their
inheritance with me here and now and getting a lot of satisfaction and joy from it.''

No amount of family talk will guarantee that the children will not turn out like Tommy Manville, the
asbestos heir who went through 13 marriages and millions of dollars, or Huntington Hartford of the
A&P fortune, who has lost a reported $90 million in a lifetime of bad business deals. But it should

Shelve the silver spoon. Psychiatrists say the lack of work experience not only alienates heirs from
humanity, but also contributes to insecurity about their ability to survive without their inheritance. H.
Ross Perot, 56, the Texas billionaire who founded Electronic Data Systems, a computer services
company, and sold it to General Motors (GM), puts it this way: ''If your kids grow up living in fairyland
thinking that they're princes and princesses, you're going to curse their lives.''

T. Boone Pickens Jr., chairman of Mesa Petroleum and worth tens of millions of dollars, remembers
his middle-class upbringing as ''the best a boy could have.'' When he graduated from college,

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Pickens thought his father, a buyer of oil leases for Phillips Petroleum, might give him $500 or so.
Instead, all he got was ''good luck.'' Pickens plans to leave at least half his estate to charity; he has
arranged what he considers small trusts for his five children and three stepchildren. Says he: ''If you
don't watch out, you can set up a situation where a child never has the pleasure of bringing home a

Don't be afraid to experiment. Robert D. Rogers, chief executive officer of Texas Industries, a
manufacturer of cement and steel, swears by a Texas-size version of every parent's basic financial
training tool -- the allowance. At 18, each of his three children began receiving annual stipends that
covered living expenses and then some -- college costs, clothing, travel. The youngsters were not
accountable for the money, but if it ran out, tough luck. As an incentive to save, the children could
claim whatever remained when they reached 25. ''My oldest son ran through his first year's income
in nine months and had to go to work,'' recalls Rogers, who credits a Texas Instruments (TXN) co-
founder, Eugene McDermott, with the idea. Young Rogers never ran out again. If you are going to
leave money to your children, a generous living allowance should give you a good idea what they
will do with it.

Parents who want to encourage their offspring to work, and provide them a little extra money
besides, can create incentive income trusts designed to match or double the child's salary. The
trusts also can be set up to pay out principal if a child achieves some objective, such as attaining
tenure at a university or even holding down a steady job.

Give later rather than sooner. Most estate advisers now agree that 21, the age of majority, is too
early for most children to reap a windfall. Warns John Train: ''Very large sums handed over to
children who have done nothing to deserve them almost inevitably tend to corrupt them.'' Ross
Perot, as usual, is more blunt: ''Anybody who gives kids a lot of money at 21 doesn't have much
sense.'' Bill Simon suggests that ''sensible parents'' put a reasonable amount in trust that only starts
paying interest at, say, 35, and then allows access to principal in two installments at 40 and 45.
What's a reasonable amount? Says Simon: ''Everybody has to define that for himself.''

Trust in God and take short views. It's 2075. Do you know who your great-great-grandchildren
are? Do you really care? Louis Auchincloss, the novelist, estate lawyer, and scion of one of
America's most prominent families, believes the ''dynastic impulse'' is on the wane in America.
''When I came out of law school, people were always deeply concerned about their great-
grandchildren,'' he says. ''Not now.'' That may be no bad thing; the U.S. is littered with indolent
people who were ruined by trusts set up by adoring grandparents.

Besides, Congress has tightened tax loopholes that encourage generation-skipping trusts. If you
want to ensure some accountability among your heirs, you might consider Ross Perot's advice to
make bequests one generation at a time. Says he: ''Let your children decide how much to give their

Don't live and die in Louisiana. The Bayou State adheres to the Napoleonic Code, which requires
forced heirship: A single child is entitled to claim one-quarter of any estate, two or more children split
half. If you want to give more, that's no problem. If you want to disinherit, Baton Rouge lawyer

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Gerald Le Van says the state recognizes a few reasons as valid -- attempted assault against the
parent, conviction for a felony, and a debatable rule, just passed by the legislature last session,
''failure to communicate for two years without just cause.'' If you want to give it all to charity, Le Van
advises moving to another state.

Put child rearing before estate planning. Chicago psychoanalyst Roy Grinker Jr. worked with the
children of the very rich for 15 years. Often the problem in wealthy households, he says, is that
parents pay too little attention to their children's upbringing. ''Rather than give rich parents money
advice, I would give them child-rearing advice,'' says Grinker. ''I would say, 'Pay attention to your
kids, spend some time with your kids, love your kids.' '' Warren Buffett cheerfully agrees: ''Love is the
greatest advantage a parent can give.''

Posted in: Berkshire Hathaway, Tap Dancing to Work, Warren Buffett


A tale of the rich and infamous

November 21, 2012: 11:40 AM ET

Email Print

By Carrie Gottlieb

This is a sidebar that ran with Should You Leave it All to The Children? in the September 29, 1986
issue of Fortune.

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Imprisoned in Virginia: Dexter Coffin III, right, with his lawyer

FORTUNE -- Dexter D. Coffin III, 37, grew up with servants, yachts, private boarding schools, and a
U.S. family tree that dates to the mid-1600s. That's when his Dexter and Coffin forebears settled
Cape Cod and Nantucket Island. He is heir to more than $6 million, held in three trusts. Their
principal holding is stock of Dexter Corp., a manufacturer of specialty chemicals that is the nation's
oldest publicly traded company; his uncle is chairman. But Coffin's wealth has not helped him. He is
serving a 17-year term in a Virginia state prison for prescription fraud.

His first skirmish with the law came at 24, when he was convicted of stealing a yacht in Florida. Four
years later, after a bout with pancreatitis, he became addicted to Tussionex, a potent, opiate-based
cough suppressant. He claims that treatment for subsequent illnesses reinforced his addiction. In
1978 he was first charged with using fraudulent prescriptions. The sentence: five years' probation.

Then Coffin attempted a comeback. Thrice divorced, he married for a fourth time, moved to Virginia,
and invested in a computer store. Coffin's drug habit led to the store's bankruptcy. "I was out every
single day trying to obtain drugs to keep myself from going through withdrawal," he says. He was up
to 60 Tussionex pills and 30 other painkillers a day, a dosage doctors say could be fatal.

Articulate and well groomed, Coffin got the drugs by impersonating doctors and lawyers. Says his
attorney, Michael Morchower: "Put him in a suit and tie and put him in front of a doctor and he could
pass for anyone." His impersonations landed him in a Charlottesville, Virginia prison. In April he
escaped. He had been returning from a psychiatric session with his wife and two armed guards
when he sneaked out of a roadside restroom and sped away in his wife's Lincoln Continental. He
says he ran because he felt his life was in danger. He was caught trying to buy drugs in New

While Coffin was on the lam, the Connecticut Bank & Trust Co., the family's bank for generations,
cut off his trust funds. They had not been paying much: $185,000 in 1984; $109,000 in 1985. One
trust has been the subject of a six-year court battle in which Coffin, his mother, and his three siblings
sought the removal of the bank as trustee. "The problem is these bankers play God," Coffin says.

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"They decide how much you're going to get, and how you're going to live." Citing client
confidentiality, the Connecticut bank declined to comment.

Reflecting on his early life of privilege, Coffin says, "I had everything and more." With his lawyer
nearby, he is not now willing to blame his problems on his inheritance. But in June he told a
Washington Post reporter: "If I had not known there would always be money, I would have done
something more constructive with my life."

BACK TO: Should you leave it all to the children?


How to - and not to - give it away

November 21, 2012: 11:39 AM ET

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By Maggie McComas

This is a sidebar that ran with Should You Leave it All to The Children? in the September 29, 1986
issue of Fortune.

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Disagreeing with the IRS over an estate's value can be extremely costly. The feds clashed with the Samuel I. Newhouse
estate over the value of his company's stock. The result: an overdue notice of $609 million and change (circled in red).

FORTUNE -- Go ahead, give it all to darling daughter Debbie. And while you're at it, disinherit John
Jr. He can't spend it in reform school anyway. But remember, merely putting such desires in a will
may not ensure that your estate winds up in the right hands.

Debbie may need some elaborate trust arrangements. She is too young to handle all that wealth
now, and her favorite beau is a no-good whose principal aspiration is to marry your money. You
must also make sure Johnny will not have his day in court and collect an inheritance anyway. Finally,
you must account for that other needy, if much-unloved, relative that estate planners refer to simply
as "Uncle." If your estate runs into the millions, he could get 55 cents on the dollar.

The first estate-planning priority is usually to provide for the surviving spouse; the kids can always
inherit the second estate. You can leave your entire estate to your spouse without paying federal
estate taxes. But if you do that, you will miss an additional break: $500,000 can go to your children
or other beneficiaries tax-free. Next year the limit will rise to $600,000. If you hang in till then, you
can use the $600,000 exemption two ways. First, you can leave that amount to the children outright.
Or you can set up a $600,000 trust that gives income to your spouse and principal to the children
when your spouse dies.

If you set up a "qualified terminable interest property," or QTIP, trust, you can control the destiny of
the unlimited amount you leave to your wife tax-free. After you are gone, your spouse will collect the
income on the trust but will not be able to tap the principal, except in emergencies. When the spouse
dies, the principal will go to the beneficiaries you have chosen, probably your children. Your
spouse's estate will have to pay taxes, but only on the amount over the $600,000 exemption. The
QTIP trust is popular in the case of second or third marriages. It prevents the surviving spouse from
diverting the wealth to someone other than the original heirs.

Tax incentives should make you want to give some of your estate away while you are still alive.
Every year you can give $10,000 to each of your children or anyone else. Your spouse can give
another $10,000 to each. Thus a couple can pass $20,000 a year to a child.

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A logical gift for children is an asset that may well appreciate, such as a growth stock or
undeveloped real estate. Such a gift will not hurt your pocketbook much and could easily fall under
the annual exemption. But if you continue to hold on to the asset, it could trigger a huge tax later on.

Larry Biehl, a financial adviser in San Mateo, California, recommends another way to avoid estate
taxes. When you purchase a condominium, say, you can divide the ownership into two parts: a
"lifetime interest," which you buy, and a "remainder interest," which your child buys. The Internal
Revenue Service requires that the child put up the money, although gifts from grandparents could
boost his purchasing power. Your life expectancy, according to IRS actuarial tables, determines how
the ownership is split -- 80% to 20%, for example. When you die, the lifetime interest is legally
dissolved and -- presto -- the child assumes full ownership tax-free.

After a lifetime of lavishing gifts on the kids, you might want to turn over most of your estate to your
grandchildren. In the past that made sense, particularly since wealth could pass to several
generations in trust, with estate taxes paid only once. Congress tightened this loophole in 1976 with
a tax on "generation skipping" trusts, though direct transfers to grandchildren were not affected. The
current tax reform bill would also apply the generation-skipping tax to direct transfers. But only the
very rich need worry: You can leave up to $2 million to each grandchild without paying the extra levy.

If you do plan to skip your children altogether, you had better say so in your will. If you simply omit
any reference to Johnny in that document, rather than specifically disinheriting him, he might have
the makings of a successful will challenge.

Where big bucks are involved, a will contest can be a real grave-spinner, like the case brought by
the children of multimillionaire Charles S. Payson who died last year at 86. Most of Payson's wealth
came from industrialist Payne Whitney, the father of his first wife, Joan. When she died in 1975, the
bulk of her $172-million estate went to Charles.

His will gave his son a cemetery plot, land, and personal property; his three daughters got only some
paintings. Payson gave $20 million in cash, stock, and real estate to his second wife, Virginia, and
put much of the rest in a QTIP trust. The income from the trust goes to Virginia.

But this case demonstrates a flaw in the QTIP setup: stepmother Virginia and the Payson children
are of the same generation (at 56, she's younger than two of them), so the "kids" may not live long
enough to collect the QTIP principal. Charles's children are challenging the will on many grounds,
including a claim that the second Mrs. Payson had used "undue influence" in directing so much
wealth her way.

Such squabbling is not limited to the rich. "Will contests are more a matter of frustrated expectations
than anything else," says Jonathan Blattmachr of the New York Law firm Milbank Tweed Hadley &
McCloy. Blattmachr tells of a widower who sought to leave 95% of his $200,000 estate to his
impoverished daughter and 5% to his son, a successful doctor, who was worth about $2 million. The
son challenged the will and settled out of court for another $5,000.

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"Uncle's" appetite for a share shows up dramatically where estate assets are hard to value, notably
family-held companies. For example, take the estate of Samuel I. Newhouse, the newspaper king
who died in 1979. In valuing his Advance Publications Inc., estate experts at Chemical Bank looked
at price-earnings ratios of similar but publically traded companies and set a market price of about $1
billion. The bank then assigned a substantial part of the value to the nonconvertible preferred stock,
owned by the Newhouse heirs. The patriarch's holdings, all the common stock, came to only $179

The IRS saw things differently. It calculated the company's market value at $1.5 billion, then
discounted that price by the cost of liquidating the preferred stock. (The assumption is that an
outside buyer would have balked at the burden of paying the preferred dividend.) The remaining
value, all assigned to Newhouse's estate, was $1.2 billion. In 1983 the IRS mailed off a "notice of
deficiency" to the estate, levying more than $609 million in additional taxes and a $306-million
penalty for fraud. The valuation is still in dispute.

Marion Fremont-Smith, an estate planner at the Boston law firm Choate Hall & Stewart, suggests
that founders of growing companies consider swapping their common stock for preferred stock and a
new issue of common. Such transactions are tax-free. The preferred shares can provide steady
income for an aging founder, while the new common stock can be given to children through annual
exclusions and the one-time exemption. Their stock will appreciate as the business thrives. So if you
want to leave your children a legacy, let it be something other than a dunning notice from the IRS.


How to live with a billion

November 21, 2012: 11:38 AM ET

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It isn't as easy as you might think. The yacht just

broke, the cook just quit, and those pesky reporters

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won't leave you alone. Here are some ways the super-
rich cope.
This story is from the September 11, 1989 issue of Fortune. It is the full text of an article excerpted in
Tap Dancing to Work: Warren Buffett on Practically Everything, 1966-2012, a Fortune Magazine
book, collected and expanded by Carol Loomis.

Master builder Sam and wife Ethel LeFrak beneath their Andy Warhol portrait

FORTUNE -- Are you sure you want a billion? Before you answer, consider H. Ross Perot. He has
nearly three of them. He also has an original of the Magna Carta, some Remington and Charlie
Russell bronzes, and Gilbert Stuart's portrait of George Washington. But what he needs is a good
pump repairman.

When Perot spoke recently to students at the Harvard business school, he warned them: ''Guys, just
remember, if you get real lucky, if you make a lot of money, if you go out and buy a lot of stuff -- it's
gonna break. You got your biggest, fanciest mansion in the world. It has air conditioning. It's got a
pool. Just think of all the pumps that are going to go out. Or go to a yacht basin any place in the
world. Nobody is smiling, and I'll tell you why: Something broke that morning. The generator's out;
the microwave oven doesn't work; the captain's gay; the cook's quit. Things just don't mean

What does? For many self-made billionaires happiness means work. Perot, with son Ross Jr., is
bringing free enterprise to the airport business by helping to build one outside Fort Worth. Most
billionaires still ply the trades that made them rich, and most discover that making all that money is a
more durable source of happiness than spending it. Says Warren Buffett, who still puts in ten-hour
days despite his $3.6 billion: ''I'm doing what I would most like to be doing in the world, and I have
been since I was 20.'' What keeps him going, he says, is the admiration he holds for his business
colleagues. ''I choose to work with every single person I work with. That ends up being the most
important factor. I don't interact with people I don't like or admire. That's the key. It's like marrying.''

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Buffett calls Berkshire Hathaway his canvas.

William Gates III could have retired before he turned 30. When the first PC was just a gleam in
IBM's (IBM) blue eye, Bill Gates, at age 13, had taught himself computer programming. By 19, he
had founded Microsoft (MSFT), the company that turned ''software'' into a household word. Money
didn't drive Gates then and it doesn't now. ''Bill's original vision,'' says Microsoft senior vice president
Steve Ballmer, ''was that you should be able to put a personal computer on every desk and in every
home. If somebody back then had bothered to run the numbers on that proposition, it obviously
would have looked like a very big business. But we never ran the numbers.'' For 1988 the numbers
showed Microsoft's net revenues at close to $600 million. Gates still stays at the office some days
until midnight.

High tech and investing have an aura of excitement and sex appeal. But billionaires hoeing far less
glamorous rows keep right on hoeing: Rudolf Oetker makes baking powder. Max Schachenmann
originally got rich by producing the ''finest putty available.'' Samuel LeFrak, building a city on New
Jersey's shore, has specialized in middle-class housing described as solid -- "with kitchens and
plumbing you could take to the bank.''

Grete Schickedanz, owner of Europe's largest mail-order catalogue business, still occasionally
picks the fashions hausfraus will be wearing next season. Ronald Perelman has had to digest a
Whitman's sampler of commonplace businesses to get his billion: perfumes, razor blades, licorice,
and cigars. And Korean-born Kenkichi Nakajima, after coming to Japan as a student and being put
to work in a defense factory during World War II, decided in 1949 that he wanted to manufacture a
product completely unrelated to war. He chose pachinko machines, Japan's version of pinball,
naming his company Heiwa, or ''peace.'' By beating words into pinball he has become the world's
biggest manufacturer of such machines, scoring $360 million in sales last year. Heiwa stock began
trading publicly in Japan a year ago; it rose nearly 70% in value the first day it was offered and is
now up another 30%.

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David Packard

The problem with working, however, is that it leads, inevitably, to the accumulation of more things --
more leaky yachts, more busted pumps. But there is a way out, elegant in its simplicity: Give money
away. If fortune becomes oppressive, show it the door.

Ross Perot, in philanthropy as in his business ventures, insists on strict accountability: ''I am dead
interested in seeing that they deliver the goods. That is one of the reasons we give a great deal of
money to the Salvation Army, because they feed the poor, they don't write books about it.''
Waldemar Nielsen, an expert on foundations and author of The Golden Donors, expects big things
from Perot's foundation: ''He seems to have strong impulses and a lot of daring. Of the present crop
of billionaires, he's one of the few with the potential to become a Carnegie.'' The beneficiaries of
Perot's largess have been the Dallas Symphony, the Texas public schools, and a major Dallas
medical center.

Giving one's entire fortune away -- without wincing -- is the ultimate way of saying, ''I didn't do it for
the money.'' Earlier this year David Packard announced that he would be giving nearly all his
Hewlett-Packard (HPQ) stock, worth more than $2 billion, to his foundation, which champions
causes he and his late wife believed in, such as reducing infant mortality.

The size of his gift seems all the more extraordinary when one considers that the very rich, as a
group, are not especially generous: Total giving seldom rises above a few percent of their net worth,
at least before their death. Though the number of foundations has grown 20% since 1981, the
number created by persons of great wealth has been in decline since 1969, when legal changes
reduced the tax benefits.

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Philanthropist H. Ross Perot, flanked by pictures of wife Margot and son Ross Jr., holds his charities strictly accountable.

Packard will help select the organizations that will benefit from his money. But other donors choose
to leave that to hired hands. Says Nielsen: ''A lot of them don't know what the hell they want to do
with their money. If a man has any real charitable or intellectual causes, of course, he would give to
those specific things. But a high proportion of people who succeed financially have no interest in
charity, no causes, no clear-cut interests. There are wonderful exceptions, but on the whole their
lives are their businesses.''

When philanthropy marries eccentricity, whimsical gifts result. Robert Lacey, a biographer of the
Ford family, believes Henry I created historic Greenfield Village so he could have a place to square-
dance. In old age, the carmaker became preternaturally fond of Turkey in the Straw, and retained a
staff of fiddlers so he could hear it on demand. He began collecting things from his childhood --
steam irons, plows, threshers, and stoves. He captured his friend Thomas Edison's dying breath in a
bottle. Though collecting industrial artifacts is accepted practice today, in the 1930s it seemed kind
of loopy. Ford's hoard of keepsakes became the Henry Ford Museum. (Josephine Ford today
upholds her family's reputation for whimsy by occasionally hiding live lobsters in her children's beds.)

While no current billionaire rivals Ford for eccentricity, some have definite notions about giving.
Master builder LeFrak has given to so many educational institutions that he has trouble
remembering them all: the gymnasium at Amherst, a library at Oxford, and an endowed chair at the
University of Maryland.

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Newcomer Ronald Perelman has been attending board meetings since he was 11. He now owns Revlon, jewel of an
eclectic empire.

''But actually,'' says LeFrak, warming to his subject, ''what I am is an explorer.'' His money is helping
finance a search in Tanzania for the missing link. If LeFrak has his way, it won't be missing much
longer. A few years ago LeFrak helped Robert Ballard locate the Titanic. The challenge of finding an
older vessel now confronts him -- Noah's ark: ''I just received from Texas, from Jim Irwin you know,
the astronaut -- a letter saying that he got permission from the Turkish government, and they want to
go up in a helicopter to find Noah's ark. They feel it's sitting on top of a mountain.''

Ed Bass, the environmentalist among the Texas Bass brothers, is building an ark right now on the
edge of Arizona's Sonora Desert. Called Biosphere II, it's a 2 1/2-acre microcosm of the earth under
glass that includes a downsize ocean, rain forest, desert, and savanna. After the necessary flora and
fauna have been installed (including mosquitoes and eight people), the ecosystem will be sealed
shut for two years, starting in 1990, to see whether it can sustain itself. By then Bass will have sunk
some $30 million into the project. What does he hope to gain? Knowledge and profit. No one before
has engineered so large an ecosystem, and if this one works, Bass's group thinks future biospheres
could be sold as habitats for Mars or stressed-out Manhattanites. Maybe Noah should have charged

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For $30 million, Ed Bass is building Biosphere II, a miniature earth under glass.

No eccentric, Warren Buffett has limited his innovations to finance. At Berkshire Hathaway (BRKA),
he has pioneered a novel approach to corporate giving. Every shareholder gets to direct a sum (last
year it was $5 per share owned) to any charity.

When it comes to personal giving, Buffett feels that picking causes is harder than picking stocks. ''In
stocks, you're looking for things that are obvious and easy to do. You try to identify the one-foot bars
you can step over. But when you get into the charitable arena, you are attacking problems that have
been the most intractable and resistant to solution throughout history. The most important ones are
all seven-foot bars.'' Population control and diffusing the nuclear threat, the two causes Buffett's
foundation supports, are ''bars so high up that I can't even see 'em. Real lulus.''

Though Buffett has spent only $10 million to $15 million on these causes so far, he intends to give
much more. Waldemar Nielsen thinks Buffett hasn't even warmed up yet: ''He's one of those very
rare guys who is not only one hell of an entrepreneur in business, but one hell of an entrepreneur in
the philanthropic field. We haven't had one in a long time.''

The Buffett Foundation will get almost all Buffett's stock when he dies. And he doesn't think giving its
trustees a narrow charter would be wise: ''That's like telling them what to invest in ten years after I
die. I would rather have a smart, well-intentioned, high-grade person looking at the problems of the
day through eyes that are open, not through my eyes that are in a coffin. I found in running
businesses that the best results come from letting high-grade people work unencumbered. Stick
around. If you're young enough, you'll see how it all works out.''
--By Alan Farnham

In the public eye

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"We are of the same breed. One of her ancestors was Attila the Hun and one of mine was Genghis
Khan. We have found each other. We are on the same wavelength." So says Prince Johannes von
Thurn und Taxis of West Germany about motorcycle-riding, electric-guitarplaying 29-year-old
Princess Gloria, his wife. He's rich -- an inherited fortune of $2.5 billion, mostly in banking and
landholdings -- and the flamboyant "Johnny TNT," 63, doesn't hide it. For what good is a billion
dollars stashed in a Swiss bank account if nobody knows it's there? It won't get much attention, and
neither will its owner.

Microsoft mogul William Gates Ill is $300 million poorer this year but retains his zest for hard work.

The TNTs are stars among a subset of billionaires who think flaunting it is half the fun. Bejeweled
Gloria, in her ever-changing hairdos and feathered, often grotesque hats, is a favorite of the
paparazzi. This year she appeared on a TV game show, and in March the couple sailed to the
Galapagos Islands on their 120-foot yacht. Later it was on to Havana to meet Johannes's friend and
former university classmate Fidel Castro. Gloria's costume ball for 200 at a Paris nightclub last
February was attended by the likes of Boy George and Jack Nicholson.

All that attention, however, has its pitfalls, and the prince and princess of kitsch had their share this
year. Unflattering tales appeared in The Andy Warhol Diaries, published in May. In July an elderly
woman demanded a payment of three million German marks; in return she promised the name of a
person she said was slowly poisoning the prince. She was nabbed by police when she showed up to
collect. And the TNTs do have their differences. Says Johannes: "We are fighting all the time. But we
have the children, and that is all that matters." The children are daughters Maria Theresia and
Elisabeth, and, to the prince's relief, fiveyear-old son Albert, the heir to his fortune.

Hungarian Baron Hans Henrich Thyssen-Bornemisza, who lives in Switzerland, attracts attention
mostly for his extraordinary art collection, which rivals the Queen of England's, but his five wives
have been noticed too. No. 2 was an English model. Life and art meet in his current marriage, to
Carmen "Tita" Cervera, in her late 40s, a former Miss Barcelona and Miss Spain who undressed

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several years ago in the German Penthouse. Tita persuaded Heini, as he's known to friends, to loan
787 of his 1,400 paintings to her native country.

Baron Thyssen-Bornemisza with his fifth wife, the former Miss Spain. She landed part of his art collection for her country.

When the 68-year-old Heini announced plans to ensure the safekeeping of his collection beyond his
own lifetime, he was courted by emissaries from Great Britain, West Germany, Japan, and France.
The Prince of Wales made a personal visit. But the word is that Tita is hoping to be named a

For the moment the collection is still housed in the baron's main residence, Villa Favorita, on Lake
Lugano in southern Switzerland. His white Rolls-Royce, equipped with three telephones, can be
found parked at the end of a cypress-lined drive. Most of the villa is open to the public, a policy Heini
adopted in 1947 after the death of his father, who preferred a little more privacy. Considered a prime
target for an abduction, Thyssen is constantly surrounded by a rotating crew of bodyguards --
rotation makes them less recognizable. Still, he consults a fortuneteller every morning.

One way to make sure the world knows you're around is to put your name on everything. That's what
Donald Trump did with the 21 planes of the Eastern Shuttle, which flies the Boston-New York-
Washington trade and which he bought for $365 million. He claims it's good business: "My name
creates big play. Let's take the Trump Shuttle. When I bought that thing, it had only 7% of the market
share. The week after it had 50%" -- a number Fortune has been unable to verify.

Trump says he's troubled by the public perception that he has a big ego. "Sure, some of the things I
do are for ego. But that has lessened so much since I first started. Now I enjoy the creative end of it
and get a big kick from giving my money away. I give to AIDS research and our Vietnam vets."
Trump says the earnings from his second book, which he's still in the process of writing, a sequel to
The Art of the Deal, will also be donated to charity.

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TV tycoon Berlusconi with a portrait of himself in his days as a youthful crooner.

Most billionaires don't announce what they're worth. Trump does. He insists it's at least $5 billion,
several billion more than Fortune is willing to credit him with after adjusting for his debt.

European television tycoon Silvio Berlusconi is another who doesn't play down his net worth.
Fortune estimates that Berlusconi's is about $2.8 billion; his own estimates run as high as twice that
figure. He's rich in terms of power as well, he points out. He has no shareholders to answer to and
no other family members with large holdings in his company, Fininvest. He says he is "much richer"
than Giovanni Agnelli, chairman of Fiat, Italy's largest private industrial group who has $1.7 billion.
Still, Berlusconi treats his fellow Italian with considerable deference: "I never forget that he's the
emperor and I am only a fellow who made a lot of money. I almost think he likes me."

Berlusconi, of course, made his money in the show-and-tell world of TV. In high school he performed
in a band with friends and played the big summer dance spots. When friends come to his home, he
often plays the piano and croons from his 1,000-song repertoire. But Berlusconi is also a workaholic.
He's not sure whether he has nine or ten homes, since he has precious little time to enjoy them.

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New York University's medical center was renamed Tisch Hospital after Larry (above) and brother Bob gave $30 mlillon.

Some get attention simply because of the power they wield. Agnelli has been chairman of Fiat for 22
years. In Italy alone, the company accounts for 12% of exports. Agnelli's sister Susanna sits in
Parliament and is under secretary at the Foreign Ministry. Brother Umberto, vice chairman of Fiat,
has been in Parliament.

While Agnelli is establishment, Sir James Goldsmith gains his notoriety by attacking it. Among his
other corporate takeover efforts, Goldsmith recently made a bid for BAT Industries.

Not all public attention is sought out, or even welcome. Take billionaire Tsai Wan-lin, 65% owner of
Cathay Life Insurance in Taipei, a newcomer and No. 6 on our list. He hates publicity, but with a net
worth of $9 billion, he's in the newspapers often. Money has been flowing into Taiwan for the past
few years because of export earnings, but investment vehicles are few. So the stock market has
become a national craze. Meanwhile, in an increasing acceptance of Western ways, large numbers
of Taiwanese are buying life insurance for the first time. The industry is growing at an annual rate of
25%. Cathay's dominant position in its market makes it one of the most popular issues on the
inflated Taipei Stock Exchange. Its stock has more than doubled in price in the past 18 months.

Murdoch's secret: He's jogging now.

Despite the value of his holdings, Tsai still lives in a modest apartment building a block from
company headquarters, refuses interview requests, and, according to Cathay managing director Liu
Chia-lin, rejected the suggestion that he trade in his 1987 Mercedes for a Rolls-Royce because "he
doesn't want to show off." Tsai's idea of high living is escaping to a suburban hillside villa on
weekends and playing an occasional round of golf. He usually tees off alone, though, since he walks
the course too fast for most partners.

The Benetton family, though they keep their private lives fairly private, also can't help being visible.
And as with Trump, name recognition means business. Luciano, Giuliana, Gilberto, and Carlo aim
to make the Benetton label a household word from Indiana to Indonesia. Says the company
president, Luciano, whose granny glasses and frizz of gray hair recall the Sixties: "The European
Community is for us a domestic market. We're paying ever closer attention to the international
market that already accounts for 37% of our billings."

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Benetton's brightly colored clothing and accessories are sold in franchise stores in 79 countries. The
company is negotiating a joint venture with the Soviet Union for production and distribution. With a
1989 advertising budget of $70 million, four times the 1984 figure, the Benettons have begun
spending to get their message out.

Secretive banker Edmond Safra

If you are rich and get in trouble with the law, watch out. You could turn into the "Great White
Defendant," to use novelist Tom Wolfe's phrase. It happened to Michael Milken, charged with
racketeering, and to Harry Helmsley and his oft-pictured wife. Leona is on trial for tax fraud and
extortion (Harry was excused from the proceedings because of illness), accused of charging to their
business $4 million in purchases for their Connecticut mansion, including Louis XVI marble-topped
dressers, a $57,000 stereo system, and a swimming enclosure. Former employees have taken the
stand against the Helmsleys, portraying Leona as a penny-pinching, manipulative, unpopular boss.
A former housekeeper testified that Leona once told her, "We don't pay taxes; the little people pay
taxes." New York City Mayor Ed Koch called Leona "the wicked witch of the West."

One way to avoid all the hassle is to take it on the lam. Commodity trader Marc Rich did, and has
avoided trial on charges that he defrauded the U.S. of $48 million in taxes on oil trades. He's now a
citizen of Spain and a resident of protective Switzerland. He has hired a staff of public relations
strategists to promote a public image of Rich the philanthropist. Recipients of his generosity: the Art
Museum of Zurich, the local Zug hockey team, mountain farmers, and a school for clowns. Rich
himself is never far from the social whirl. "It's open house all winter long," says a frequent guest at
his Swiss chalet. He's also spending more and more time at his lavish estate in Marbella, Spain,
hobnobbing with pals Enrique Muijca, Spain's Minister of Justice, and Manuel Chaves, Minister of

The best way to stay out of the papers is to stay out of trouble. The Marriott name is everywhere --
on some 500 hotels and 1,100 restaurants -- but as devout Mormons, family members lead lives of
such boring rectitude that they are almost never mentioned except in financial journals like Fortune,
which put J. Willard on its cover this year for his outstanding performance as a business leader. --By
Julianne Slovak

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Behind the moat

In sharp contrast to Donald Trump and Silvio Berlusconi are billionaires you probably have never
heard of, men who work hard -- and successfully -- at being invisible.

Morocco's King Hassan II -- with son Prince Sidi -- has been lucky as well as rich. He has survived three assassination

Take Donald W. Reynolds, who started almost three-quarters of a century ago selling newspapers
on the streets of Oklahoma City. Today his Donrey Media Group in Fort Smith, Arkansas, owns 57
dailies in 20 states. Yet he is virtually unknown outside his company, and even within Donrey only a
few key employees see much of him. He lives in a fortress-like home near Las Vegas, jetting into
Fort Smith in his private Boeing 727.

Why do some billionaires try to hide? Shyness is one reason. Class is another. "It's more tasteful,"
says one. A third motive is to avoid hassles. As Michael Phillips wrote in his book, The Seven Laws
of Money, wealth can bring lots of headaches. Envy. Endless pleas for donations. Kidnapping.
Terrorism. Finally, a few just might have something to hide.

Secrecy does not come cheap. For those willing to pay, a coterie of professional minions-cum-
martial-artsexperts stand ready to scramble phones (at least $600), debug offices ($1,500 and up),
and scope out restaurants ahead of time as well as thwart the advance of fans by stepping on their
feet ($55 an hour).

The ultimate, of course, is a private island. The Bahamas, with 700 shards of palm-treed sand, offers
a wide selection, from $300,000 (ten acres) to $4 million (500 acres). But the solitude isn't complete.
Says Rodney Dillard of Sotheby's International Realty: "A lot of people think if they buy an island,
they will get sovereignty. But it can't be done."

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Sullen in Brunei

Sovereignty doesn't buy much in the way of safety anyway. With the aid of a battalion of Gurkhas,
the Sultan of Brunei, the richest man in the world, has managed to keep his tiny, oil-rich country
quiet since a brief rebellion in 1962. King Hassan II of Morocco, who is said to have baraka, or
soldier's luck, has survived three assassination attempts. In an abortive coup in 1972, Moroccan
Royal Air Force fighters riddled his 727 as he returned from France. The quick-witted Hassan
grabbed the plane's microphone and, pretending to be a crew member, radioed that the king had
been "mortally wounded." The attackers thoughtfully stopped firing to avoid harming other
passengers. The plane landed on one engine, and Hassan escaped into the nearby woods.

Islands and kingdoms aside, Switzerland is the haven of choice. It has more known billionaires per
capita than any major country -- approximately one in 360,000 -- and about half were born
elsewhere. Though the country no longer holds a monopoly on secrecy -- Austrian and Hungarian
banks, for instance, offer greater confidentiality -- it still boasts the best overall package.

Residents of Switzerland are not allowed to disclose ownership in companies, and for the very rich
income taxes are negotiable. If that's not enough, the Swiss Bankers' Association publishes a 100-
page guide to "asset management" that includes a list of 22 tax havens around the world, including
little-known Nauru in the South Pacific. The pamphlet describes intricate maneuvers that in many
countries would look a lot like tax evasion.

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As untouchable as cactus: Few of the editors who work for Donald Reynolds's chain of 57 newspapers ever lay eyes on him.

One industrialist who takes advantage of all Switzerland has to offer is Otto Beisheim, owner of
Metro International, a retail and wholesale giant with $25 billion in annual sales. This West German
entrepreneur, who introduced the concept of "cash and carry" to Europe -- a process in which a
retailer pays cash to the wholesaler and takes the merchandise with him -- is not known by sight or
by name in the Swiss town of Baar, where he lives.

His unpretentiousness is nothing new. Old-timers at Metro recall that the day before Beisheim
opened his first cash-and-carry market in 1967, he was painting lines in the parking lot. His wife was
inside erecting a jewelry booth.

For a native Swiss, circumspection comes as naturally as yodeling. The Andre family, owners of
Andre & Cie, a $6.8-billion-a-year international trading company in Prilly, live so quietly and conduct
their affairs so discreetly that even their closest advisers don't know how much they are worth. Their
holdings include Garnac Grain, a Kansas-based company that controls nearly 10% of the world's
grain market, plus shipping companies, cattle ranches, and coffee-processing plants.

For generations, the Andres have been part of the Plymouth Brethren, a religious group that seeks
to restore the simple, austere life of the early Christians. Not for them lavish chalets, priceless art
collections, or soirees with the Bianca Jagger crowd. The Andre clan -- Henri, Eric, and Pierre --
leadmodest, middle-class lives near Lausanne.

Equally inconspicuous is their countryman Mark Diethelm, a quiet, serious fellow resembling an
overweight bank clerk, who owns Diethelm & Co., a $1.5-billion-a-year diversified trading company.
With the exception of an interview last year in the Swiss financial magazine Bilanz, Diethelm has
steered clear of the press. Don't look for his picture: a worldwide photo search came up empty.

Playing confidential banker to this club is an equally secretive Lebaneseborn financier who glides
quietly about in a limousine bearing the license plate EJS 555. EJS stands for Edmond J. Safra:
The number five, many Middle Easterners believe, brings good luck.

It seems to have worked for Safra. Since his early days in Lebanon, where he helped his father
finance camel caravans, Safra has built a worldwide network of banks from Tokyo to Buenos Aires
to New York, where he controls Republic National Bank. Along the way he acquired a celebrated
clientele of wealthy Latin Americans and Arabs by providing personal investment advice through the
private banking arm of his empire, the Trade Development Bank.

Safra sold his bank to American Express (AXP) in 1983 for $550 million, and went along as
chairman. He departed 18 months later for reasons that were never fully explained. In 1988, on the
expiration day of his agreement not to compete with American Express for five years, he opened a
new private bank in Geneva. Safra Republic Holdings is on the same street as American Express.

Perhaps afraid that Safra would take back some of his old customers, a few American Express
representatives earlier this year apparently did some whispering that tied Safra to drugmoney

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laundering. Safra threatened to sue. In August, American Express revealed that as a settlement it
had paid $4 million to some of Safra's favorite charities. A few days later the company said that it
had actually settled for $8 million. Why the discrepancy? As with so many matters involving Safra
and his money, questions remain.

Until recently one country appeared even more secretive than Switzerland: the Soviet Union. In the
absence of a Russian billionaire, we offer an American who operates like one -- Whitney
MacMillan, powerful chairman of Minnesota-based Cargill, the largest private corporation in the
country. If his name doesn't ring any bells, don't feel dull. Despite running a company that handles
about 25% of world grain trade and employs more than 50,000 people, MacMillan remains eerily
anonymous -- even in agriculture and commodity-trading circles.

Cargill's worldwide intelligence network controls the flow of information in and out of the company
with the sophistication of the KGB. Marvels Ralph Nader, who conducted countless interviews with
friends and relatives of MacMillan for his book The Big Boys: "There were businessmen in
Minneapolis who had never heard of him."

The private persona of Whitney MacMillan -- a tall, handsome man with a full head of silver hair --
comes as hermetically sealed as the business one. Conversations with some of his closest pals,
including George Pillsbury, who is married to MacMillan's cousin, and Yale classmate G. Richard
Slade, president of the Minneapolis College of Art and Design, present a picture of a quiet,
competitive man who is as formidable on the tennis court as he is in business, but who remains aloof
from his own community

Besides his family -- pals say wife Elizabeth is his best friend -- his one outside passion seems to be
international politics, particularly issues involving the Soviet Union, which he visits often. MacMillan
has been criticized privately by his fellow CEOs for not giving more time and money to cultural and
charitable organizations -- Cargill reportedly donates less than 1% of pretax income. He did,
however, take the time to travel to Moscow last June with the Minneapolis Children's Theatre.

His older brother, Cargill MacMillan Jr., is just as private. Last year Cargill divorced his wife of 30
years and married an executive secretary named Donna who worked at the company. As is the way
along the shores of Lake Minnetonka, where the clan lives, the incident was kept so quiet that a year
later a local gossip columnist had still not heard of it. Friends are not forthcoming. "That's a whole
other story," says Pillsbury cryptically. "The blind is going down."

And so ends our peek into the lives of the world's unseen billionaires. The MacMillan brothers
remain an enigma, as do all the others. And that is for the best. Because, maddening as mystery is,
reality might be worse. Do you want to know what dashing, dealing media mogul Rupert Murdoch
really talks about at lunch? Taking up jogging, and the new diet book he just read. Sound familiar?
Like maybe too familiar? Fantasy is a lot more fun. --By Nancy J. Perry

Posted in: Berkshire Hathaway, Tap Dancing to Work, Warren Buffett

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Are these the new Warren Buffetts?

November 21, 2012: 11:37 AM ET

Email Print

The dozen young investment managers you'll meet

here are brainy, ethical, and good at making money
grow consistently.
By Brett Duval Fromson

This story is from the October 30, 1989 issue of Fortune. It is the full text of an article excerpted in
Tap Dancing to Work: Warren Buffett on Practically Everything, 1966-2012, a Fortune Magazine
book, collected and expanded by Carol Loomis.

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Warren Buffett

FORTUNE -- Wouldn't you like to become partners with someone who would double your money
every three to four years ad infinitum? To put it another way, wouldn't you like to invest with the next
Warren Buffett?

Riches come to investors who, early in their lives, find great money managers. Buffett is certifiably
one of the greatest. His early clients are now worth tens of millions of dollars (See "And Now A Look
at the Old One" in Tap Dancing to Work). He achieved that by compounding money consistently and
reliably at about 25% per annum. The young investors you will meet here show signs of comparable
talent. But even if they can return only 20% a year -- most have done at least that well so far --
$10,000 invested with them today would be worth $5.9 million in the year 2025.

What reveals their potential? Strong investment performance, of course. But that is not conclusive,
especially among young managers who generally lack a ten-year record. More important are certain
character traits. Buffett himself starts with ''high-grade ethics. The investment manager must put the
client first in everything he does.'' At the very least, the manager should have his net worth invested
alongside that of his clients to avoid potential conflicts of interest. Those profiled here have put the
bulk of their assets with their customers'. Buffett says he would invest only with someone who
handled his mother's money too (as he did).

Brains help, but above a certain level they are not the salient distinction among investment
managers. Says Buffett: ''You don't need a rocket scientist. Investing is not a game where the guy
with the 160 IQ beats the guy with the 130 IQ.'' The size of the investor's brain is less important than
his ability to detach the brain from the emotions. ''Rationality is essential when others are making
decisions based on short-term greed or fear,'' says Buffett. ''That is when the money is made.''

More often than not, the best money managers, like Buffett, are ''value investors,'' intellectual
descendants of the late Benjamin Graham. He emphasized buying securities of companies selling

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for less than their true worth. The dozen young managers presented here are Graham's
grandchildren, in a sense, but they are not necessarily dogmatic Grahamites. A few dredge for
average companies at rock-bottom prices -- Graham's specialty. Others follow Buffett's approach
and buy great companies at reasonable prices to hold for a long time. Two practice arbitrage, buying
stock in companies about to be taken over or restructured in publicly announced deals. One
prospers by selling overvalued companies short. Most do some of each, especially in a market
where value is increasingly hard to find.

Surveying these relative rookies, a reasonable man should ask, ''How will they do in a bear market?''
Probably better than other money managers because they comprehend the basic rules of investing:
No. 1, Don't lose money. No. 2, Don't forget the first rule. Each searches intently for discrepancies
between a security's price and its worth, whether measured by asset value, earnings, cash flow, or
dividend yield. If they are wrong about a security -- and everyone is sometimes -- the difference
between price and value provides a margin of safety.

The best way to spot a potentially outstanding investment manager is to ask another one. Each of
the 12 presented below was named by his or her peers as someone they would entrust money to.
They tend to handle money for the rich and the famous; each has at least one investor whom any
reader of Fortune would recognize -- if the clients allowed their names in print. With the exception of
the two who manage mutual funds, the required minimum ranges from $250,000 to $5 million.

Most of these promising players will succeed. Some will fail. But the odds are that at least a few will
go on to investing fame and their clients to fortunes. In order of how long they've been managing
money on their own:

Michael Price, Mutual Shares

The bargain hunter

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It hardly seems possible that Michael Price is only 38. He has been picking stocks at Mutual Shares,
the estimable no-load mutual fund based in Short Hills, New Jersey, for 15 years. He came to
investing immediately after graduating from the University of Oklahoma. ''I was a mediocre student,''
he says. Perhaps, but Price gets nothing but A's for his work on Wall Street. If you had invested
$10,000 with Mutual Shares ten years ago, you'd have $62,289 today. Before taxes but after all fees
and expenses, that works out to a 20% average annual compound rate of growth.

''I like cheap stocks,'' says Price. ''I'm basically a guy who looks at a company's balance sheet and
asks, 'What is the company worth? Give me a number.' If the answer is, 'Substantially more than the
price,' then I get interested.''

Price usually holds about 350 securities in his $5.7 billion portfolio. He spreads his holdings because
many of his picks are small-capitalization issues whose prices would surge or collapse if Price
bought or sold heavily. His largest holding, however, is Time Warner (TWX), parent of Fortune,
which he bought at an average of $60 a share starting in November 1986. Time was languishing
because the government had nailed Ivan Boesky and scared away many a speculator investing on
takeover rumors. Price saw a good media business at a cheap price and accumulated 1.9 million
shares. Time Warner traded recently at around $135.

A Freudian Grahamite

Randy Updyke remains virtually unknown, even to his peers. Perhaps that's because he is a solitary
soul who rarely talks to other money managers. ''Investing is about survival,'' he says. ''I stay away
from the herd.'' And how. When the bright lights of Philadelphia get too distracting to him, the 46-
year-old Updyke removes to his ranch in Idaho or his plantation in South Carolina. Solitude seems to
serve him well. If $100,000 had been invested in his partnership ten years ago, it would be worth
about $850,000 today. That works out to a 24% average annual compound rate of return.

Updyke is a decidedly unconventional investor: He combines the teachings of Benjamin Graham

with those of Sigmund Freud. ''I like to buy things for a lot less than I think they are worth,'' he says.
''But to me the psychology and mood of the market are more important than anything.'' Updyke uses
a variety of gauges to measure its state of mind -- for instance, whether corporate insiders are
buying or selling. If he thinks the market or a sector of the market is headed south, he unloads

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stocks en masse (some 60% of his portfolio was in cash before the October 1987 crash). ''I don't
care how good the fundamentals are. Very few people make money in down markets,'' Updyke says.
What does he think of the market's prospects? Recently, 32% of the $225 million currently under his
management was in cash.

John Shapiro and Glenn Greenberg, Chieftain Capital Management

The passionate and the skeptical

Warren Buffett would be proud of the two young men who run Chieftain Capital Management. They
scout for a few excellent companies selling for reasonable prices and loose their arrows only at
robust businesses with top-notch management. This style has served them and their small tribe of
investors well over the past 5 1/2 years. If you had invested $100,000 with them early in 1984, it
would be worth $409,000 today. That's a 28% average annual compound rate of growth.

Glenn Greenberg, 42, and John Shapiro, 36, work as a team, much as Buffett does with his partner,
Charles Munger. Greenberg, son of Hall of Fame slugger Hank, is usually passionate one way or the
other about a stock. Shapiro is more the detached skeptic. Their stock selections are joint decisions.
Says Greenberg: ''That way we avoid blaming each other for our losers. We try to be competitive
with the rest of the world, not with each other.''

This duo likes to be wedded to their stocks for years. That is why they check them out thoroughly
before investing and then put as much as 20% of their money into a single investment. Their biggest
position is in Burlington Resources, an oil and gas producer spun off by the Burlington Northern
railroad in late 1988. They bought in at an average price of $27. It traded recently at $47.

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Seth Klarman, Baupost Group

Seeking subtle signs of value

At 32, Seth Klarman is already a legend among colleagues and competitors. ''Seth is as good as
they come,'' says his former boss, Mike Price of Mutual Shares. Certainly no one in his generation
has a better investment record. From his offices at the Baupost Group just off Harvard Square, he
invests for a small group of affluent families who snagged him to run their money soon after he
graduated from Harvard business school in 1982. A $100,000 stake entrusted to Klarman at the birth
of Baupost today is worth on average $500,000 -- a 28% average annual compound rate of growth.

Klarman's exceptionally quick and subtle mind allows him to see value in many different guises. With
stocks high, he looks for ''market-insensitive opportunities.'' By that he means companies whose
financial performance depends on bankruptcies, announced mergers, liquidations, restructurings, or
spinoffs -- corporate events largely independent of the vagaries of the financial markets. For
example, he bought the senior bonds of the ailing discount chain Pay'n Save for 62 cents on the
dollar. They yield 23% to maturity in 1996 and are backed by assets far in excess of bondholders'
claims. Klarman also has clear ideas about what isn't value. A vocal critic of junk-bond financing, he
says he would never buy a new issue of a highly leveraged company.

Klarman's insistence on protection from market fluctuations served his clients well in the October
1987 crash. For the fourth quarter of 1987 his portfolios broke even, and for the year as a whole they
earned an average of 20%. Says Klarman: ''I focus on what could go wrong. Before buying, we
always ask ourselves, 'What would we pay to own this company forever?' ''

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Thomas Sweeney, Fidelity Investments

A scientist on Wall Street

At Fidelity Investments, where he runs the Capital Appreciation Fund, they hail Thomas Sweeney,
33, as the second coming of Peter Lynch, legendary manager of Fidelity's Magellan Fund. This shy
workaholic lives across the street from his downtown Boston office to put in 80 hours a week more
conveniently. In almost three years of steering Capital Appreciation, Sweeney has sailed right by
Lynch's more celebrated ship. That is no mean feat, even if Sweeney's $2.4 billion fund is about
one-fifth the size of Magellan. Anyone who invested with him 2 1/2 years ago has seen the stake
double. Average annual compound rate of return: 28%.

Sweeney picks stocks like a scientist. Says he: ''Where I came from -- Wappingers Falls, New York -
- business was looked down on. Smart people were supposed to go into the sciences.'' He almost
became a geneticist, and calls his approach ''pattern recognition,'' after a discipline geneticists use to
predict behavior under specific conditions.

His favorite pattern? ''People always panic,'' he says. ''If you study this phenomenon over time, you
see that eight times out of ten you make money by buying into a panic.'' Sweeney was eyeing
Monsanto (MON) in early 1988, but the price, about $86, was too high for him. In September a
federal court ordered the company to pay $8.75 million to a woman hurt by a Copper-7 intrauterine
contraceptive device manufactured by a subsidiary. The news prompted a wave of selling by those
who failed to recognize that the company was fully insured. Sweeney bought 940,000 shares at an
average cost of $77. He sold in 1989 at $110 a share for a 65% annual rate of return. He has
recently loaded up on electric utilities, especially those with extra generating capacity and high-
powered cash flow that are near regions lacking adequate sources of energy. One of his favorites is
DQE Inc., formerly Duquesne Light Co.

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James Chanos, Kynikos Associates

Turning value upside down

You have to marvel at shortseller Jim Chanos. After all, he makes money on a stock only when it
goes down -- and the Dow has gone up 250% since the bull market began in August 1982. Even
more amazing, the Milwaukee-born Yale graduate has kept his sense of humor. ''I'm a great market
timer,'' says Chanos, 31. ''I wrote my first short recommendation on August 17, 1982.'' Pointing to a
combat helmet on a shelf in his Manhattan office, he adds, ''On really bad days, I put it on and hide
under my desk.''

He is too modest. If you had invested $100,000 with Kynikos (cynic in Greek) Associates back in
October 1985 when it began, you'd have $173,119, an annual compound rate of return of 15.7%.
That may not sound so hot until you understand that people who invest with Chanos think of his
services as insurance against a bear market. Says Chanos: ''The difference between my policy and
Aetna's is that their clients pay for the insurance and my clients get money from their insurance.'' As
long as he earns more than the riskless rate of return on T-bills, his clients are satisfied.

Chanos is in truth a perverse kind of value investor. Using the same techniques as the others, he
looks for overvalued stocks. He stays mainly in large-capitalization issues. That way there is more
liquidity and thus less chance of a short squeeze, which would force him to liquidate his position
because he could no longer borrow shares from brokers. Last winter Chanos made a big bet against
Harcourt Brace Jovanovich, the troubled publishing company that was trying to sell its Sea World
amusement parks to avoid drowning in debt. Chanos figured HBJ wouldn't get as much as
management hoped to. Lo and behold, when it finally sold the parks to Anheuser-Busch in
September, the price was some $400 million less than most analysts anticipated, and HBJ shares
tumbled. Chanos sees no reason to take his profit yet. Says he: ''We think the common is worth

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James and Karen Cramer, Cramer & Co.

Mr. and Mrs. Aggressive

In a windowless lower Manhattan office, a young married couple with matching desks furiously buy
and sell stocks. ''Sell at three-quarters,'' she says to a broker at the other end of her line. ''Terrific. I
want to participate,'' he says to his broker. Karen and Jim Cramer, 31 and 34, are the quintessential
Eighties couple, equal partners in work and at home.

So far, the Mr. and Mrs. have succeeded in both venues. They recently celebrated 12 months of
excellent financial performance -- and their first wedding anniversary. Their investors are toasting
both. Someone who placed $100,000 with them in April 1987 would now have $165,000 -- an annual
compound rate of return of 23%. The Cramers divide the labor. He generates most of the investment
ideas; she handles the trades, using techniques she learned at the feet of master trader Michael
Steinhardt, head of Steinhardt Partners. Their strategy is nothing if not aggressive. They place about
50% of their $19 million portfolio in stocks chosen with an eye to long-term value. A current favorite
is Williams Cos. (WMB), a natural-gas pipeline and telecommunications company. The Cramers
bought 65,000 shares at an average price of $39. It traded recently for $42 a share.

They commit the other half to intraday trading. ''Our goal is to make money every day. That is why
we trade,'' says he. ''I never want to write a letter to our investors saying that we didn't participate
this quarter because we think the market's too high. That's none of our business.''

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Edward Lampert, ESL Partners

Pairing value with arbitrage

Two years ago, at 25, Edward Lampert left the safety of Goldman Sachs (GS) to go out on his own.
He had a bright future in arbitrage there, but after meeting dealmaker Richard Rainwater, a Goldman
alum, on Nantucket, he decided he wanted more than becoming a Goldman arb. Says he: ''I wanted
to set up my own business to invest in undervalued securities as well as arbitrage situations.''
Rainwater, maybe seeing a bit of himself in the young man, helped him get started in April 1988.
ESL Partners of Dallas started with $29 million under management.

Lampert's strategy gives him enormous flexibility. Says he: ''Arbitrage helps our value investing. If
we can earn 20% to 25% annualized returns in arbitrage, then for the long term we can buy only
stocks that we think will earn comparable rates of return. Conversely, if deal stocks get overpriced,
we will begin investing in companies with good long-term prospects at low prices.'' Like Buffett, he
doesn't talk about his current holdings in case he decides to buy more. His results, however, are
eloquent. Had $100,000 been placed with Lampert a year ago April, it would be worth $165,000
today. That's a plump 44% average annual rate of return.

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John Constable, Constable Partners

Mr. Preservation of Capital

This teddy bear of an investor is living his boyhood dream. As a boy in Glencoe, Illinois, John
Constable, 33, took Warren Buffett as his hero. ''It amazed me that by simply thinking and being
careful you could make money in stocks,'' he says. Constable followed his dream to Harvard, where
he took night-school extension courses and worked all-day as a block trader for the university's
endowment fund to pay tuition. He went on to apprentice at some of the most successful value-
oriented investment shops, including three years at Ruane Cunniff & Co., managers of the
redoubtable Sequoia Fund.

Constable went out on his own in August 1988. He has $28 million under management. As befits a
value player in a pricey market, Constable is cautious. He owns a few stocks involved in publicly
announced deals where he can make, say, 10% in 90 days if the deal goes through. But he prefers
to buy ''wonderful companies'' like Nestl for the longer haul. He owns 160,000 shares, bought at an
average cost of $24. Why? ''It was one of the world's superb food companies selling at 9.5 times
earnings,'' he says. Nestle traded recently at $25 a share.

In large part because Constable has kept 30% of the money entrusted to him in T-bills, his limited
partners are only 16% richer than a year ago. That's not quite up to his 20%-a-year target, but he's
prepared to wait patiently for the day when prices come down and he can accumulate an entire
portfolio of Nestles. His clients aren't restless. ''First and foremost, my investors want preservation of
their capital,'' he says.

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Richard Perry, Perry Partners

A formula for deals

Like his friend Eddie Lampert, Richard Perry, 34, is a veteran of Goldman Sachs's arbitrage unit. He
too chose to leave Goldman because of its size; there are 132 partners. ''I wanted something
smaller, where a few partners could work closely together,'' he says. After asking the advice of his
uncle, James Cayne, president of Bear Stearns, he established Perry Partners in September 1988
with $50 million to invest in publicly announced risk arbitrage deals, including mergers, tender offers,
and bankruptcies.

His investment approach? E(V) = {P(UPx) + [(1-P) (DPx)]} (1 + COF). That simply means he
values a deal by calculating the odds that it will go through, how long it will take, and what the
investment is worth with and without the deal. Why all the effort to quantify? Says Perry: ''There are
no lay-ups in the arbitrage business. This helps us maintain clear, high standards for buying a deal.''
It seems subjective, but so far it seems to work: $100,000 invested with Perry ten months ago is
worth $120,000 today, an annual compound return of 24%.

Like his confreres, Perry is having a devil of a time finding great value in the stock market. One of
the few good deals he found recently was NWA, the parent of Northwest Airlines, which became the
object of a takeover attack this past spring. In June he bought 82,000 shares at $115 a share. Using
his special equation, he estimated an expected annualized return of 27%. When he sold in July at
$121, his return was 50%. Today, however, deals are pricier, and he does not anticipate such quick
profits. He is buying one deal for every five he looks at. Says Perry: ''To be consistent over a long
time, you have to know when to say no.''

Mr. Buffett would approve.

Posted in: Berkshire Hathaway, Tap Dancing to Work, Warren Buffett

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The children of the rich and famous
November 21, 2012: 11:36 AM ET

Email Print

Not spendthrifts, sots, nor simps, these billionheirs

and billionheiresses are working hard - even though
they don't have to.
By Alan Farnham

This story is from the September 10, 1990 issue of Fortune. It is the full text of an article excerpted in
Tap Dancing to Work: Warren Buffett on Practically Everything, 1966-2012, a Fortune Magazine
book, collected and expanded by Carol Loomis.

Lisa Simmons, Harold's daughter and a onetime Vista volunteer, now makes full-time work of doing good running Dad's

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FORTUNE -- They're exotic. Some, neurotic. They're billionaire children -- saplings bent by a green
money wind. Until now they seemed too rare to be of much interest to the rest of us. When the world
has thought of them at all, it has imagined them as tiny pashas-to-be, happily cocooned. Indeed, in
the palace of the Sultan of Brunei, a corridor leading to the rooms of Prince Azim, age 6, is
decorated like a path through a forest, with a tree trunk that has a hole large enough for the young
prince to hide in.

Soon these golden boys and girls may come in for closer scrutiny, as their less privileged
contemporaries seek to learn the secrets of coping with wealth. In the U.S. alone, the passing of
parents from the World War II generation will put a $6.8 trillion inheritance into younger hands. Many
middle-class kids will confront a problem once reserved for the rich: Why work? If you know where
your next meal is coming from -- Lutce -- why even get out of bed?

Wealthy children lack that spark of want that sends other people scurrying to offices and factories
each day. From this deficiency flow others: Parents may have been too busy getting wealth to have
taught heirs how to keep it. Those certain to inherit may succumb to idleness and dissipation; those
not so sure of what they're getting may forfeit chances for security while yearning for a windfall.
Some inheritors feel so intimidated by a forebear's accomplishments that they never attempt
anything of their own, while those who do try may find their efforts dismissed as mere dilettantism.
So long as their money flows, a train of con men and false friends follows them.

Against this unhappy backdrop, some inheritors learn to use their wealth to good effect, like a tool.
They escape the pitfalls of their class and lead full, productive lives, accomplishing what they have
set out to do. How do they succeed? What motivates them? The reasons range from personal pride
to a pining for adventure. Much depends on how they were raised.

Telling children early and bluntly whether or not they will inherit makes for a good start. British
publisher Robert Maxwell made it clear to his sons Kevin, 31, and Ian, 34, from the time they were
small, that they should not expect to get his $2.2 billion, since the money would be going to medical
research and other worthy causes. The Maxwell boys have had time to adjust to the idea that they
will inherit nothing and today work alongside their father as dual managing directors of Maxwell
Communications. Warren Buffett's son Howard knows that Dad intends to use his Berkshire
Hathaway (BRKA) lucre to curb population growth. Yet Howard, 35, has not wasted time
complaining. He farms corn and soybeans just outside of Omaha, and in 1989 he was elected
commissioner of Douglas County, Nebraska.

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Howard Buffett, left, and son Howie, 6, raise beans -- with a little help from Grandpa Warren's billions.

These kids know where they stand. But many do not. Joanie Bronfman, a social psychologist who
specializes in counseling adults from wealthy families, has found that many parents deliberately
keep an adult child in the dark about inheritance. They use his uncertainty about his financial future
to control his behavior.

Such withholding is but one example of the bad parenting from which wealthy children can suffer.
Says Bronfman: ''The public is wrong in assuming children of wealth have happy childhoods. If
anything, it's more possible for parents to buy out of parenting altogether.'' The product of just such a
buyout is Edoardo Agnelli, 36, son of Fiat's Giovanni Agnelli, 69. Long before he earned the
nickname Crazy Eddie at Princeton for his wild behavior, Edoardo had lost his father's favor. To the
disappointment of Agnelli, who skied and raced cars, Edoardo, even at age 8, was too timid to dive
from the family's yacht. The father paid less and less attention to his son. Once Agnelli promised to
take him to a soccer match. Edoardo waited eagerly. The date came, then went: Agnelli had

A troubled Edoardo later turned to spiritualism for solace. In adulthood, he gave an embarrassing
interview to the Italian press in which he claimed that he was Fiat's heir apparent. His father promptly
announced that his own brother Umberto would be his successor and later restructured Fiat to keep
it out of Edoardo's hands. Agnelli's niece Delfina Rattazzi has said: ''Yes, we're an exemplary family;
others have had discord and have seen the end of their empires. But the other side of the coin is
harshness. When one of us goes through a difficult period, he or she feels enormously isolated. It is
a family for the strong.''

Having to measure up to one's family name can be daunting. His famous dad is the reason Howard
Buffett never had a lemonade stand as a kid: ''I felt discouraged from trying. It seemed nothing I

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could do would be as successful as what he did. And what I did might reflect badly on him.'' The
shadow of the elder Buffett's success stretches across the imagination of his 6-year-old grandchild.
Says Howard: ''Little Howie owns ten shares of Coke (KO) stock that he bought with money that he
saved. One day my wife was explaining how there's a first time for everything, and he said, 'I don't
think there'll ever be a first time I can afford to buy a share of Berkshire Hathaway.' ''

Dilek Sabanci, 26, is more than happy to be a member of the Turkish banking clan and fully
appreciates the many blessings her name confers. Yet she says: ''I have to be careful. People
always watch me because they have expectations from a Sabanci daughter. I have to act as a role
model or else they become the most merciless critics.''

Ross Perot Jr., left, dug 25-cent holes for Senior.

All rich kids suffer from a form of discrimination that Joanie Bronfman calls ''wealthism.'' The term
includes the many forms of prejudice ordinary people hold against the rich, but one in particular can
be powerfully demotivating: Anything a rich kid accomplishes is apt to be dismissed as dilettantish.
Laurie Tisch, 39, daughter of Preston Robert Tisch of Loews Corp. (L), is the chairman of the
Children's Museum of Manhattan, where she has helped to raise $7.5 million. Not everyone,
however, sees this accomplishment as the fruit of hard work. ''Having Tisch as a last name helps
open doors,'' she says, ''but it doesn't mean donations just roll in automatically.''

False flattery can be as galling as uninformed criticism. Asked if people try to befriend him for his
money, investment banker Warren Stephens, 33, son of Jackson T. Stephens of Little Rock's
Stephens Inc., answers, ''Hell, yes.'' Years of dealing with sycophants have made him wary: ''There's
a level of cynicism that will always be there with any new person until, over time, it's worn away or
proven correct.''

Laurie Tisch's brother Jonathan, 36, head of the Loews Hotel chain, discovered how many friends
his family has when he worked one summer at the front desk of the Loews-owned Americana hotel.

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He disguised his identity from customers by wearing a name tag reading Jonathan Mark. Whenever
the hotel was full, people angry they couldn't get a room would pull rank by insisting they knew some
Tisch or another. One day an exceptionally pushy fellow fixed Jon with a withering stare and told him
he'd better find him a room ''because I know all three Tisch brothers -- Preston, Robert, and Larry.''
Said Jon: ''Take a hike.''

Howard Buffett is philosophical: ''There are jerks with money and jerks without.'' He regularly suffers
from the public's assumption that anyone named Buffett must be rich. ''One night at a restaurant,'' he
recalls, ''I pulled out my checkbook to pay the bill, and some guy says, 'Gee, I wish I had that
checkbook!' I didn't have the patience to tell him, 'No, buddy, you really don't.' '' Though he tries to
behave as if his father's money didn't exist, doing so for long is impossible. ''When I get back to my
office this afternoon, there will be nine messages,'' he says. ''Eight of them will be from people
wanting something from my dad.''

Successful sons and daughters agree they learn more about how to handle wealth from watching
their parents than from listening to them. Like most children of wealth who turn out to be hard
workers, Winston Wang, 39, son of Formosa Plastics king Y. C. Wang, 73, credits his parents with
showing him the value of work. His lessons are far from over. Wang recently spent a weekend with
his father at Formosa Plastics' office in New Jersey. The two discussed business for three hours
Sunday, after which Y. C. spent the rest of the day composing faxes to Taipei. Says Winston: ''When
he works like that, even on Sunday, I can't do any less.''

Paul Balthazar Getty takes his acting tips from Jack Nicholson.

''Were we trained how to behave with money?'' Warren Stephens asks. ''By telling? No. By
watching? Yes. Neither of my parents ever made a big deal out of money. Their attitude was, Take
pride in what you do, enjoy what you do, and things will turn out OK.'' Adds Richard LeFrak, 45, son
of developer Samuel LeFrak: ''You observe your parents. If they don't seem to be enjoying what
they're doing, then maybe you aren't going to turn out to be a worker. How can you have self-
fulfillment just spending the old man's money? I started working when I was 13 and was only too
happy to dig in with both feet.''

Rich kids in turn try to pass these attitudes on to their own children. Howard Buffett says, ''There are
certain basic things you need to do with kids, whether you have money or not. My mom and dad

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taught me responsibility: Clean out the gutters and mow the grass. When you do wrong, pay the
consequences.'' Teaching his own son Howie how to live with privilege has not been easy. When
basketball hero Michael Jordan visited Omaha, Howie wanted to sit at the head table with the other
dignitaries. Howard senior had to explain to him that he wasn't automatically entitled to.

Allowances -- and yes, even piggy banks -- can help give children self-discipline and a healthy
respect for the value of a dime. Heirs who grew up saving pennies are not likely to mistreat billions
later. Recalls Warren Stephens: ''We had an allowance. If you went over -- too bad. There was no
more money. It was gone.'' H. Ross Perot, the founder of EDS and later of Perot Systems, says that
when his son, H. Ross Perot Jr., was small, ''he was given very little money. One day, a reporter
from Australia was in my office when Ross walked in. 'So, young man,' says the reporter, 'how does
it feel to be the son of the richest man in Texas?' Ross just stared at him. 'Mister,' he said, 'all I know
is I get 25 cents a week.' ''

Andrew Tisch, 41, Laurie and Jon's cousin and the son of Laurence Tisch of Loews Corp. and
CBS, desperately wanted a Timex watch when he was 7. ''My parents said, 'Save for it.' '' Now the
head of Lorillard (LO), Andy gives his own kids, 7 and 9, $1 a week each in spending money. ''My
son wants me to buy him baseball cards,'' he says. ''Oh, does he want baseball cards! I've told him
to save up. He needs to learn that things aren't free.''

Was Gordon Getty's singing voice a bark, a growl -- or a howl? All three, said a local music critic.

Winston Wang's 11-year-old is getting the same training: ''My son knows he has a rich grandfather.
Sometimes he says, 'Dad, why don't you ask Grandpa to give you some money?' I tell him that's not
the right way to think. You have to make your own way.'' Remembering childhood with his own
notoriously thrifty dad, Howard Buffett says: ''If you went to the movies, you never knew if he would
buy your ticket or not. His attitude was, Everybody pulls his own weight.''

As a boy, Ross Perot Jr., 31, learned the meaning of a quarter one summer shoveling holes for
petunia bushes on EDS property. ''Ross was digging away, at 25 cents a hole,'' remembers his

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father, who was paying. ''It was hotter than you can imagine, and Ross hit bedrock. He stuck with it --
kept right on going. I admired him for it.''

One weakness of rich kids, observes Laurie Tisch, ''is that they have a very low frustration level. You
don't have to do something, so you just walk away.'' The best-motivated children are usually those
who feel best loved. Says young Perot, who grew up in Dallas: ''Kids have to know you've made
them your No. 1 priority. Even when Dad was busy traveling around the country on business, he
would fly back to see us if we were in a school play. He always made sure we knew how special we
were to him.''

When parents are preoccupied, the right mentor can sometimes fill the gap. According to Oklahoma
City newspaperman Frosty Troy, Eddie Gaylord, 33, son of publishing, broadcasting, and country-
music mogul E. L. Gaylord, was ''the original spoiled brat.'' But the adult Eddie has turned out to be
a responsible, well-liked rodeo patron -- and husband to Miss Rodeo America. What happened? A
foreman on the family's Texas ranch took Eddie in tow during the boy's teenage years. Explains
Clem McSpadden, rodeo announcer and grandnephew of Will Rogers: ''I've announced rodeos for
Eddie. He gives 25 cents of every ticket to charity, though he doesn't like to say so. The first one I
did, he gave the money to leukemia. That's what the foreman died of. He'd taught Eddie how to
saddle and shoe a horse. There's always some father figure you love, and that was this old foreman
-- a man of the soil. Because of him, Eddie's turned out to be a very unpretentious fellow.''

Samuel LeFrak & Son: "How can you have self-fulfillment just spending the old man's money?"

Ross Perot willingly shares credit for his son's strength of character with a Marine sergeant who rode
the kid hard during 13 weeks of officer training at Quantico, in Virginia. The man pushed Ross's face
in the dirt and challenged him to prove he was something more than a rich boy. ''Surviving that
experience,'' says Ross Jr., ''taught me I could do anything I set my mind to.''

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Almost all billionaires' children really do want to work. John Sedgwick, author of Rich Kids, says that
heirs tell him the worst question they ever have to face is: What do you do? Says Sedgwick: ''Not
having a job makes you separate from the rest of the human race.'' The children appreciate that by
starting a career or business they will increase their self-esteem and gain independence from their
parents. But where parents are bankrolling the experiment, such gains can prove ephemeral.

Howard Buffett farms 406 acres and loves the work: ''I've been farming nine years. It's a very
independent type of activity -- everything's up to you. It teaches you a value system and gives you
an instrument to achieve that.'' So far so good.

Except for one thing: ''Dad owns the land. I pay him a percentage of the gross income as rent. I
probably shouldn't tell you this, but the rent is based upon my weight. I'm 5 foot 8, and I weigh
around 200 pounds. He thinks I weigh too much -- that I should weigh 182.5. If I'm over, my rent is
26% of gross income. If I'm under, 22%. It's the Buffett family version of going to Weight Watchers. I
don't mind it, really. He's showing he's concerned about my health. But what I do mind is that, even
at 22%, he's getting a bigger payback than almost anybody around. Somehow he always manages
to control the circumstances.''

Wise parents give their offspring maximum career freedom. Some kids who easily could get work in
family businesses don't because they feel their parents are trying to hustle them into it. Says Ross
Perot: ''It's important to give your kids a lot of rope -- sons especially.'' Apparently the rope was long
enough for Ross Jr. After he got out of the service in 1985, ''I said to Dad, 'What sort of things can I
help you do?' He said he wanted me to take over the real estate operations. Dad likes raw land.''
Junior has since turned 4,800 acres near Fort Worth into Alliance Airport, catering to manufacturers
and shippers, not commercial passengers.

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Warren Stephens, left, followed Jack's example.

Jon Tisch felt he needed to ''make a name for myself'' outside his family's hotel businesses. After
college, he got a job in Boston as a TV cameraman and was later promoted to producer. He's quick
to point out, ''This was 12 years before Uncle Larry was involved in CBS.'' Eventually, his work won
him two Emmy nominations. Jon, who now runs Loews Hotels, feels the TV experience has made
him a better innkeeper: ''It trained my eye for details that matter to a guest, like dirty ashtrays and
sconces that are askew. Hotels are really just another part of the entertainment industry.''

Will Hearst III, 41, son of William Randolph Hearst Jr., broke a family tradition by becoming the first
Hearst to graduate from college. In this case, from Harvard, the school his famous grandfather had
left after only three years. Though Will could have worked exclusively in Hearst Corp. sinecures, he
chose instead to help Jann Wenner launch Outside, an outdoor adventure-travel magazine. Today
Hearst runs his family's flagship paper, the San Francisco Examiner, to which he has added Pacific
Rim bureaus and a Sunday magazine called Image.

Not every heir to a family business feels he has to refuse the cup three times. Some are not the least
bit hung up about their good fortune. Says Warren Stephens, the Arkansas investment banker: ''I've
never felt I had to establish my independence. I'm not sure I want to be totally independent. I'm given
more opportunity right here.'' He thinks the reason some kids are crushed by family money or
tradition is that ''they get caught up thinking about it too damn much. They carry some sense of guilt,
like 'Isn't this terrible.' I don't see it as terrible. It's the American way. Our attitude has been, Let's see

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if we can't lift this family up. The money's there for you to use and to enjoy. It's not there for it to use

Will Hearst's high-proof talent: Warren Hinckle, left, Larry Kramer, top, and Hunter Thompson, right

If money is a tool, these inheritors believe, call it the world's best hammer. Richard LeFrak thought
about starting his own law practice. ''But hey, I like it here,'' he says, referring to the LeFrak real
estate empire. ''This is the family business. I'm the only son of an only son. I saw it as an opportunity
and a responsibility. I hope someday my own two sons, at their own initiative, will want to join us.''

Some heirs feel compelled to put themselves at risk or to undertake extraordinary challenges.
Terminally comfortable, they need to prove to themselves they're still breathing. Says John
Sedgwick: ''They're sponges for experience. Comfort pushes them toward extremes.'' John Levy, a
Mill Valley, California, consultant to parents and children coping with inherited wealth, concurs:
''They turn either to venture capitalism or kayaking.''

Many prefer arenas where money cannot buy them victory. Gordon Getty, 56, one of oilman J. Paul
Getty's five sons, has withstood appraisal as a composer of symphonic music; now he has opened
up a second front as a concert singer. A music critic for the San Francisco Chronicle, reviewing
Getty's July performance of selections from Schubert's Die Winterreise song cycle, wrote: ''It should
be irrelevant that when Gordon Getty goes public as a singer he is doing so as one of the world's
richest men. Yet there was no other reason for attending his recital Friday night.'' The review
described Getty's voice as ''a groan lapsing into a growl'' and ''a bark that becomes a howl.''

Gordon's great-nephew Paul Balthazar Getty, age 15, garnered better reviews for his screen debut
as Ralph in this summer's remake of Lord of the Flies. With evident pride, he told a London paper,
''The film people did not know who I was.'' Balty -- as he is known to friends at home in Southern

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California -- insists his only acting instruction so far has been ''a few tips from Jack Nicholson, who I
see at baseball games.'' His latest film is Young Guns II.

Idle only for a moment are the Tisch children: Andrew, left, Laurie, and Jonathan.

Business and the arts do not exhaust the rich kid's avenues for self-expression. Charity can serve as
well. Lisa Simmons, 34, has taken charge of her corporate-raider father's charitable giving. A
former Vista volunteer, she is president and sole staff person of the Harold Simmons Foundation,
where she reviews, approves, or rejects funding requests. Last year the foundation pledged more
than $40 million to the University of Texas for a cancer institute and a Simmons Arthritis Research
Center: ''My Dad suffers from arthritis,'' she says. Did she choose philanthropy out of a deeply felt
sense of social obligation? No. ''I just liked the work.''

Old movies appealed so strongly to David Packard, 49, son of Hewlett-Packard's co-founder, that
he decided to restore a vintage movie palace, the Stanford, that he remembered from his youth in
Palo Alto, California. Nearly eight million Packard Foundation dollars later, the Stanford reopened
this year with its own collection of 2,000 classic silent films and talkies, and one of the mightiest
Wurlitzers around.

Packard personally designed the console's electronic controls -- the apple doesn't fall too far from
the tree. ''I didn't know anything about theater organs,'' he says, ''but I decided the Wurlitzer was too
important to our enterprise to leave it to volunteers.'' Meanwhile, his wife, Pamela, got so wrapped
up in replicating the exact shade of the Stanford's original stage curtain that vats of dye filled the
Packards' kitchen. David feels satisfied with what the two have accomplished: ''We've been doing
extraordinary business -- 7,000 people a week. Still, that's just enough to pay our way. It all takes a
lot of my time now.''

In philanthropy, in personal relations, and in professional life, sons and daughters of wealth often
have to work harder than ordinary people to win respect and credibility. The extra cost is part of their

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mixed birthright. They work to establish their worth to themselves and for the pleasure that
accomplishment can bring. But at bottom, they work because, as Laurie Tisch puts it, ''there's
something to be said for wanting to be like everybody else."

Posted in: Berkshire Hathaway, Tap Dancing to Work, Warren Buffett

The world's best brand

November 21, 2012: 11:35 AM ET

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CEO Roberto Goizueta's heaviest burden is the load of

expectations he has built up by making Coke
shareholders $50 billion richer. It's getting harder to
maintain the pace.
By John Huey

This story is from the May 31, 1993 issue of Fortune. It is the full text of an article excerpted in Tap
Dancing to Work: Warren Buffett on Practically Everything, 1966-2012, a Fortune Magazine book,
collected and expanded by Carol Loomis.

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Taking no chances: A bottling plant in Radzymin, Poland, is blessed at its recent opening.

FORTUNE -- It's been more than 12 years now since the Coca-Cola Co.'s patriarch -- a
nonagenarian, cigar-smoking, Old South tycoon known simply as The Boss -- emerged from the live-
oak shadows of his Georgia plantation to commit one last, seminal, almost Shakespearean act.
That's when Robert Woodruff flexed the power of his stock and vetoed the handpicked successor of
his imperious -- but ailing and confused -- CEO, J. Paul Austin. Instead of Austin's choice, Ian
Wilson, Woodruff summoned Coke (KO) executive Roberto Goizueta, a 48-year-old, Cuban-born
chemical engineer, to his office and asked a simple question: ''Roberto, how would you like to run
my company?''

Goizueta, a Latin patrician who is nothing if not courtly, responded, ''Well, Mr. Woodruff, I'd be
flattered.'' Then, Goizueta recalls, he asked Woodruff if he could pick his own team, if he could name
as his right-hand man Don Keough, a Coke executive whom many outsiders had believed to be the
front- runner for the chairman's job. ''You have answered my question,'' Woodruff replied. ''You are
running my company, so you can do whatever you want. There's no sense to talk anymore. Good-
bye. I'm going to take a nap.''

Goizueta took Woodruff's words to heart. His first significant act was to name Keough, a charismatic
leader and quintessential Coke salesman, as his president and COO, giving him sweeping authority
across the organization. Then the new chairman summoned all his senior executives to a meeting in
Palm Springs, where, as Keough puts it, ''he let them know several things: We weren't here to be a
nice company; we were here to be a growth company. We were going to get our balance sheet in
order. And we were going to reward the hell out of performance, but we were no longer going to pay
for perfect attendance.''

An introverted Yale intellectual who speaks English as a second language, Goizueta was happy to
have the boundless energies of Keough to dispatch around the world while he spent more of his time
in Atlanta ruminating on strategic matters, particularly on a subject with which he had become
obsessed: enhancing shareholder value -- not a big topic among CEOs in those pre-LBO days. It
was time well spent. Coke's market value in 1980 was only slightly more than $4 billion, pegging the
company as a ripe takeover target. By the end of last year it had risen to about $56 billion, making it

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America's sixth most valuable public company. Before Goizueta, Coke's ten-year total return to
investors averaged less than 1% a year; under Goizueta it has averaged almost 30%.

As promised, executives who performed were rewarded -- with bonuses, stock options, and
especially stock grants that mature upon retirement. When Goizueta, 61, hosted a retirement dinner
for Keough, 66, in April, the departee had the security of knowing he was taking with him stock,
options, and grants of Coke stock worth about $166 million. The current value of Goizueta's eventual
stake is around $378 million. Stock grants have made virtually every one of the 35 or so other
corporate officers attending that dinner a paper millionaire several times over.

That's the raw score, which somehow makes it all sound like clear sailing. It wasn't. To refresh some
memories, here are just a few highlights of the Goizueta-Keough era:

Goizueta celebrates with the chairman of Coke's Norwegian partner at the startup of a plant in Warsaw.

Diet Coke. Introduced in 1982, the first-ever extension of the company's hallowed trademark.
Forbidden by Goizueta's predecessor and opposed by company lawyers as a risk to the copyright.
Now the world's third most popular soft drink after Coke Classic and Pepsi. Probably the most
successful consumer product launch of the Eighties.

Columbia Pictures. Coke bought it for $692 million in 1982 and quickly won an Oscar for Gandhi,
but never really got the hang of running a studio. Invested well in TV programming, especially game
shows, then sold its stake to Sony (SNE) in 1989 for $1.55 billion, reaping a healthy profit.

New Coke. Probably the most embarrassing consumer product launch ever, worse even than the
Edsel. Goizueta and Keough took full responsibility for the 1985 disaster, wiped the egg from their
faces, and brought back Coke Classic. Pepsi (PEP) executive Roger Enrico was moved to write a
book titled The Other Guy Blinked.

Warren Buffett. Through Berkshire Hathaway (BRKA) he bought some 93 million shares of Coke
stock starting in the late Eighties, making him the company's largest stockholder, with more than 7%
ownership. The self-styled investment guru, who admits to a five-Cherry-Coke-a-day habit, has
watched the value of his investment almost quadruple in about six years.

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Says Buffett: ''If you run across one good idea for a business in your lifetime, you're lucky, and
fundamentally this is the best large business in the world. It has got the most powerful brand in the
world. It sells for an extremely moderate price. It's universally liked -- the per capita consumption
goes up almost every year in almost every country. There isn't any other product like it.''

He's right. Coke, the drink, is still priced moderately. But Coke stock -- following a 92% run-up two
years ago -- is by most measures hardly a bargain. With a price/earnings ratio of 26, it trades at
about a 40% premium to the S&P 500, while its price is around 13 times book value -- among the
highest multiples for any blue chip. Partially because of these high multiples, Coke's stock price has
scarcely changed over the past year.

Result: For all the glory of the recent era, these are tense times at Coke. Like several other
superstar performers of the past decade -- Wal-Mart (WMT), for one -- Coke is facing what may be
its toughest challenge yet: how to continue the growth magic of the Eighties when the targets of the
Nineties keep getting harder to hit. Granted, this is a problem many big corporations would love to
have, but it is a problem nevertheless. When a company spotlights shareholder value as brightly as
Coke does and uses stock appreciation to motivate the troops, the uninterrupted nature of its climb
takes on outsize importance. Coke won over the shortsighted seers of Wall Street by consistently
reporting earnings increases of 18% to 20%, year after year, no surprises. Now it is being held to its
own high standards.

Says Jay Nelson, a security analyst for Brown Brothers Harriman, who has a hold recommendation
on the stock: ''Coke is and has been one of the best big companies in the world. People know that,
and it is priced accordingly.'' Adds Mark Rowland of Rowland & Co., an Atlanta money manager: ''It's
a great company at a supernatural price. In the last decade the stock has outperformed the
company. Now we may begin to see the company outperform the stock.''

Coke's top international executive, John Hunter (in Mexico) must deliver 8% to 10% volume increases.

With every executive's net worth riding on the results, the pressure inside the company to maintain
growth in volume and earnings -- to keep up the magic -- is intense. Especially on the international

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front, where Coke earns more than 80% of its profits and where it has staked its future on rapid
growth in volume. Now it faces recession in such key markets as Brazil and Australia. International
unit volume increased only 4% last year, short of the company's stated long-term goal of 8% to 10%,
which it hasn't achieved since 1990.

Still, given Goizueta's track record of leveraging every ounce of mystique and profit from the world's
best-known brand, few are betting against him, especially over the long haul. His strategy seems
logical enough. Says he: ''We have really just begun reaching out to the 95% of the world's
population that lives outside the U.S. Today our top 16 markets account for 80% of our volume, and
those markets only cover 20% of the world's population.''

Coke's international strategists really get torqued up when they start talking ''per capitas.'' In a
mature market such as the U.S., for example, the per capita is 296, which means that on average,
every man, woman, and child in the country drinks 296 eight-ounce servings of Coke products a
year. At that level growth comes damned slow and damned expensive. But when the standard of
living in developing countries rises, goes the theory, so does sugar consumption, and Coke plans to
make its sugary products available to catch that tide anywhere it may happen to rise. The outcome is
not entirely determined by demographics or even climate. ''Per capita is a state of mind,'' says John
Hunter, a salty Australian who is the executive vice president responsible for international business.
He points out that among Coke's highest per capita countries are, strangely, Iceland at 397 and,
maybe less amazingly, American Samoa at 500.

Coke has, of course, long had a global presence -- built to critical mass by Woodruff's decision to
provide the drink to American GIs during World War II and further enhanced by Austin's love of
international adventurism. But before Goizueta, its empire was strung together as a loosely knit
chain of very eccentric fiefdoms, affording Atlanta virtually no control over how its bottlers chose to
grow, or not grow, their Coca-Cola business. Describing the corporate culture when he took over,
Goizueta says, ''Unprofessional would be an understatement. We were there to carry the bottlers'
suitcases.'' The difference today? ''We used to be either cheerleaders or critics of bottlers. Now we
are players.''

MORE: Revealed - Coke's next CEO

That seemingly minor distinction represents the most sacred cow slain by Goizueta and Keough,
and a quantum leap in profit opportunity for a company that always said it was in the business of
selling concentrate and syrup, not actually bottling soft drinks. The breakthrough came in 1981,
when John Hunter, then Coke's regional manager for the Philippines, came to Atlanta and declared
that if Coke wanted to reverse Pepsi's 2-to-1 market share lead in that important market, the
company would have to invest $13 million to become a controlling joint-venture partner with its
bottler, which was neglecting the Coke business in favor of its San Miguel brewery. Goizueta said
go. Keough oversaw the deal. Hunter and a manager he brought in from Australia, Neville Isdell,
made it work. Coke regained a 2-to-1 lead in the Philippines, in the process sending a powerful
message that the era of bottler entitlement was over.

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The Philippine campaign spawned numerous legacies, including a new template for Coke's overseas
business: the anchor bottler, a big, committed, well-heeled bottling outfit, sometimes controlled by
Coke, always ready to expand into other markets around the world. Hunter, who spearheaded the
operation, is now in charge of all international business. And Neville Isdell is president of the
Northeast Europe/Middle East Group.

Isdell -- a towering, animated Irishman -- played host to Goizueta when he recently toured a group of
former Soviet bloc satellites for a firsthand look at how Coke and its partners are investing the $1
billion they have committed to the region. That doesn't include $450 million in the former East
Germany or $100 million in the former Soviet Union. The trip offers a glimpse at Coke's operating
style and the response that its brand elicits.

On his last global jaunt before retiring in April, President Don Keough pressed the flesh in Estonia.

The CEO's tour begins in Prague, where the new $28 million bottling plant is a textbook case of how
the modern template for international expansion works. The plant is operated by Coke's largest
anchor bottler, Coca-Cola Amatil, an Australian-based company in which Coke owns a controlling
interest. Amatil already operates more than 35 bottling plants in eight other countries, including
Austria and Hungary, which makes it a natural choice to open the franchise in the neighboring Czech
Republic. As Hunter says, ''There's very little necessity to go from country to country reinventing the

Arriving at the plant, Goizueta's entourage of Coke executives and partners is a vision of the true
global company: an Irishman, a Turk, a Greek, and an Australian. Goizueta addresses the
assembled crowd, taking the opportunity to play on his Cuban heritage: ''Today, hundreds of Prague
citizens will take an important step -- the beginning of their careers at the Coca-Cola Company -- just
like the one I took in Havana, Cuba, in 1954.''

The Czech Prime Minister, Vaclav Klaus, is on hand to salute Coke's remarkable progress in
bringing the plant to production in less than a year, which wouldn't exactly be a miracle in, say,
Atlanta, but is impressive in a country where the former government tried for seven years to finish
this same plant and failed.

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Says the Prime Minister, who sees a hopeful parallel: ''Very often we hear complaints from those
hoping to do business here about the problems they encounter with bureaucracy and regulations.
Yet some firms succeed and some don't. Coca-Cola shows that you need a vision of what you want
to do and people who know how to do it. They started in an incomplete plant and transformed it. I am
certain our country will be as successful in its attempts to transform.''

The dignitaries on the dais push some ceremonial buttons, and the bright red cases of Coke come
rolling down the line. A Bohemian band of clarinets and accordions strikes up a unique rendition of
an old Patsy Cline tune, and the buffet lunch begins. Goizueta doesn't linger over the canaps. He is
off to Poland.

Minutes after his Gulfstream IV touches down in Warsaw, the chairman is whisked by motorcade to
an appointment with Polish Prime Minister Hanna Suchocka. The two discuss her difficulties in trying
to push privatization legislation through a recalcitrant parliament, but then she has a personal
question for the distinguished American capitalist: ''When are we going to get Coke Light [Diet Coke]
in Poland?''

Goizueta is quick to respond: ''As soon as your government approves it, we will sell it.'' Two weeks
later he receives word that the Polish government has approved Coke Light. This is good news. The
profit margin is usually considerably higher than that on regular Coke.

The next day, at the opening of a bottling plant in Warsaw -- operated by another anchor bottler,
Ringnes of Norway -- Goizueta tells the assembled Poles: ''We do business in more than 195
countries, but today we are most excited about East Central Europe. Coke is not a novelty here
anymore. It is an important part of Poland.'' Indeed, on Saturday afternoon, the square of Warsaw's
Old Town is dotted with red and white Coke umbrellas, while young Coke employees walk around
handing out samples of the soft drink.

The more distant a country's culture is from America's, it seems, the more potent Coke is as an icon
of American culture and -- especially in the former communist world -- as a symbol of the market
economy. On a visit to a fast-food restaurant festooned with the Coke logo and called the Atlanta
Bar, Neville Isdell explains, ''It's hard to believe, but this is a country where a crowd gathered and
spontaneously applauded one of our first delivery trucks coming down the street.''

Poland is a large, relatively sophisticated market compared with poor, benighted Romania's, where
Coke's first-class corporate style sticks out from the moment Goizueta's plane touches down at the
Bucharest airport. His G4 is the only thing here that is sparkling clean and in good working order;
everything else at the airport is rusted and seemingly inhabited by mongrel dogs picking through the
detritus of a collapsed society. Still, per capita here is eight and growing, and the workers at the
Coke plant, who look to be from another time, crowd around Goizueta as if he had come to
personally save them.

Misu Negritoiu, a senior Romanian official, welcomes Goizueta to his country: ''Mr. Goizueta, you are
the highest-ranking international businessman to visit our country in the two years since our
transformation. You are investing $80 million, but Coca-Cola is more than that. Coca-Cola is the

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spirit of the system, the symbol of our new life. It brings jobs and color to our streets, and now that
you are here, we are confident other businesses will come. You have that power.'' The minister's
speech sounds as if it were written by Coca-Cola, which it wasn't but which isn't really so implausible
given that company lawyers had to help the Romanian government draft the national decree and
subsequent laws allowing them to open for business.

After the ceremony the Coke party returns to the airport, where Goizueta will hop his plane back to
the more civilized confines of Dusseldorf. But Muhtar Kent -- a hard-charging Turk who, under Isdell,
oversees a territory of 21 countries between the Alps and Himalayas inhabited by a quarter of a
billion potential Coke drinkers -- is off to Sofia, Bulgaria, and possibly on to Albania to stir up some
per capitas. Right now Isdell and Kent are clearly among the most golden of the company's golden
boys. An independent market survey showed that during last year's fourth quarter Coke had taken
the market share lead in every Eastern European country, a region where Pepsi basically held
exclusive rights under the communist regimes. For the year, Pepsi still maintained leads in several

Coke strategists can barely contain their excitement over Muhtar Kent's territory, mostly because per
capitas have grown from 20 to 31 in just two years. By 2000, he projects with relish, per capita will
reach 71. In Hungary today per capita is already 83, close to the per capita eight years ago in
Austria, which is now more than 150. Coke hopes the Czech Republic falls right into this line of
growth. The model can't, of course, anticipate instability in such places as Bosnia-Herzegovina.

Goizueta believes the sophistication and progress he sees on this trip underscore a major change:
''We used to be an American company with a large international business,'' he says. ''Now we are a
large international company with a sizable American business.'' As Goizueta toured Eastern Europe,
Don Keough was hopping around Russia in his G4, slapping backs, visiting customers, and making
speeches in such cities as St. Petersburg, where Coke will build a $50 million plant. This was
Keough's final globetrot as president of Coca-Cola, and it raises the question of who, or what, will
take his place.

''I don't think he's replaceable, no question about that,'' says Warren Buffett, who knew Keough as a
young man when they were neighbors in Omaha. ''But if you think you've got a great business and
it's dependent on one guy, it's not really a great business. And Coke has a great business. There's
no one to fill his shoes, but this company can take it.''

Everyone concedes that there is no gregarious, warm-hearted motivator waiting in the wings to
extract the last ounce of emotional commitment from the troops while simultaneously kicking them in
the rear if necessary. But even Keough -- who has a lot riding on the company's continued success -
- argues that big corporations in the information age may have somewhat different needs than those
he served.

Says he: ''In this day and age, he who has the information fastest, and uses it, wins. And this
company has the best information flow of any global company in the world. These young guys are as
comfortable calling stuff up on their screens and teleconferencing between continents as I was

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getting on a plane at midnight, catching a few winks, then shaving and getting back out there.
Believe me, this ship has just left the dock.''

Predictably, Coke argues that it has the finest group of young international executives anywhere and
lets it be known that the best among them are chained to the company's future with heavy-gauge,
18-karat-gold handcuffs. Ostensibly, Keough is being replaced by two executive vice presidents:
Hunter, 55, principal operating officer, international; and Doug Ivester, 46, principal operating officer,
North America. Goizueta insists that the race for succession to Keough's job is still wide open. For
the time being, the world supposedly divides equally between Ivester and Hunter, but a quick
comparison of stock, stock grants, and options dispels that myth: The younger Ivester stands to own
some $55 million in stock, while Hunter is slated for a mere $20 million.

In assessing Coke's future, the more relevant point is this: Roberto Goizueta has spent the better
part of the past decade reengineering Coca-Cola -- culturally, organizationally, and in particular
financially -- to meet his vision of the future. And at age 61 he clearly plans on staying around to see
it unfold. From his beginning as CEO, Goizueta applied his engineer's mentality to a large,
hidebound, diffuse corporation. He took it apart methodically, examined each piece in the process,
then decided what it should look like when he put it back together.

As part of the effort, he enlisted bright young protgs: Ivester and Jack Stahl, the 40-year-old chief
financial officer, also frequently mentioned as a candidate for higher office. He took them into his
confidence, heaped responsibility on them, and allowed them to take bold risks so that today they
run much of the company they helped design. None of this is to take anything away from Hunter, a
Keough protege whose strong relationship with overseas bottlers and 40-lashes-of-the-whip
approach to motivation are crucial to the company right now. He has perhaps the clearest job
assignment at Coke: Deliver those 8% to 10% international volume increases, and keep those per
capitas rising.

The much more sophisticated Coca-Cola Co. that has emerged from Goizueta's reworking is one of
the simplest of all large corporations to define -- certainly much less exotic than some of its previous
incarnations. Gone are the wine, coffee, tea, industrial water treatment, and aquaculture businesses
that Goizueta inherited, as well as the entertainment business he bought. Today Coca-Cola is a
beverage company. More specifically, it is a global soft drink company that holds 45% of the world
market in carbonated drinks; it has 47% of the market outside the U.S. and plans to make that 50%
in the next two years. It is more focused, more single-minded, and, surprisingly, more open about its
intentions than at any other time in its 107-year history.

Goizueta concedes that his record has benefited tremendously from the unusual circumstances
under which he assumed command. His predecessor, J. Paul Austin -- a tall, handsome, red-haired
Olympic rower from Harvard -- had been suffering, without Coke's knowing it, from a combination of
Alzheimer's and Parkinson's diseases, and many believe from alcoholism as well. ''The company
had no sense of direction whatsoever,'' says Goizueta. ''None.''

His most horrifying discoveries, he says, were financial. Coke prided itself on a nearly debt-free
balance sheet. But most of the capital the company was investing was equity capital, with an

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effective cost of about 16%. So with all its businesses except soft drinks and juices returning only
8% to 10% a year, says Goizueta, ''we were liquidating our business, borrowing money at 16 and
investing it at eight. You can't do that forever.''

What's more, even if rationally financed, many of Coke's businesses didn't stand up to the engineer's
scrutiny. ''It's simple,'' says Goizueta. ''You make a chart. Across the top you put your businesses:
concentrate, bottling, wine, foods, whatever. Then you put the financial characteristics on the other
axis: margins, returns, cash flow reliability, capital requirements. Some, like the concentrate
business, will emerge as superior businesses. Others, like wine, look lousy.'' So, says Goizueta,
while Keough went off to straighten out the company's disorganized, sometimes disastrous, and
absolutely crucial relationships with bottlers, ''I stayed home to clean out the stables.'' He quickly
sold off the ''lousy'' businesses. Everybody else around the company learned just as quickly how to
make financial charts, which, among other things, calculated their cost of capital. From now on, all
company operations would be judged on what Coke calls economic profit: after-tax operating profit in
excess of a charge for capital.

Says Goizueta: ''When you get right down to it, what I really do is allocate resources -- capital,
manpower. And I learned that when you start charging people for their capital, all sorts of things
happen. All of a sudden inventories get under control. You don't have three months' concentrate
sitting around for an emergency. Or you figure out that you can save a lot of money by replacing
stainless-steel syrup containers with cardboard and plastic.''

Goizueta, who spent years on the technical side of the company before moving on to administration,
is sensitive to the charge that he is strictly a financial guy who surrounds himself with other number
crunchers, like Ivester and Stahl. ''We're not just financial people,'' he says, ''but until 1981, none of
our operating executives could even read a balance sheet. What we've insisted on is weaving a
strong financial thread into the marketing fabric of this company.''

Now it is a couple of weeks after the infamous Marlboro Friday -- when Philip Morris kicked all
national-brand consumer stocks in the teeth with its precipitous bow to pricing pressure from private-
brand cigarettes. Goizueta, now Keoughless, is seated on a dais alongside his new management
team -- Ivester, Hunter, Stahl -- at Coke headquarters in Atlanta. In the audience are most of the
Wall Street security analysts who follow food and beverage stocks. They have, in effect, been
summoned to Atlanta for an emergency briefing on the drop in Coke stock since the Philip Morris

Goizueta, clearly annoyed, opens the session with barely concealed anger: ''It's one thing when your
stock drops 10% because of some mistake your company has made,'' he tells the analysts, ''but it's
something else when it gets caught in a downward spiral of irrational market behavior, when it drops
because of a development in a business with totally different financial and social dynamics. We are
getting a bum rap.''

To explain why generic soft drinks aren't as threatening as generic cigarettes, Goizueta unleashes
Ivester, whose presentation is typical of his, and Coke's, approach to such situations. He bombards
the analysts with research, leading them methodically through a logical analysis: U.S. soft drink

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prices have remained low while consumption has increased; premium cigarette prices, by
comparison, have skyrocketed while consumption has declined. But in case they aren't buying the
explanations, Ivester also gives them some ''oh, by the way'' news. Coke has just cut two deals that
strike at the heart of the private-label issue: one, to stock a new beverage aisle in 1,500 Wal-Mart
stores; two, to replace McDonald's (MCD) private-label orange drink with Coke's own Hi-C brand
orange drink. So there.

While Wall Street pressure may force Goizueta to fret constantly over his stock's short-term
performance, the man -- to his soul -- is the essence of a genuine owner-manager, the strategist
who tries to envision his company ten, 20, 30 years out. He has never sold a share of Coke stock --
which constitutes almost his entire net worth -- and still owns the first 100 shares he bought after
joining the company, valued today at over $1 million. Cuba is one of the few countries on earth
where Coke is not sold. Had Castro not taken power, Goizueta says, his father -- a wealthy sugar
grower and refiner -- would have purchased the Havana Coca-Cola bottling franchise, and today he,
Roberto, would probably be an anchor bottler.

As Goizueta peers far into his company's future, he seems to see himself still coming to work in the
next century. He is, after all, one of only two men who can truly be said to have been in charge of
Coca-Cola since 1923. The other is his benefactor, The Boss, who retired from the company
presidency in 1939 to pursue his passions for golf, bird dogs, and strong drink. But Woodruff stayed
on as chairman of the executive committee and was still strong enough in 1980 to hand the keys
over to Goizueta before dying at age 95 in 1985. Now Chairman Goizueta has been dropping hints
in his recent writings on corporate governance that he favors separating the jobs of chairman and
CEO -- a pretty clear indication that he sees no end to his own chairmanship.

The company's other owners seem comfortable with that prospect.

Herbert A. Allen, the New York investment banker who came on to Coke's board with the acquisition
of Columbia Pictures and stayed after he helped sell the entertainment company to Sony, says he
puts his money on people and argues that you can't find a better bet than Goizueta. ''A lot of people
underestimate Roberto because he is quiet and self-effacing,'' says Allen, who brought Keough over
to his investment banking firm as chairman upon his retirement from Coke. ''They say Coke had one
of the great names when he took over. But there were a lot of other great names back then too:
Sears (SHLD), IBM (IBM), American Express (AXP), Bank of America (BAC), Eastman Kodak.''

Allen is no disinterested observer: He controls almost five million shares of Coke stock. Another fan
with a huge bet on the table is Warren Buffett. ''If you have the 1927 Yankees, all you wish for is
their immortality,'' he says. Buffett recently sold some put options that would allow him to increase
his holdings by about $175 million should the stock price drop another 15% or so. ''As long as we
have the kind of people who are as focused as they are, I don't worry about the business. If you
gave me $100 billion and said take away the soft drink leadership of Coca-Cola in the world, I'd give
it back to you and say it can't be done.''

Maybe not. But just maintaining leadership won't be enough. The real challenge facing Coca-Cola in
the Nineties is whether it can continue to conquer the world rapidly enough -- and at a big enough

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profit -- to keep shareholder value rising on the kind of trajectory of which only a few companies dare
to dream.

Posted in: Berkshire Hathaway, Tap Dancing to Work, Warren Buffett


Revealed: Coke's next CEO

November 21, 2012: 11:34 AM ET

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By John Huey

This is a sidebar that ran with The World's Best Brand in the May 31, 1993 issue of Fortune.

After a European tour, Ivester's tough job is moving more Coke in the mature U.S. market.

FORTUNE -- You heard it here first: Barring disaster, the next CEO of CocaCola (KO) will be M.
Douglas Ivester, 46, a former outside auditor who worked his way through the University of Georgia
as a Kroger bag boy.

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When he will ascend is up to CEO Goizueta, who doesn't reach 65 for four years and will probably
keep the title of chairman when the time comes. Despite Goizueta's insistence that he hasn't chosen
a successor, Ivester has been his hand-groomed protege for years, as well as the architect of many
of Coke's fancier financial plays, including the creation of Coca-Cola Enterprises (CCE) -- a spun-off
conglomerate of big U.S. bottlers that Coke effectively controls without absorbing its liabilities.

Ivester has wielded considerable influence in shaping the company's future. He was the main force
behind Coke's $150 million investment in information technology, driven by his frustrations in trying
to get faster financial information. He finally solved the problem -- the process now takes a few days,
not six weeks -- he says, by getting to know everyone in the typing pool on a first-name basis. While
president of Coke's European Community Group he developed the company's cutting-edge
teleconferencing system because, he says "the travel was breaking my back."

Goizueta has broadened Ivester's skills by moving him beyond finance to such front-line operating
jobs as head of European operations and now head of the North American business, where he has
proved himself capable. In Europe he backed Coke's rapid -- and high risk -- deployment into the
former East Germany, which set the company's pace in Eastern Europe. In the U.S. he has been
central to working out strategic alliances with huge customers Wal-Mart (WMT) and McDonald's

Taciturn and media-shy, Ivester is almost the opposite of retired president Don Keough, a world
champion back slapper, flesh presser, and motivational speaker. As a Wall Street analyst puts it,
"After Keough, a team of Goizueta-Ivester could be pretty dour." Dour perhaps, but very focused.

BACK TO: The world's best brand

Posted in: Berkshire Hathaway, Tap Dancing to Work, Warren Buffett



What really happened at Coke

November 21, 2012: 11:33 AM ET

Tap Dancing to Work Page 147

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Doug Ivester was a demon for information. But he

couldn't see what was coming at the showdown in
By Betsy Morris and Patricia Sellers

This story is from the January 10, 2000 issue of Fortune. It is the full text of an article excerpted in
Tap Dancing to Work: Warren Buffett on Practically Everything, 1966-2012, a Fortune Magazine
book, collected and expanded by Carol Loomis.

Forced out: As CEO, Ivester was a master of the details, but they added up to a picture some very important people didn't

FORTUNE -- First of all, let's clear up any mystery about why Doug Ivester -- at age 52 and after
only a little more than two years on the job -- suddenly resigned as chairman and CEO of Coca-
Cola. He was pushed. Hard.

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Sure, he was beleaguered by a string of setbacks in his short, unhappy tenure. But aides who
worked with him every day -- and who were as shocked as anyone when the dogged executive
threw in the towel -- report that everything was business as usual on the first day of December, a
Wednesday, when Ivester flew from Atlanta to Chicago for a routine meeting with McDonald's (MCD)

Upon his return, everything seemed to have changed. What hasn't come to light until now is that
while Ivester was in Chicago he attended another, very private meeting -- this one called by Coke's
two most powerful directors, Warren Buffett and Herbert Allen. At that meeting the two directors
informed Ivester that they had lost confidence in his leadership.

For most of the past year Buffett had remained in the wings, while Allen had had numerous
conversations with Ivester about his cramped management style. This time it was different,
according to well-placed sources close to the situation. Together, Buffett and Allen, the board's two
800-pound gorillas, told Ivester that they had reached an irreversible conclusion: He was no longer
the man who should be running Coke (KO). It was time for a change.

The meeting was nonconfrontational -- even sympathetic -- and it apparently ended without a
conclusion as to the next step. Conceivably Ivester could have decided to fight. But it's also
conceivable that Buffett and Allen could have decided to force the issue, perhaps as early as the
next board meeting, scheduled for two weeks later. Their leadership as directors is outsized,
considering that Buffett's Berkshire Hathaway (BRKA) (of which he owns 31%) controls about 200
million shares, or 8.1%, while Allen owns or controls about nine million shares.

Whatever they were all thinking when they left the meeting, Ivester returned to Atlanta and called an
emergency board meeting for that Sunday, at which he quit. His announcement stunned executives,
directors, employees, and Wall Street -- even the man who was named to replace him, Doug Daft, a
56-year-old Australian whose experience has mostly been running Coke's businesses in Asia.

It was hard to believe that a man who once said, "I know how all the levers work, and I could
generate so much cash I could make everybody's head spin," had come to such a quick, stark end
as a corporate leader. Or that a man almost obsessed with doing things in an orderly, rational way
would leave behind such a mess. Not only must Daft put Coke's financial performance back on track,
but he'll also need to mend fences on all sorts of fronts, from bottlers to foreign governments to
customers. Among his first priorities will be to name a second-in-command, something the board will
demand of him. A good bet for the job would seem to be Jack Stahl, head of the Americas group, a
"people person" and a veteran of the crack finance department that Ivester built and ran in his glory
days as CFO.

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Whoever is chosen, the board has made clear it
wants no more one-man high-wire acts. It wants results. Now. On Ivester's watch Coke's earnings
declined for two years running. Its return on shareholders' equity is expected to decline to 35% this
year from 42% last year and 56.5% in 1997. Its market value, which grew 34-fold to $147 billion from
$4.3 billion during Goizueta's 16-year tenure, stands essentially flat, at $148 billion, after Ivester's
two-year stint.

Ivester's sudden fall from one of the world's premier corporate jobs is more than just a tale of bad
luck or plans gone wrong. It is a management story full of leadership lessons. It features colossal
arrogance and insecurity. Its main character was blind to his own weaknesses and unwilling to take
advice. He became increasingly isolated and obsessed with controlling the tiniest details -- think
Jimmy Carter in his final year as President.

For two decades Ivester had toiled away patiently inside Coke, the last ten years aiming directly at
the top spot and dazzling CEO Roberto Goizueta with his hard work and creative execution of
company strategy. A onetime accountant -- an outside auditor from Ernst -- he was carefully
groomed by Goizueta and put through all the paces to give him the breadth of experience he would
need in marketing, in global affairs, in charm and public speaking. But for all his brilliance -- and

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nobody doubts that Ivester is brilliant -- he somehow failed to grasp the vital quality that Goizueta
had in abundance: that ethereal thing called leadership.

To be fair, if the planets were all aligned favorably for Goizueta, Ivester was star-crossed. He
inherited the job upon Goizueta's death in the fall of 1997, just as the Asian financial crunch took
hold. Coke was on the back end of a bottler-consolidation strategy that had given it a steady stream
of extra earnings. The weak dollar that had helped Coke's earnings for years suddenly strengthened.

But the ultimate measure of a CEO is how he handles crises, and again and again, in the view of
certain directors and powerful bottling executives, Ivester was a day late and a dollar short. "It's a
little like mountain climbing," says a source close to the board. "Anyone can get to a certain level.
But very few can function well in the really rare air. Doug was simply unable to give people a sense
of purpose or direction."

Almost from day one it was apparent that Ivester lacked political skills. After Goizueta's death, the
history of the company began to be rewritten, with Ivester taking greater credit for revamping the
company's bottler system and dragging the company out of the technological dark ages. By letting
that story stand, Ivester gave great offense to one very powerful constituent, Donald R. Keough,
who'd been Goizueta's president and COO. The real mystery to the story is this: Why would Ivester
want to run the risk of offending Keough, who, as the chairman of Allen & Co., was the right-hand
man to one of his most powerful board members, Herbert Allen, and who, as a native of Nebraska,
was an old friend of his other most powerful board member, Warren Buffett, and who, just for good
measure, was on the board of McDonald's, Coke's largest customer? As times got tougher, the
gregarious Keough by default became the unofficial father confessor to the disaffected throughout
the Coca-Cola system -- customers, bottlers, employees.

The story has some eerie echoes of the messy leadership transition Coke went through a generation
ago. In 1980 the company's 90-year-old patriarch, Robert Woodruff, emerged from his own
retirement to overrule then-CEO J. Paul Austin's choice for a successor and pick from a slate of
candidates a dark horse, Cuban chemical engineer Roberto C. Goizueta, to lead the company.
Ivester, like Goizueta, was in many ways an unlikely choice. He had emerged from a corporate
backwater. Like Goizueta, he was painfully reserved. His rags-to-riches story was different from
Goizueta's but no less extraordinary. Ivester grew up the only child of factory workers in a
conservative Southern Baptist household in tiny New Holland, Ga. He was evangelical in his
approach to his work -- some would say rigid. He was big on discipline, telling Fortune last year,
"The highly disciplined organizations are the most creative. If you can create high discipline, in effect
you've created security and safety ... It's follow-up. It's returning phone calls. It's adhering to the
control system. We operate with a rigid control system. It is an enabler, not a restricter."

Ivester had a system for everything. He'd schedule meetings with top aides at 30-day intervals, 12
months out. His far-flung group presidents knew to leave him voice mail almost nightly. Whenever
anybody got a communiqu from Ivester, they knew to respond by the date in a corner of the memo
or they'd hear from him.

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Analytical and data-driven, Ivester spent heavily on technology for the quick and efficient delivery of
vast amounts of information. His goal was to make Coke the ultimate Learning Organization, and he
made his case convincingly. A year and a half ago Fortune conjectured, "Ivester may give us a
glimpse of the 21st-century CEO, who marshals data and manages people in a way no pre-
Information Age executive ever did or could."

New blood: As the new CEO, Doug Daft will have to mend fences on all sorts of fronts, from bottlers to foreign governments
to customers.

He took pride in being a substance-over-style guy -- but that translated into taking no heed of image
and perception issues, which are merely all-important to a company like Coke. He took pride in
managing for the long haul -- but that made him unyielding in the face of immediate circumstances.
And while he was in command of a vast number of details, he seemed to lose sight of the big

Ivester pursued an inflexible acquisition strategy even in the face of the brewing anti-big-American-
business backlash. That cost him Orangina and the Cadbury Schweppes business in most of
Europe. His aggression stirred up a hornet's nest; Coke now faces investigations into alleged
anticompetitive practices by regulators in Austria and elsewhere in Europe; it is appealing a ruling
against it in Italy.

Handling the Belgian crisis last summer, Ivester had all the data but missed their larger meaning. He
determined that what had made the schoolchildren sick was that Coca-Cola had been made with a
bad batch of carbon dioxide. It was a minor problem, hardly a health hazard, he judged. By the time
he addressed the issue publicly, it was a full-blown crisis.

When it came to the loss of Carl Ware, Coke's highest-ranking African American, Ivester
demonstrated a shocking naivet. Ivester had enlisted Ware, a senior vice president, to head his
diversity council after the company was socked with a race-discrimination lawsuit last spring. Then
Ivester shuffled management last fall -- and in the process moved Ware into a position in which he
would be reporting to Daft, another senior vice president, instead of directly to Ivester. The change

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outraged Ware, who announced his intention to retire, and caused some board members to question
Ivester's judgment.

While those problems were grabbing headlines, Ivester's emphasis on substance over style caused
Coke's marketing to suffer. One recently departed Coke marketer recalled feeling pressured to
document how much revenue the company could expect from every dollar he spent on marketing,
which, he said, "made you concentrate on the sure-thing single instead of the home run." While
Ivester's Coke was great at blocking and tackling, it neglected the big stunt ad or marketing
campaign needed every three to five years to rev up excitement in the brand. The biggest news
Coke made on the marketing front was its decision in November to raise prices on its concentrate.

That move illuminates what may have been Ivester's biggest blind spot as Coke's CEO: The job is
not just the running of a company but the leadership of a kind of principality, in which big, powerful
bottling companies are substantial fiefdoms. Almost 90% of Coke's business is in the hands of
bottlers, and the balance of power -- as well as diplomatic relations -- must be maintained.

It wasn't a good idea to alienate Coke's 11 big anchor bottlers around the world, especially given the
incestuous nature of the business. Take, for example, the largest one, Coca-Cola Enterprises
(CCE), the cornerstone of the anchor bottling system created by Goizueta, Ivester, and Keough.
CCE handles 70% of the company's bottles and cans in the U.S. and, as it happens, its business in
Belgium. It is a nearly $15 billion Big Board company, almost as big as Coca-Cola, and 39% owned
by Coca-Cola. It also, as it happens, is run by Summerfield Johnston Jr., the grandson of Coca-
Cola's first franchised bottler and a hunting buddy of Coke board member Jimmy Williams. On its
board is Howard Buffett, son of Warren Buffett.

As Coca-Cola's problems grew, CCE's stock price plunged; it fell from $37 in June to $18 in mid-
December, wiping out more than half the company's market cap. The troubles in Belgium began the
decline; an ill-considered comment Ivester made about developing vending machines that could
automatically raise prices in hot weather further angered bottling executives, who are the ones
actually in the vending-machine business. Finally, significantly raising the price bottlers had to pay
Coke for concentrate seemed an unconscionable affront -- and whacked their stock some more.

"We're big boys with big businesses," says one high-ranking bottling executive. "But the perception
on the Street was that Ivester was running the Coca-Cola Co. at our expense. Some had the view
that he was raping the bottlers."

But Ivester continued trying to go it alone. At one point Don Keough sent him a six-page letter with
constructive suggestions on how he could improve his situation. What did Ivester do? He sent
Keough a one-line response, thanking him for his input.

Ivester was never one to show signs of weakness. "I just don't know what it's like to feel a lot of
stress," he told Fortune last summer in the heat of the Belgian crisis. And he has adopted an almost
breezy attitude since turning in his resignation. He has told Coke system executives that he is
unembarrassed and essentially well-off. He's made a lot of money. As of last February, he owned
5.3 million shares of Coke (including 2.5 million shares he could acquire by exercising options),

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which, at mid-December's price of about $60, would be worth $318 million. Last year Ivester had a
salary of $1.25 million and a bonus of $1.5 million, which, according to the proxy, reflected the
company's performance and "the committee's confidence in Mr. Ivester's leadership in difficult

What happened? How could so brilliant a CEO as Roberto Goizueta have dialed such a wrong
number? Simple. Goizueta was planning on living a long life, stepping back into the role of chairman,
and letting Ivester run the company with his discreet guidance. It probably would have worked.
Ivester was indeed a brilliant No. 2.

But in retrospect, maybe we should have seen this coming. Back in October 1994, Ivester, then
newly named president and COO, took center stage at a big industry trade show and delivered a
speech that was unforgettable for its surliness. It was called "Be Different or Be Damned," and it was
some debut. Ivester seemed almost to be trying to differentiate himself from the larger-than-life
Goizueta. He described himself as a wolf -- highly independent, nomadic, territorial. "I want your
customers," he told the stunned audience." I want your space on the shelves ... I want every single
bit of beverage growth potential that exists out there." Make no mistake, he told them, he was their
competitor. He would not pretend to be their statesman. He would be different or be damned. Or, as
it turned out, both.

Untangling the derivatives mess

November 21, 2012: 11:32 AM ET

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They didn't melt down the financial system. But these

red-hot instruments proved too tempting for both
buyers and sellers. This is the story of how lies,
leverage, ignorance - and lots of arrogance - burned
some big players.

Tap Dancing to Work Page 154

By Carol Loomis

This story is from the March 20, 1995 issue of Fortune. It is the full text of an article excerpted in Tap
Dancing to Work: Warren Buffett on Practically Everything, 1966-2012, a Fortune Magazine book,
collected and expanded by Carol Loomis.

Chiding regulators at a hearing for not taking the derivatives problem seriously enough, Senator Paul Sarbanes held up an
early 1994 Fortune article and read its warnings about derivatives lurking like alligators.

FORTUNE -- It was the year of the derivative. From last spring on, as if a blockade of ice had
suddenly given way, bad news about these exotic financial innovations started to flow, and victims,
corporate and public alike, began to wash ashore. In the wake of billions of dollars in losses since
then, opinions about these new-age instruments have drastically hardened. "Derivatives," observes
Richard Syron, chairman of the American Stock Exchange, which trades the species called puts and
calls. "That's the 11-letter four-letter word."

The word's elevation to pejorative status is probably justified, but not simply because wild market
swings turned many derivatives players into big losers last year. What magnified those losses and
sent a troubling message to regulators was disturbing instances of managerial blindness, desperate
behavior, even outright fraud. Among the most spectacular misadventures were those of Gibson
Greetings, the Cincinnati card and wrapping paper company, which was the victim of lies that were
subsequently exposed, Watergate style, by a taped conversation, which we'll listen in on in a bit. The
preeminent purveyor of leading-edge derivatives, Bankers Trust, was censured and fined by
regulators for its role in Gibson's loss. Enormous complexities delayed investigators in that case, just
as the general confusion of derivatives has kept the world unsure of exactly what transpired in most
of the other derivatives calamities. Only lately have the arresting details come to light.

The thread running throughout last year's disasters was the misuse of derivatives, now standard
equipment in the financial quarters of many companies. When they are employed wisely, derivatives
make the world simpler, because they give their buyers an ability to manage and transfer risk. But in
the hands of speculators, bumblers, or unscrupulous peddlers, they are a powerful leveraged
mechanism for creating risk. Last year the worst sort of crowd grabbed hold of the tool and took over
the plant.

Like Gibson, Procter & Gamble (PG) was chewed up by derivatives that incorporated astounding
leverage and confounding complexity. It is currently engaged in a court fight with Bankers Trust,

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which sold it the derivatives. Other large companies publicly acknowledged losses (see "Milestones
of the Year," below) and behind the scenes there were undoubtedly more slips and falls that never
came to light. Then there was the nightmare of Orange County, California, which brought to life the
dread of many Wall Streeters, a major loss of public money linked to derivatives. Many of these
derivatives bear the fingerprints of Merrill Lynch.

In a way that the corporate disasters had not done, Orange County, with its mean effects on millions
of citizens, triggered alarm in Washington. But at Senate Banking Committee hearings on derivatives
in early January, a troop of top-level regulators were largely reassuring. In particular, they noted the
absence of systemic risk last year. That is, no deep problem -- extreme distress, say, at a major
derivatives dealer -- clutched the financial market and, by chain reaction, choked off the liquidity on
which the system lives. Fears of such a crisis have ballooned with the prodigious growth of
customized, over-the-counter derivatives. But a meltdown obviously didn't happen in the otherwise
wretched year of 1994, and that has left regulators feeling relief. At the hearings, they went on to say
they did not see themselves as needing new authority to deal with the hazards at hand. Good thing,
since most of the committee's Republicans, newly ascended to power, were in no mood for

Gibson's Sottile: His company wheeled and dealed in derivatives -- and then got clobbered.

But to the ranking Democrat, Paul Sarbanes of Maryland, the Senate committee's attitude, in the
wake of this dramatically troubled year, smacked too much of "complacency." Holding up a ten-
month-old Fortune cover article about over-the-counter derivatives (March 7, 1994), he read its
warnings, among them the fact that these things "make leverage all too easy to come by" and turn
existing accounting rules into "hash." He stressed the article's title, "The Risk That Won't Go Away,"
and read out the subhead that followed: "Like alligators in a swamp, derivatives lurk in the global
economy." What, he said in effect to the regulators, are you going to do about this?

Thanks for the plug, Senator, and we will readily accept some credit for our timing. Right after that
article was published, the alligators crawled out of the swamp and got their jaws going. But if we may
also offer an update, Senator, the add-on news is that horrendous trouble has, as usual, sped
change. For one thing, those banking, securities, and commodities regulators who were sitting
before you have emphatically toughened up their act. For another, new rules about disclosure have
just gone into effect and will be adding a mixture of density and light to 1994 annual reports. On the

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clarity side, corporations must now state their purpose in using derivatives, a directive that just by its
existence may deter speculation.

Even so, there remain plenty of reasons to worry. High on the list is the bedeviling variety and
complexity of over-the-counter derivatives, a continuing pain for the accounting crowd and a true
mind-bender for anyone trying to value these instruments. Commonly, the tools for valuations are
complicated mathematical "models" that factor in, say, estimates of what interest rates will do and
with what degree of volatility. The dealers who sell derivatives are customarily the experts on
valuation, and many customers -- including Gibson, to its sorrow -- have simply taken the dealers'
word as to what their derivatives are worth.

Then, of course, there is the tendency of markets to do what they wish, including becoming turbulent
on occasion, and that means derivatives disasters will multiply. The bad guy last year was interest
rates, which rose with a force and suddenness beyond the expectation of the treasurer of P&G, the
treasurer of Orange County, and most of the world. The severe drop in the value of the Mexican
peso (almost 40% as of late February) has already produced a few derivatives problems, and more
are likely to surface. Do you think, perhaps, that the stock market could crater as it did in 1987?
Equity derivatives were troublesome back then, and their numbers have since multiplied greatly.

Simon Lorne, general counsel of the Securities and Exchange Commission, recently spoke
optimistically about all the steps that regulators have taken to get a grip on the derivatives market.
But he also agreed the progress might not match the intensity of the problem: "That's the point
Fortune made a year ago. This is the risk that won't go away."

The wrecks at Gibson, P&G, and Orange County point up everything about the risks, including the
complexity and confusion of derivatives and their seeming determination to get out of control. But
these incidents also raise the definitional problems that have come to both fuzz up this game and
add to its mystery.

As the term is most commonly used, derivatives are contracts. They are written between two parties
(the "counterparties") and have a value that is derived -- that's the key word -- from the value of
some underlying assets, such as currencies, equities, or commodities; from an indicator like interest
rates; or from a stock-market or other index. The options and futures traded on exchanges are
derivatives contracts. So are the over-the-counter options and forwards sold by dealers (such as
Bankers Trust) and bought by end users (such as Gibson and P&G). All of these instruments are "off
balance sheet," a fact that tends to obscure the leverage and financial might they bring to the party.

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The cousins of these contracts are
derivatives securities, which show up on the balance sheet. In a pure sense, a security of this type
has some sort of derivatives contract embedded within it -- an option, for example. But as the
notoriety of derivatives has increased, this pure definition has been extended to the point that all
manner of securities that do not incorporate derivatives contracts are often referred to as derivatives.
In short, if it's complex, it's apt to get the name.

To the extent that the Orange County mess was about derivatives, the villain was securities. (For an
account of what happened there, click here). But the agent of doom at Gibson Greetings and P&G
was totally derivatives contracts, sold in each instance by Bankers Trust, the seventh-largest bank
holding company in the U.S. Over the years, Bankers has made itself a specialist in complex,
"proprietary" derivatives, turning these into a highly lucrative business. In ads, Bankers has said,
"Risk wears many disguises. Helping you see beneath its surface is the strength of Bankers Trust."

Those lines are quoted bitterly in the lawsuit that P&G has brought against Bankers, which has in
turn launched a counterclaim against P&G. In another, still more dramatic set of legal actions, the
Federal Reserve, the SEC, and the Commodity Futures Trading Commission have all levied
penalties on Bankers Trust because of its behavior in dealing with Gibson.

The CFTC's order against Bankers describes the way in which Gibson gorged on a derivatives' diet.
Between November 1991 and March 1994, the company entered into 29 derivatives transactions
and amendments, managing in the process to deliver $13 million in revenues to Bankers. Many of
the contracts, usually because they contained options, incorporated leverage that caused Gibson's
losses to increase dramatically in response to small changes in interest rates. Many, according to
the CFTC, also had lingo names, among them "the ratio swap, periodic floor, spread lock 1 and 2,
Treasury-linked swap, knockout call option, Libor-linked payout, time swap, and wedding band 3 and

"What is a wedding band?" Fortune recently asked Charles S. Sanford Jr., 58, chairman of Bankers
Trust and a onetime trader. He suggested we get an answer from one of the bank's technical
experts. Next day the company's investor relations director called to relay an expert's statement that
a wedding band "was a swap containing a series of barrier options."

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He went on, but this lurch into "barrier options" had shut down the listener's mind. After further
research, Fortune submits this simplified explanation: A wedding band is typically a swap on which
the client makes out well as long as interest rates stay within a relatively narrow range -- "the band" -
- but that turns into a loser if rates move either below the band or above it. A gambler could get
similar action by placing money on the total points to be scored in the Super Bowl. Gary Gastineau,
head of derivatives research at S.G. Warburg, says that given long enough, he might be able to think
of a risk management reason for entering into a wedding band swap: "But that's not really their
purpose. These things are done by people who think they know better than the market where
interest rates are headed."

Gibson gets taken, on tape

Gibson, which definitely thought it was smarter than the market, has nevertheless described itself in
legal papers as "a conservatively managed company." This is also the corporation that William
Simon, former Secretary of the Treasury, took private in a 1982 leveraged buyout and remarketed to
the public a year later, thereby famously adding about $70 million to his net worth. Simon has been
out of the company for years, and it is today run by Benjamin Sottile, 57, whose background is
consumer products. In 1993, the latest year for which figures are available, Gibson had sales of
$547 million and was not big enough to make the Fortune 500. The company's profits that year were
$20 million.

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In the manner of many other seers, Gibson's
financial officers -- the boss was then Ward Cavanaugh, now 65 and retired -- believed from late
1991 on that interest rates were sure to drop, and they backed their belief by purchasing derivatives.
But because of its small size and avowed conservatism, Gibson felt -- and claims to have told
Bankers Trust -- that it could not tolerate a derivatives loss greater than $3 million. Originally that
thought was irrelevant, because Gibson's first two derivatives contracts, both closed out within eight
months of their inception, delivered Gibson $260,000 in profits. Or at least that is the profit accorded
Gibson by Bankers Trust, whose valuation models were the source of all Gibson's knowledge about
profits and losses.

After Gibson's initial profits, the question of how much the company was making or losing on its
derivatives becomes murky for two reasons. First, the two parties, Gibson and Bankers, began
chain-linking transactions, so that just what was going on in the first vs. the next became obscure.
Second, Bankers Trust people began lying to Gibson about how much money it was losing.

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According to the CFTC and SEC, the lies began at the end of 1992 and caused Gibson to release
inaccurate financial statements for 1992 and 1993. But more recent evidence of dishonesty is now
emblazoned on the record because two Bankers Trust people holding an incriminating phone
conversation were taped, caught in fact by an internal system that Bankers uses to monitor trades.
In this smoking-gun conversation, which took place on Wednesday, February 23, 1994 -- about three
weeks after the Fed had first begun to tighten interest rates -- one of the two talkers worriedly
discussed misinformation that Gibson was getting from Bankers and went on to consider strategies
for getting out of the problem. Buried among thousands of tapes that Bankers Trust began listening
to after various derivatives disasters hit the news last spring, this particular tape did not turn up for
months. But when it did, it went to Washington's regulators and became the cornerstone of their
disciplinary moves against Bankers Trust.

The essence of the problem described on the tape was that Bankers' data showed Gibson to have
lost amounts that far exceeded what Gibson had been told was the case. Here, in sentences that
include clarifying, parenthetical phrases inserted by Washington's regulators, is an unidentified
managing director of Bankers Trust Securities discussing the "differential":

"I think that we should use this [a downward market price movement] as an opportunity. We should
just call [the Gibson contact] and maybe chip away at the differential a little more. I mean, we told
him $8.1 million when the real number was 14. So now if the real number is 16, we'll tell him that it is
11. You know, just slowly chip away at that differential between what it really is and what we're
telling him."

Later the same day, the managing director spoke ominously of just what would happen if Bankers,
looking at the large amounts Gibson now owed it, had to tell Gibson that it must stop the bleeding by
"unwinding" its trades. In that case, of course, the truth would come out. Said the managing director:
"We gotta try and close that gap ... If the market hasn't changed at all, or was just kind of dottering
around within a couple of ticks, then you know, there's nothing that we can really say ... But when
there's a big move ... and he is down another 1.3, we can tell him he is down another two. And vice
versa. If the market really rallies like crazy, and he's made back a couple of million dollars, you can
say you have only made back a half a million."

Perhaps because interest rates pressed ever higher, the gradual return to reality that this
conversation contemplates did not occur. On the Friday after the Wednesday of the taped
conversation, Bankers Trust told Gibson that its losses had increased from the $8.1 million to $13.8
million. By the following Thursday, the figure was a remarkable $17.5 million, and Bankers, so says
Gibson, was describing the company's losses as "potentially without limit." Gibson therefore took
action: It signed up the next day for one amendment and one new derivative -- the 28th and 29th of
its transactions -- that capped its loss at a maximum of $27.5 million but also held out the possibility
that it could reduce its loss to $3 million.

Grasp the implications of that move: At that moment, Gibson could have settled with Bankers Trust
for less than $27.5 million -- perhaps something close to the $17.5 million. But gripped, no doubt, by
desperation, Gibson took the chance of entering into new transactions that had the potential of
increasing its losses. "I tell you," says a director of another company that reeled into derivatives

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trouble last year, "it's a lot like gambling. You get in deep. And you think, 'I'll get out of it with this one
last trade.' "

After the new agreements, Gibson's losses in fact rose. As of September 30, 1994, they were up to
$20.7 million. But just before that date, Gibson swerved in strategy, suing Bankers Trust in an effort
to get out of paying on the deals. Gibson claimed it had been misinformed and misadvised by
Bankers, which Gibson charged had a "fiduciary relationship" with its client. In October, Bankers
denied those allegations and launched a counterclaim that presented Gibson -- a "large and
sophisticated corporation," said the legal papers -- as simply the victim of its own rotten judgment.

And then Bankers Trust found the smoking-gun tape. Without knowing of Bankers' discovery, the
world soon got the impression of wheels whirring. To begin with, the news leaked that Bankers was
reassigning five executives, pending an internal investigation into certain derivatives deals. Next,
Bankers announced that Gibson would pay it a settlement amount of $6.2 million, obviously a much-
reduced figure.

Procter & Gamble's Artzt: Outraged at his company's embarrassing $157 million derivatives loss, he's suing Bankers Trust.

The names of three of the executives reassigned have never been disclosed. The other two were
managing directors of BT Securities: Jack A. Lavin, who headed the sale of corporate derivatives,
and Gary S. Missner, who reported to Lavin and handled the Gibson account. Lavin, who continues
to work for Bankers, was definitely not a participant in the taped conversation. Missner definitely
was. He has left the bank and so has the other participant in the taped talks. Meanwhile, the internal
investigation continues.

The tape's existence became publicly known only when the CFTC, the SEC, and the Fed came
down hard on Bankers Trust in late December. The Fed's "written agreement" -- a serious kind of
sanction -- requires Bankers to rework and greatly improve its procedures for selling leveraged
derivatives and to hire an independent legal counsel to consider what disciplinary actions against

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Bankers' people might be appropriate. The agreement specifically directs the counsel to inquire into
whether management failed to supervise its employees.

The CFTC's and the SEC's "orders" against Bankers charge it with both giving Gibson wrong
information about its losses and causing Gibson to issue inaccurate financial statements. The SEC
throws in a "failure to supervise" charge, and by its very presence on the scene makes the new point
that certain kinds of over-the-counter derivatives are securities subject to its jurisdiction. Finally, in
an allegation that has shocked many a derivatives dealer who never wanted to be a fiduciary of any
kind, the CFTC finds Bankers to have been a "commodity trading adviser" that defrauded its client.

This allegation is tied to still other incriminating tape conversations, in which a Bankers managing
director says, "From the very beginning, [Gibson] just, you know, really put themselves in our hands
like 96%." The same executive acknowledged that Gibson was no derivatives whiz: "These guys
[Gibson] have done some pretty wild stuff. And you know, they probably do not understand it quite
as well as they should ... And that's like perfect for us."

For all of these misbegotten deeds, the CFTC and the SEC jointly fined Bankers Trust $10 million.
That is not a huge fine by SEC standards (its largest was the $300 million levied on Drexel Burnham
Lambert in 1989 for insider trading and other violations of securities laws), but it is big stuff for the
CFTC. Mary Schapiro, chairperson of the CFTC, says the $10 million "is not unrelated to the $13
million in revenues that Bankers Trust took in from Gibson." Could it also, she is asked, be roughly
equivalent to Bankers' profits on the Gibson business? She says she doesn't know but "wouldn't be
surprised" to find that true.

The SEC and CFTC orders state that Bankers has consented to the regulators' findings, without
either admitting or denying these. Informally, the company has said wrongs were clearly committed.
But CEO Sanford tends to believe the problem was simply "two guys" guilty of rogue behavior. In
general, he says, "I think our people have been acting very fairly with customers."

He is asked to what extent he thinks top management bears responsibility for what happened with
Gibson. "I don't think they -- That would be pretty hard. There's four or five levels of management
below. I don't know what people are saying on the phone or doing until it's brought to our attention."

Some people who have worked at Bankers claim, nevertheless, that the Gibson behavior grew out of
a culture that puts an almighty importance on profits. Says a former Bankers managing director who
held a responsible position in its derivatives business: "This is very much a management issue. Any
sales force is extremely sensitive to management. If you go for several years paying and promoting
certain kinds of salespeople, the message gets across that what they do is acceptable behavior."

As of now, new rules about acceptability are in place at Bankers. Under the Fed agreement, Bankers
is directed to make sure that its customers know about every wart, wrinkle, and whisker of their
leveraged derivatives. Most significantly, Bankers is required to provide "transparency" about prices.
If a client, for example, has entered into a highly leveraged contract, it is entitled to know on a daily
basis what the contract's value is.

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The regulators: Falling behind. They sounded confident at the Banking Committee's hearings in January, but these four
senior regulators know that the rocket scientists of derivatives have a habit of staying at least one step ahead. From left:
Deputy Secretary of the Treasury Frank Newman; Fed Chairman Alan Greenspan; SEC Chairman Arthur Levitt Jr., and
CFTC Chairperson Mary Schapiro.

Along the way, that requirement seems likely to provide clients with new information about what
Bankers is taking in on its trades. Imagine that a client asks on Day Two of a transaction what the
contract's value is -- in other words, what it would cost him to undo it. The client would be aware that
he buys at an "offered" price and sells at a "bid" price. So when Bankers comes forth with an answer
about the derivative's Day Two price, it will in effect, assuming that the market has been quiet, be
divulging the "spread, " or revenues it booked on Day One. Revenues in this business certainly
aren't equivalent to profits, since they must cover compensation and the sometimes sizable costs
that a dealer will incur trying to hedge the risk it has just shouldered. But as a rough indicator of
Bankers' take on the deal, the figures should be of keen interest to clients.

At the hearings in January, Fed Chairman Alan Greenspan said unequivocally that the Bankers
Trust agreement should not be construed as setting general guidelines for the industry. Even so,
other big derivatives dealers have been poring over the agreement, trying to understand what it
means for them. Will they also be forced, perhaps even by customer pressure, into daily valuations?
On a kind of ludicrous level, but with legal problems definitely in mind, should they do more taping or
less taping? And what about that huge question of their fiduciary responsibility to the corporate
clients with which they deal? Most dealers have thought of their customers as sophisticated types
not needing handholding. But does the Gibson case suggest that the dealers must get deeply into
what's appropriate for customers to own? That is, in fact, a question right now on the plate of
Washington's regulators, who have so far not produced an answer.

P&G: A jury's nightmare

Any summation of the Gibson case would have to conclude that this company had no business
signing up for leveraged derivatives. Beyond that, a match pitting Gibson against Bankers, with all its
erudition in derivatives, was indisputably an unfair fight. But what should we think when the bout is
between P&G and Bankers? Can P&G really be classed a victimized innocent? In a recent speech,
Merton Miller, a well-known University of Chicago finance professor, got out the needle and
delivered his answer: "You know Procter & Gamble? Procter is the widow, and Gamble is the

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P&G is doggedly claiming, nonetheless, that in late 1993 and early 1994 it was cheated by Bankers
into buying two swaps having "huge, concealed risks." One of P&G's complaints is that it was the
prisoner of "a secret, proprietary, complex, multivariable pricing model" that Bankers would not share
and whose inscrutability stood in the way of P&G figuring out how to mitigate its losses. Certainly
P&G did not marvelously mitigate. Its derivatives loss, announced last April, was $157 million before
taxes. Essentially, that was the present value of super-high payments that the company, by the
terms of its two swaps, was obligated to make to Bankers Trust over the next several years.

P&G, however, has not yet paid a penny on the swaps, and in its lawsuit is asking that they be
rescinded. It wants a jury trial, a mind-bending fact considering the complexities of this case -- hardly
the stuff for Court TV. Bankers, meanwhile, has denied wrongdoing of any kind and has
countersued, asking that P&G be forced to hand over all it owes.

Here is a vastly simplified description of the morass that P&G got into -- and that a jury would have
to boot up for also. This is a company that over the years had done many kinds of business with
Bankers Trust and that throughout the banking world had a reputation for aggressively managing its
interest costs. In the early 1990s, for example, P&G swapped good-size quantities of its fixed-rate
debt into floating-rate debt, thereby successfully betting on a drop in rates. At the wheel in this period
was treasurer Raymond D. Mains, now 56, who from all appearances regarded his operation as a
profit center.

In October 1993, still expecting rates to fall, P&G talked to Bankers Trust about ways of replacing a
fixed-to-floating swap that was maturing. P&G's specific objective was to negotiate a new $100
million swap that would (a) again put it in the position of paying floating rates and (b) squeeze these
to a minimum. Specifically, the company wanted to pay its standard, upper-crust commercial paper
rate (then about 3.25% for six-month paper) minus 40 basis points -- that is, 0.4 of 1%.

No problem, said Bankers Trust. In the way of big dealers and especially itself, Bankers was
prepared to tailor-make a contract to fit the client's wishes and then to cover its own flanks by
hedging the risk it had just taken on. In interest rates, however, as in life, there is no free lunch. If
P&G were to do this deal, it would be required to take on extra risk, which would come in the form of
reduced returns if interest rates did the unthinkable and went up. Keep talking, said P&G. Bankers
then proposed several different deals, one after another, and to each P&G said no. This ping-pong
had the feel of a never-give-up stock salesman saying, "Okay, if you don't like that one, how about
this one?"

Finally a deal was struck. In early November, suddenly raising their sights to $200 million rather than
half that, the two parties signed up for a five-year swap whose leverage sprang from an option
included within it. For the first six months of the deal, P&G was to pay a floating rate not just 40 basis
points, but 75, below commercial paper rates. For the 4 1/2 years after that, the floating rate was to
be dictated by a brain-twisting formula whose components would include five-year and 30-year
Treasury rates as of May 4, 1994, which was the six-month anniversary of the deal. Under the best
case for P&G, the floating rate would continue at 75 basis points below commercial paper for the full
term of the swap. Under the worst case -- well, that's what the lawsuit is about.

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For all the deal's complexity, the gist of it can be stated quite simply: The swap had a "notional," or
principal, value of $200 million. Assume that P&G scored to the maximum, saving 75 basis points for
five years. On the $200 million, that would be $1.5 million a year, for a total of $7.5 million. The
annual savings would have cut P&G's interest bill, which runs around $500 million, by 0.3 of 1%.

And what risk did P&G accept in return? For this lure of $1.5 million annually -- think of that as kind
of an insurance premium payable to P&G -- the company agreed in effect for the next six months to
act as an insurer covering the risk of interest rate earthquakes. With remarkable fury, these quakes
then occurred: Five-year Treasury rates rose from 5% in early November 1993 to 6.7% on May 4,
1994, a dramatic increase. P&G's other benchmark, 30-year Treasury rates, went from about 6% to

At an early point in this action-packed period, P&G went so far as to increase the money it had on
the table. On February 14, 1994, just ten days after the Fed tightened rates, the company entered
into another highly leveraged swap geared again to the idea that rates would not soar. This swap
had a principal value of about $93 million, a term of 4 3/4 years, and was -- ready? -- a wedding
band. Or perhaps, since it was denominated in deutsche marks, it should be called a Trauring.

We will not translate the terms of the swap into German, since they are difficult enough in English.
This swap bestowed a very favorable floating interest rate on P&G for the first year of the swap and,
over its full term, offered the promise of about $940,000 in total savings if everything went right with
a certain German "swap rate." These savings would result if the rate, then 5.35%, did not fall below
4.05% or rise above 6.10% at any point before April 14, 1995.

On the other hand, if the rate popped out of that band, even for a day, another crazy-quilt formula
took over. Under this formula, the level of the swap rate on the precise day of April 14, 1995, and its
relationship to 4.50% -- yes, we know that's a percentage you haven't seen before in these
paragraphs -- would determine what interest rate P&G paid for the last 3 3/4 years of the swap (are
you getting all this, ladies and gentlemen of the jury?).

The danger, then, for P&G occurred, first, if the swap rate jumped out of the prescribed band and,
second, if the swap rate was above the 4.50% benchmark rate on April 14, 1995. In that event, P&G
was to begin paying interest that included its base rate for the first year plus a "spread." And this
spread was ten times the difference between 4.50% and the swap rate. So once again P&G had
sold earthquake insurance.

As it happened, the magic date of April 14, 1995, never precisely came into play. Just 16 days after
the contract went into effect -- we are now in early March 1994 -- the swap rate flew out of the band
on the upside. From all appearances, P&G then started to realize just how catastrophic things could
get with its swaps if rates kept going up. It promptly began trying to mitigate the dangers by
negotiating a "lock-in interest rate" for each of its swaps. In other words, it wanted to firmly set the
rates that it would pay for the duration of the swaps, rather than leave itself at the mercy of interest
rate movements.

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Therein lies the crux of the legal dispute between P&G and Bankers. P&G claims that before the
swaps were signed, Bankers repeatedly assured it that in the early stages of the swaps, the
company would be able to do lock-ins at acceptable prices. Court papers, in fact, include letters from
Bankers that make such assurances, though these consistently cite assumptions of stable or only
slightly rising rates. P&G says, however, that on one occasion it "pointedly" asked the Bankers Trust
person with whom it was dealing what the lock-in situation on the first swap would be if rates and
volatility were not "stable." The answer, P&G says, was that "possible changes in rates or volatilities
would not have a material or significant effect" on the company's lock-in position.

But when P&G commenced to negotiate lock-ins, so it says, it found itself frustrated by that "secret,
proprietary, etc." pricing model and by loss figures that it found dismaying. Bankers Trust, says P&G,
actually attributed part of the lock-in problem to the protective hedges the bank had itself set up after
making the first swap contract. The hedge position was so large, P&G was given to understand, that
unwinding it might itself drive up U.S. interest rates! Eventually, P&G came to believe that Bankers
Trust, trying to cover all the leverage that had been packed into this one $200 million contract, had
put on no less than $3 billion in hedges.

In the end, dismaying loss figures or not, P&G was forced to accept the deals that Bankers offered.
By April 11, P&G had locked in rates on both swaps and confronted the horror of insuring quakes:
For the duration of the first swap, which runs to late 1998, the company agreed to pay interest rates
that are 1,412 basis points (14.12%) above the commercial paper rate. And as long as the wedding
band binds -- that's until late 1998 also -- P&G must pay rates 1,640 basis points (16.40%) above
the base rate specified by the swap.

Treasurer Mains left P&G last September. CEO Edwin Artzt, a man of a well-known and no doubt
recently exercised temper, has called the swaps "a violation of the company's policy against
speculative financial transactions" and banned all leveraged swaps henceforth. Hans Stoll, a finance
professor and derivatives expert at Vanderbilt University, says the swaps are simply "not something
that a corporation that manufactures things should be involved in." Imagine, in fact, an investor who
bought P&G stock in early 1994. He would have thought he was buying soap, cosmetics, and a few
cups of coffee. But wedding rings?

It is not yet clear what role tapes may play in the litigation between P&G and Bankers Trust.
Amending its lawsuit recently to include the wedding-band swap, P&G said that in the process of
legal discovery it had secured tapes from Bankers Trust that "confimed" P&G's belief that it had
been misled when entering into that swap. But were this another instance of a smoking-gun tape,
Bankers would surely have settled, and it has shown no inclination to do that.

More tapes, more trouble

There is one other derivatives-troubled company that appears to have reaped a tape bonus: Federal
Paper Board, a Montvale, New Jersey, company of Fortune 500 size. Last spring Federal emerged
as one of several companies caught in a change that required certain highly leveraged derivatives to
be shifted from "accrual accounting," which allows the gradual recognition of gains and losses, to
"mark-to-market accounting," which requires prompt and full recognition. The change caused

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Federal to restate its 1993 profits, reducing these from $20.8 million to $6.4 million, and to begin
taking mark-to-market losses in 1994 as well.

But recently it became clear that Federal was enswirled in other derivatives dramatics besides. In
December the company announced that two foreign currency contracts written with Bankers Trust
had been canceled, a move that resulted in a $12 million gain for Federal. Both sides avoided further
explanations. But Fortune has learned from someone close to the situation that Bankers found "a
Gibson-like interlude" in taped conversations about Federal, which probably explains the settlement.

If that took care of one derivatives problem, Bankers has plenty of others. It acknowledged as much
in January by making special provisions for $423 million that it was owed on derivatives. It
reclassified these debts as receivables in the loan account and started carrying them on a "cash"
basis, a designation meaning that Bankers will book interest on the loans only when it is actually
paid. Right after making that move, Bankers charged off $72 million of these debts to its reserve for
credit losses, thereby treating these as uncollectible. The remaining $351 million, says Bankers,
sweeps in both P&G and other leveraged contracts that "likely will not perform." These could, for
example, include swaps that Bankers entered into with Air Products & Chemicals (APD), which
announced large derivatives losses in the middle of last year and is believed to be still negotiating
with Bankers about their disposition.

The current state of the derivatives market may be suggested by the 1994 results that Bankers
reported for the business it calls "client financial risk management." This operation had a splendid
first quarter, earning $114 million. After that, things went south. By the fourth quarter, with the papers
full of derivatives headlines and the financial markets jumpy, earnings were down to only $28 million.
For the full year, this business had profits of $259 million against $336 million earned in 1993.
Another 1994 casualty was Bankers' stock. The price fell from a February all-time high of $85 to a
December low of $55. Recently the stock was about $63.

In the midst of this trouble, one of Bankers' competitors, Citicorp, ran an ad containing a definite dig:
"You expect derivatives to solve problems, not create them." Asked about that ad, Bankers' Sanford
looks pained, but says: "Well, they can do whatever they want." In January, Bankers itself ran
multipaged year-end ads that focused on its skills in another part of its business, investment
banking. But the ads ended with an admission of problems with leveraged derivatives. Bankers said
it was both taking a "critical look" at its procedures and reaffirming its commitment to
"uncompromising standards." Then came a wind-up mea culpa: "The loss of even one client is a
stinging lesson. Lesson learned."

The future of derivatives is an uncertain matter, depending partly on whether the subject is
leveraged derivatives or all others. In general, says Sanford, the use of derivatives will grow. He
even sees the misadventures of the past year as having had a salutary effect, in the sense that
many CEOs, learning about derivatives for the first time, came to understand their "positive effects."
Asked for names of CEOs who might be representative of that breed, Sanford declines to give any:
"Nobody's going to come out and say anything publicly, because they get skewered by the press
and everybody else. You know, 'So-and-so's in derivatives.' " Fortune itself ran into evasions as it

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called companies to inquire what they were doing in derivatives. You would have thought we'd asked
about incest.

On the other hand, it is possible to find burn victims who will themselves deliver testimonials to the
matches that got them. Listen to P&G boss Artzt: "Straightforward derivatives -- or, as the financial
community calls them, plain vanillas -- are a very effective way of managing interest rates and
foreign exposures. So we plan to continue using them." Most regulators seem to agree with his view:
It is the rare regulatory speech that does not stress the risk management benefits that derivatives

Leveraged derivatives are a subject that regulators find harder to address, partly because they do
not really wish to arbitrate the difficult question of what's risk management and what's speculation.
Said Fed Chairman Greenspan at the January hearings: " 'Speculative' is a very fuzzy term."

In the end, leveraged derivatives may fall of their own weight. The commotion of the past year has,
for the moment, made them a drug on the market. Many boards have indeed banned their use. In
addition, the change last year in which mark-to-market accounting began to be required for highly
leveraged contracts is itself a turnoff. Many companies despise mark-to-market accounting and will
steer clear of those leveraged dudes if they come packing that kind of baggage.

The next question, though, is whether "mildly leveraged" derivatives will somehow be forced into the
same mold. Many regional banks, among them Banc One and PNC Bank Corp. (PNC), manage
their interest rate risk by entering into contracts called "index amortizing swaps." These swaps
include a gentle form of option and are therefore considered to be mildly leveraged. Normally,
options must be marked to market, but these instruments have so far escaped that treatment. A
change would be important. Based on information provided in footnotes to the banks' financial
statements, it is clear that a switch to mark-to-market accounting would force many of these low-
leverage derivatives players to recognize significant losses on their positions. So, is an accounting
change coming? Says John T. Smith, head of Deloitte & Touche's financial instruments research
group: "You just can't tell. But, in my opinion, it should. An option is an option, and I can't see why
you should give the mild ones special treatment."

That's one derivatives surprise that might materialize, and there will surely be others. It would be
reassuring to think that regulators could anticipate all the shocks that derivatives could deliver and
minimize their impact. But the financial world, and especially its derivatives component, moves so
fast that total foresight just isn't possible. One bank regulator understanding that well is Douglas
Harris, senior deputy comptroller for capital markets at the Office of the Comptroller of the Currency
and formerly a lawyer in the derivatives operation of dealer J.P. Morgan. Harris was brought into the
OCC specifically to build up its expertise in derivatives, and he has been an important figure in their
regulation. But he concedes a timing problem: "From the day I got here, I felt I was falling behind
what was going on in the market. That doesn't mean we can't supervise. It just means we're always
running to keep up."

Given the range of complications that derivatives present, outside directors cannot possibly achieve
close communion with the contracts their companies hold. Most chief executives won't master the

Tap Dancing to Work Page 169

game, either. In the end, the choice of what risks to hedge, what derivatives to employ in doing it,
and how to draw the bright line between risk management and speculation will be largely left to
financial people down the corridor -- some of whom, recent train wrecks notwithstanding, may think
of themselves as running a profit center. And on the other end of their phones will be derivatives
salespeople trying to sell the latest innovation, which assuredly will not be a plain-vanilla hedge.

It's not a particularly cheerful picture -- not for a problem as big as derivatives. So maybe what we
need is new thinking, a fresh approach, a suggestion so radical it goes off the page. Here's one:
Warren E. Buffett, chairman of Berkshire Hathaway (BRKA), says he'd deal with derivatives by
requiring every CEO to affirm in his annual report that he understands each derivatives contract his
company has entered into. Says Buffett: "Put that in, and I suspect you'll fix up just about every
problem that exists." In a market that seems to thrive on complexity and obfuscation, such a solution
won't happen. It's too simple. But he's right.

Posted in: Berkshire Hathaway, Tap Dancing to Work, Warren Buffett


Why Warren Buffett's betting big on

American Express
November 21, 2012: 11:30 AM ET

Email Print

Though losing market share, the company - and its famous

green card - has one thing still going for it: the brand.
By Linda Grant

This story is from the October 30, 1995 issue of Fortune. It is the full text of an article excerpted
in Tap Dancing to Work: Warren Buffett on Practically Everything, 1966-2012, a Fortune
Magazine book, collected and expanded by Carol Loomis.

Tap Dancing to Work Page 170

Amex CEO Harvey Golub sees a bright future for the Amex brand: Nestled in his elegant
quarters overlooking New York harbor, the CEO plot his company's comeback. He can view
Ellis Island, where his father landed in 1907.

FORTUNE -- Warren Buffett loves to tell a parable about the stock market's irrationality. It was
1963, and a scandal involving fake inventories of salad oil at a small subsidiary of American
Express drove down the price of Amex shares. How bad a problem was this? To find out, Buffett
spent an evening with the cashier at Ross's Steak House in Omaha seeing if people would stop
using their green cards. The scandal didn't seem to give any of the diners indigestion, so Buffett
seized the opportunity to buy 5% of the company for $13 million. He later sold his holding for a
$20 million profit.

Now Buffett hopes to relive the story -- with much larger numbers. Over the past few years the
CEO of Berkshire Hathaway (BRKA) has accumulated more than 49 million shares of American
Express (AXP), a 10.1% stake. Its value, about $2.2 billion, makes it one of Buffett's largest
investments, along with Coca-Cola (KO), Gillette, and Capital Cities/ABC. Once again he thinks
Wall Street is irrationally down on Amex stock. The trouble this time is not salad oil but a long
and well-publicized catalogue of strife: A nearly dysfunctional management team led by James
Robinson III damaged the brand in the early 1990s; his grand strategy to build a financial
supermarket fell like a house of cards, with Amex's Shearson Lehman brokerage subsidiary
eating up $4 billion in capital before being sold last year. More recently the tarnished American
Express card has been losing market share to Visa (V) and MasterCard (MA) as Amex's
principal consumer benefit -- prestige -- becomes a tougher sell. And the company's international
business, say analysts, is in the doldrums.

Always the patient investor, Buffett -- worth $14.2 billion at last count -- believes the latest
troubles are little more than a distraction. What he likes is exactly what has made him rich
before: a mighty brand coupled with a healthy cash flow. After all, American Express, according
to London marketing group Interbrand, is still one of the ten most-recognized brands in the

Tap Dancing to Work Page 171

world. Buffett believes the name remains "synonymous with financial integrity and money
substitutes around the world." As he explained to Berkshire Hathaway shareholders at last
spring's annual meeting: "By far the most important factor in [Amex's] future for a great many
years to come will be the credit card. We think American Express's management thinks well
about ... how to keep the card special." Buffett probably isn't particularly concerned about the
company's loss of market share. More likely, he's gambling that Amex, even if it fails to grow
dramatically, will become a very profitable niche player in the card market.

But if American Express is to fulfill Buffett's expectations, it will have to breathe new life into
its brand -- no easy task. The big question is whether Harvey Golub, who became CEO in 1993
after the board booted Robinson, is up to the job. He came to Amex from McKinsey & Co. and
has done a sterling job doing what consultants do -- cutting costs and shedding money-losing
divisions like Shearson Lehman. He imposed discipline on Amex's free-spending ways by
cutting a draconian $1.6 billion out of gross operating costs. Amex, with 1994 revenues of $15.6
billion (No. 55 on the Fortune 500), saw operating profits grow 18% last year. Since Buffett
started heavily buying the stock over the past year, it has risen -- thanks mostly to the cost
cutting -- from $25 a share to a recent $44. (For more on Buffett's investing style, see "How
Buffett Rated Amex a Buy," p. 129, Tap Dancing to Work.)

"American Express has the best and most

loaded-up battleships," says Salomon Brothers analyst Thomas Facciola: "Now it's a question of
whether the company can hit its targets." The answer is not at all clear. In the highly competitive
credit card market, which includes Visa and MasterCard, American Express is launching salvos
of new cards like Optima True Grace as well as ones aimed at students. But so far critics find
Amex's new credit cards ho-hum, modest successes that seem too little too late. The company,
they say, needs to wow the market with a sizzling hit like AT&T's Universal card or GM's (GM)
5% rebate card. Argues H. Eugene Lockhart, MasterCard CEO and one of Golub's biggest rivals:
"Will Golub ever achieve the growth rates that we and Visa are achieving now? I really doubt it
because of the basic core proposition. We offer better value to the customer than they do."

Seated behind a gleaming cherry-wood conference table on the 51st floor of his company's
baronial headquarters in Manhattan's World Financial Center, Golub puffs on a Benson &
Hedges cigarette and sips coffee from a mug promoting his company's PARTNERSHIPS WITH

Tap Dancing to Work Page 172

SUPERMARKETS. This day he comes off as a taciturn man, given to monosyllabic answers and
long pauses. During this interview with Fortune he displayed no excitement about his campaign
to resuscitate Amex.

Golub is a classic McKinsey consultant, a brilliant analyst who, as he has proved, knows how to
restructure a broken business. But that doesn't mean he knows how to inspire, revitalize, and
grow one profitably. At IBM (IBM), CEO Louis Gerstner, also a McKinsey alumnus (and former
Amex president), has done a skilled job cutting costs but now faces a similar dilemma in making
Big Blue grow. At Westinghouse, yet another McKinseyite, Michael Jordan, has so far failed to
get a troubled company rolling.

And that could be a problem. Golub needs to transform a slow-moving, arrogant American
Express culture into one that more closely resembles those of its competitors: gung-ho,
innovative, and fast moving. Over the years, Amex acquired a reputation for being a bear to
work with. You may recall the Boston Fee Party, when one restaurateur, upset about the high
fees Amex was charging, stuck a chef's knife through an Amex green card, an event that made
national TV. In another instance, AT&T (T), American Airlines, and others approached the
company with offers to issue joint cards with nifty perks for customers, but Amex management
haughtily turned them down. Says Golub: "We should have seen what was happening, but we let
success blind us. We were inflexible. We were arrogant. We were dreaming."

Yet Golub can't readily explain his antidote. When asked whether arrogance is still a problem at
Amex, the portly 56-year-old with blue eyes blazing behind wire-rim glasses responded as
follows: "You want to have an organization that is humble and proud, that is confident but not
arrogant, is confident but not self-delusional. So it's a fine line, and I'm sure that to some people
what may be viewed as confidence comes across as arrogance. To others it comes across as
humility. If we had everybody saying we're not arrogant, my guess is we would be servile."

Tap Dancing to Work Page 173

The vice-chairman at the 100-year-old Paris office: Chuck Farr, pictured here on Rue Scribe,
near the Paris Opera, oversees traveler's checks, the corporate card, and electronic banking.

Even if his strategy is on target, little in Golub's past suggests he has the charisma to rally the
troops. In 1967 he joined McKinsey, where he stayed for 14 years, save for a three-year stint
running a New Jersey trucking firm. His attempt to grow that company never got off the ground.
Golub left, he says, over a strategy disagreement. The business later went bust.

Golub's entree to Amex was through his work at McKinsey, which included advising Amex's
Travel Related Services business. He championed quality programs like replacing lost cards
within 24 hours. In 1984 he took a job at IDS, American Express's personal finance division,
where he gets much credit for improving the sales force and customer service.

But even Golub's fans wonder whether he has the right stuff to take on as big a challenge as
Amex. Colleagues admire his blunt, direct style, feeling he's not afraid to face the truth, no
matter how bad -- a rare quality in a CEO. At the same time, he is not seen as what anyone
would call a forceful leader. Says a former Amex manager who wished not to be named:
"Harvey is regarded as very tough. I've never heard anyone say that they like him. Never heard
anyone say they would lay down their life for him. No one at Amex waxes about what a great
guy he is. He's basically 'In Your Face Harvey,' just like those awful pictures of him where he's
always leaning forward in his suspenders looking like he's about to bite your face off."

Inside the company, Golub is both feared and respected. Basically, he has three different styles:

The Brooder. In the first he becomes silent and angry looking, and doesn't say anything. He just
conveys unhappiness.

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The Attacker. In the second he gets angry. Says a former top executive who has left the
company: "I was in a budget review with him where he attacked people at the most basic level.
He yelled at them, 'Why the hell should we pay all this money when nothing happens? All you
do is cause problems, you aren't even trying, this is the first area I should cut.' "

The Consultant. His third is the highly analytical consultant who cross-examines people. It's an
acceptable style that can work, but only when accompanied with reinforcing actions like
recognizing people and thanking them. Says the ex-employee: "I have no knowledge of his ever
doing that."

Vice chairman Kenneth Chenault, on the other hand, is well liked and trusted by employees.
Before coming to Amex, he worked for two years as a consultant at Bain & Co. His sunny
personality and marketer's savvy are welcome contrasts to Golub's gloomy persona. But when
Golub's friend George "Chuck" Farr left McKinsey last May to join the CEO's office as another
vice chairman, employees wondered why. They questioned whether another consultant was what
Amex needed.

No matter what kind of leader Golub turns out to be, most everyone in the industry agrees that
his strategy to revive the brand basically makes sense. Says one consultant: "What I've picked up
working there is that compared with the old regime, people now have a clear sense of where they
are going."

Golub is convinced that Amex can clamber back to its former preeminence by adhering to a
starkly simple statement of strategy: "To become the world's most respected service brand."
Whether that turns out to be a rallying cry or just hubris, it has so far provided Golub & Co. with
a road map for revival. Says Farr: "The brand is the engine that will drive the business. If we
can't use the brand, we won't be in the business." Clearly words that would comfort Buffett.

Chenault leads the drive to beef up credit cards: If he plays his hand right, Amex's affable vice
chairman will expand the brand into many new niche markets around the world.

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If the brand is the strategy, the heart of the brand remains the American Express card. Amex
today consists of two main parts: Travel Related Services, including cards, traveler's checks, and
a travel agency business, which last year contributed 72% of revenues and 65% of pretax
earnings, and American Express Financial Advisors (formerly IDS), which sells mutual funds
and other financial products and accounted for 23% of revenues and 29% of earnings.

The good news for Golub is that the card market is booming. Credit cards -- think of them as a
pawnshop for yuppies -- have been a hugely profitable business. Last year Americans tallied up
$611 billion in card charges; that's $2,336 for every man, woman, and child, and 23% more than
the year before. This $611 billion represents only 10% of total consumer spending, so the
industry still has room to grow.

But American Express has mostly missed out on the best part, the business of financing credit
card loans. Its most obvious difference from such competitors as Visa and MasterCard is that you
must pay the entire balance each month. The competition's business is astonishingly lucrative
because of an equally astonishing spread; issuers today borrow at about 7%, then lend those
funds to cardholders at around 17%. Various bells and whistles like below-market teaser rates,
insurance, frequent-flier miles, and cash rebates eat into some of that lucre. Issuers must also
invest substantial sums in technology to keep track of all that business.

Why are consumers willing to pay an ungodly 17% to borrow money for things like White Sox
tickets and a night out at a Sizzler? This anomaly so mystifies University of Maryland economist
Lawrence Ausubel that he recently presented a paper on the subject to the National Bureau of
Economic Research. His conclusion: Issuers can get away with charging such steep interest rates
because consumers underestimate the amount they'll borrow. And once cardholders do borrow,
rose-colored glasses of denial prevent them from acknowledging how much debt they've
assumed. In a 1992 study, Ausubel reports, borrowers claimed to owe cumulatively $70 billion
in debt when in truth they owed $156 billion.

The bizarre consumer behavior doesn't stop there. Some people, not wanting to hassle with the
paperwork, don't bother to trade in their high-interest credit card for one with a lower rate. Others
just don't think about the financial ramifications. A woman in Westchester County, New York,
chalked up $4,000 on her Visa last month. Though she could afford to pay off the whole thing,
she cut a check for only $1,000. As she explains, "I wanted to keep a high balance so I wouldn't
be tempted to run up my card again." Understand? In any case, lucky Visa collects a handsome
17% annual interest on her balance.

This has been one great party that Amex came late to -- and now the party looks to be ending.
Michael Auriemma, a credit card consultant at a Westbury, New York, firm that bears his name,
thinks commoditization in the card business is only a matter of time, irrational cardholders
notwithstanding. The industry is shifting to a buyer's market as the 5,000 financial institutions
that issue Visas, MasterCards, and others scramble to grab customers by eliminating annual fees
and offering attractive initial interest rates. In the U.S. an incomprehensible 2.4 billion
preapproved credit card solicitations were mailed last year, enough for every family to receive
two a month.

Tap Dancing to Work Page 176

The landscape is becoming so treacherous that among the fastest-growing issuers today are four
barely known low-cost Visa/ MasterCard credit card companies: Advanta, Capital One, First
USA, and MBNA (For more, click here).

Commoditization is bad news for Amex because the American Express card has always been
marketed as a high-fee, high-prestige item -- $55 a year for a green card, $300 for a top-end
platinum. Although its corporate card business remains strong, many individuals are beginning to
doubt whether this privilege still merits a premium. Amex's share of the U.S. card market,
measured by dollar volume, has dropped from nearly 25% in 1990 to 16% this year, behind Visa
(49%) and MasterCard (27%). Explains MasterCard's Lockhart: "The consumer today simply
doesn't see the need to pay fees for a card that gives them no greater functionality than anything
we or Visa would give them."

Golub's challenge, then, is one of the trickiest in management -- to make his brand all things to
all people. "The company thinks of its brand as homogeneous," says Thomas O. Jones, a former
Amex executive: "But it's not. It is one brand internationally for the business traveler, one for the
general public that remembers Karl Malden and 'Don't leave home without it,' and one for the
merchants who accept it. It is a huge asset that needs to be watered properly, but I think the
company could be doing a much better job."

American Express targets college campuses: An American University student in Washington,

D.C., uses a new card that electronically stores a value of $100. With it he can buy books or

Priority No. 1 is hanging on to its high-profit, high-rolling customers. Amex cardholders charge
on average $4,000 a year, vs. $1,500 for Visa and MasterCard, and Golub wants to offer them
more value through special services. American Express Platinum Card members, for instance,
now can get calls reminding them to buy a present for their mother's birthday -- which they can,
by the way, charge. He also wants to capitalize on the company's vast database of information
about customer purchases and retailers' sales. The company's goal is to glean from these records
individual tastes such as, say, a customer's predilection for Italian food. Armed with the
knowledge, Amex might run a promotion that offers the cardholder a free bottle of wine at a new
Italian restaurant opening in his neighborhood. Such customized rewards won't be widely
available until next year.

Tap Dancing to Work Page 177

When it comes to polishing the card's carriage trade image, Golub also needs to work on what
marketers call "the experience." This is the strategy that has helped companies like Disney (DIS)
and McDonald's (MCD) flourish. Disneyland, for example, is more than a theme park. It
provides a certain type of enjoyable and predictable experience for its little Mouseketeers.
Similarly, McDonald's is not just any fast-food restaurant. Diners know what to expect under the
golden arches. Ask a McDonald's executive what the company provides, and he'll give you the
official answer: "a consistent, family-oriented, convenient hamburger experience." Or as a Coke
(KO) exec would say: "a simple moment of refreshment."

In American Express's world, the card is supposed to offer a sense of financial security and
cachet -- an announcement that when you use this card, you've made it in the world. For years
that's what has made American Express cards and traveler's checks successful -- both products
projected the comforting image of Amex taking care of its members whether at home or
traveling abroad. Studies show that some 70% of cardholders feel that emotion is as important as
price when choosing a card. Some people believe that whipping out an American Express card
will impress a client -- will announce they've arrived.

To his credit, Golub is working hard to improve the Amex experience by making sure members
aren't treated like lepers when they pull out their platinum cards. By lowering merchants' fees
and making payments to restaurants and stores more promptly, Golub has multiplied the number
of places that accept his cards. In addition to the usual four-star restaurants and resorts,
consumers can now use American Express cards to buy plebeian items such as stamps at the post
office, eggs at ShopRite, socks at Kmart, a cup of coffee at Starbucks, and a movie at
Blockbuster. But the company still has a long way to go to build up the Amex experience
overseas, especially in Europe, where the card is not nearly as widely accepted for shopping as
Visa and MasterCard.

Just rebuilding the traditional Amex aura will be tough enough, but Golub must do it while
moving downscale to find more cardholders. Observes David Aaker, a U.C. Berkeley marketing
professor and author of the soon-to-be-published book Building Strong Brands: "When you
move down-market you run the risk of losing what you had, and then you don't have anything."
Adds Atlanta credit card consultant Bruce Brittain: "Can you maintain an upscale image while
you go after a downscale market?"

Amex plans to capture the downscale market by going mano a mano against Visa and
MasterCard with its Optima card. As with Visa and MasterCard, you must pay your Optima
balance each month or pay interest. Optima is what is known in marketing circles as a subbrand,
which means it capitalizes on the brand name but has a distinct identity of its own. That's why
the Optima card is blue, not green, and has a different name, though American Express is printed
prominently on the card. Says Aaker: "You use a subbrand to represent the mass market, while
still keeping your prestige brand. The problem is not losing the overall distinction of the brand."
It could happen. If the green-, gold-, and platinum-card members sense the brand is being
debased with Optima, they'll flee. Conversely, a brand with a history of snob appeal isn't
necessarily an easy sell to the masses in an increasingly egalitarian age.

Tap Dancing to Work Page 178

Amex knows it is plunging into a competitive inferno and is working hard to boost its appeal
with new services. Last year, for example, Amex successfully introduced a variation on Optima
called Optima True Grace. This card starts running the interest meter only after a grace period of
25 days has passed from the date of a purchase. True Grace was snatched up by an estimated 1.4
million users, about twice as many as the company says it predicted, in part because of an
effective $40 million ad campaign featuring that purveyor of Waspy lifestyles, magazine
publisher-cover model Martha Stewart. This summer Amex sewed up an important deal by
winning the right to issue a new Optima credit card jointly with Delta Air Lines (DAL), the last
big airline without its own card. The launch of Delta SkyMiles Optima is a coup for Amex, says
Card News editor Lurdes Abruscato, because at least 13 other competitors, including Chemical
Bank and Wachovia, lobbied hard for it.

Today, Amex is testing all manner of combinations -- cards with rebates, low rates, no fees, and
a card targeted at students. Among them is a so-called stored-value card, a handy plastic
substitute for quarters and dollar bills in various denominations, say, $25, $50, and $100. Armed
with this plastic, college students can call home, buy meals at their cafeteria, or purchase books,
and New Yorkers can pay for washing clothes in apartment laundry facilities. It's a great niche
for Amex since the company plans to invest the float, i.e., funds paid for the card but not yet
spent. Traveler's checks are such a stored-value product, and currently Amex carries a hefty $6.7
billion of these free funds on its balance sheet.

Is Golub up to bringing all this together? He thinks so. As he made clear in a recent talk to
students at New York University's Stern School: "To succeed, I believe an organization has to
change and adjust before it is forced to do so by external forces. It must reinvent itself and
become the very company that could put it out of business before somebody else does."

No matter how tough the challenges that lie ahead for Amex, it's rarely wise to bet against
Warren Buffett. After all, he has wagered on strong brands like Coke and Gillette and made a
bundle. He also invested successfully in auto insurer Geico, which, like Amex, has a strong cash
flow. When Buffett comes up aces, it's usually because he's backing a strong management hand.
What's hard to see this time around is how a bunch of consultants can rake in the pot in a truly
cutthroat game.

Why Warren Buffett's betting big on

American Express
November 21, 2012: 11:30 AM ET

Tap Dancing to Work Page 179

Email Print

Though losing market share, the company - and its famous

green card - has one thing still going for it: the brand.
By Linda Grant

This story is from the October 30, 1995 issue of Fortune. It is the full text of an article excerpted
in Tap Dancing to Work: Warren Buffett on Practically Everything, 1966-2012, a Fortune
Magazine book, collected and expanded by Carol Loomis.

Amex CEO Harvey Golub sees a bright future for the Amex brand: Nestled in his elegant
quarters overlooking New York harbor, the CEO plot his company's comeback. He can view
Ellis Island, where his father landed in 1907.

FORTUNE -- Warren Buffett loves to tell a parable about the stock market's irrationality. It was
1963, and a scandal involving fake inventories of salad oil at a small subsidiary of American
Express drove down the price of Amex shares. How bad a problem was this? To find out, Buffett
spent an evening with the cashier at Ross's Steak House in Omaha seeing if people would stop
using their green cards. The scandal didn't seem to give any of the diners indigestion, so Buffett
seized the opportunity to buy 5% of the company for $13 million. He later sold his holding for a
$20 million profit.

Now Buffett hopes to relive the story -- with much larger numbers. Over the past few years the
CEO of Berkshire Hathaway (BRKA) has accumulated more than 49 million shares of American
Express (AXP), a 10.1% stake. Its value, about $2.2 billion, makes it one of Buffett's largest
investments, along with Coca-Cola (KO), Gillette, and Capital Cities/ABC. Once again he thinks
Wall Street is irrationally down on Amex stock. The trouble this time is not salad oil but a long

Tap Dancing to Work Page 180

and well-publicized catalogue of strife: A nearly dysfunctional management team led by James
Robinson III damaged the brand in the early 1990s; his grand strategy to build a financial
supermarket fell like a house of cards, with Amex's Shearson Lehman brokerage subsidiary
eating up $4 billion in capital before being sold last year. More recently the tarnished American
Express card has been losing market share to Visa (V) and MasterCard (MA) as Amex's
principal consumer benefit -- prestige -- becomes a tougher sell. And the company's international
business, say analysts, is in the doldrums.

Always the patient investor, Buffett -- worth $14.2 billion at last count -- believes the latest
troubles are little more than a distraction. What he likes is exactly what has made him rich
before: a mighty brand coupled with a healthy cash flow. After all, American Express, according
to London marketing group Interbrand, is still one of the ten most-recognized brands in the
world. Buffett believes the name remains "synonymous with financial integrity and money
substitutes around the world." As he explained to Berkshire Hathaway shareholders at last
spring's annual meeting: "By far the most important factor in [Amex's] future for a great many
years to come will be the credit card. We think American Express's management thinks well
about ... how to keep the card special." Buffett probably isn't particularly concerned about the
company's loss of market share. More likely, he's gambling that Amex, even if it fails to grow
dramatically, will become a very profitable niche player in the card market.

But if American Express is to fulfill Buffett's expectations, it will have to breathe new life into
its brand -- no easy task. The big question is whether Harvey Golub, who became CEO in 1993
after the board booted Robinson, is up to the job. He came to Amex from McKinsey & Co. and
has done a sterling job doing what consultants do -- cutting costs and shedding money-losing
divisions like Shearson Lehman. He imposed discipline on Amex's free-spending ways by
cutting a draconian $1.6 billion out of gross operating costs. Amex, with 1994 revenues of $15.6
billion (No. 55 on the Fortune 500), saw operating profits grow 18% last year. Since Buffett
started heavily buying the stock over the past year, it has risen -- thanks mostly to the cost
cutting -- from $25 a share to a recent $44. (For more on Buffett's investing style, see "How
Buffett Rated Amex a Buy," p. 129, Tap Dancing to Work.)

"American Express has the best and most

loaded-up battleships," says Salomon Brothers analyst Thomas Facciola: "Now it's a question of

Tap Dancing to Work Page 181

whether the company can hit its targets." The answer is not at all clear. In the highly competitive
credit card market, which includes Visa and MasterCard, American Express is launching salvos
of new cards like Optima True Grace as well as ones aimed at students. But so far critics find
Amex's new credit cards ho-hum, modest successes that seem too little too late. The company,
they say, needs to wow the market with a sizzling hit like AT&T's Universal card or GM's (GM)
5% rebate card. Argues H. Eugene Lockhart, MasterCard CEO and one of Golub's biggest rivals:
"Will Golub ever achieve the growth rates that we and Visa are achieving now? I really doubt it
because of the basic core proposition. We offer better value to the customer than they do."

Seated behind a gleaming cherry-wood conference table on the 51st floor of his company's
baronial headquarters in Manhattan's World Financial Center, Golub puffs on a Benson &
Hedges cigarette and sips coffee from a mug promoting his company's PARTNERSHIPS WITH
SUPERMARKETS. This day he comes off as a taciturn man, given to monosyllabic answers and
long pauses. During this interview with Fortune he displayed no excitement about his campaign
to resuscitate Amex.

Golub is a classic McKinsey consultant, a brilliant analyst who, as he has proved, knows how to
restructure a broken business. But that doesn't mean he knows how to inspire, revitalize, and
grow one profitably. At IBM (IBM), CEO Louis Gerstner, also a McKinsey alumnus (and former
Amex president), has done a skilled job cutting costs but now faces a similar dilemma in making
Big Blue grow. At Westinghouse, yet another McKinseyite, Michael Jordan, has so far failed to
get a troubled company rolling.

And that could be a problem. Golub needs to transform a slow-moving, arrogant American
Express culture into one that more closely resembles those of its competitors: gung-ho,
innovative, and fast moving. Over the years, Amex acquired a reputation for being a bear to
work with. You may recall the Boston Fee Party, when one restaurateur, upset about the high
fees Amex was charging, stuck a chef's knife through an Amex green card, an event that made
national TV. In another instance, AT&T (T), American Airlines, and others approached the
company with offers to issue joint cards with nifty perks for customers, but Amex management
haughtily turned them down. Says Golub: "We should have seen what was happening, but we let
success blind us. We were inflexible. We were arrogant. We were dreaming."

Yet Golub can't readily explain his antidote. When asked whether arrogance is still a problem at
Amex, the portly 56-year-old with blue eyes blazing behind wire-rim glasses responded as
follows: "You want to have an organization that is humble and proud, that is confident but not
arrogant, is confident but not self-delusional. So it's a fine line, and I'm sure that to some people
what may be viewed as confidence comes across as arrogance. To others it comes across as
humility. If we had everybody saying we're not arrogant, my guess is we would be servile."

Tap Dancing to Work Page 182

The vice-chairman at the 100-year-old Paris office: Chuck Farr, pictured here on Rue Scribe,
near the Paris Opera, oversees traveler's checks, the corporate card, and electronic banking.

Even if his strategy is on target, little in Golub's past suggests he has the charisma to rally the
troops. In 1967 he joined McKinsey, where he stayed for 14 years, save for a three-year stint
running a New Jersey trucking firm. His attempt to grow that company never got off the ground.
Golub left, he says, over a strategy disagreement. The business later went bust.

Golub's entree to Amex was through his work at McKinsey, which included advising Amex's
Travel Related Services business. He championed quality programs like replacing lost cards
within 24 hours. In 1984 he took a job at IDS, American Express's personal finance division,
where he gets much credit for improving the sales force and customer service.

But even Golub's fans wonder whether he has the right stuff to take on as big a challenge as
Amex. Colleagues admire his blunt, direct style, feeling he's not afraid to face the truth, no
matter how bad -- a rare quality in a CEO. At the same time, he is not seen as what anyone
would call a forceful leader. Says a former Amex manager who wished not to be named:
"Harvey is regarded as very tough. I've never heard anyone say that they like him. Never heard
anyone say they would lay down their life for him. No one at Amex waxes about what a great
guy he is. He's basically 'In Your Face Harvey,' just like those awful pictures of him where he's
always leaning forward in his suspenders looking like he's about to bite your face off."

Inside the company, Golub is both feared and respected. Basically, he has three different styles:

The Brooder. In the first he becomes silent and angry looking, and doesn't say anything. He just
conveys unhappiness.

Tap Dancing to Work Page 183

The Attacker. In the second he gets angry. Says a former top executive who has left the
company: "I was in a budget review with him where he attacked people at the most basic level.
He yelled at them, 'Why the hell should we pay all this money when nothing happens? All you
do is cause problems, you aren't even trying, this is the first area I should cut.' "

The Consultant. His third is the highly analytical consultant who cross-examines people. It's an
acceptable style that can work, but only when accompanied with reinforcing actions like
recognizing people and thanking them. Says the ex-employee: "I have no knowledge of his ever
doing that."

Vice chairman Kenneth Chenault, on the other hand, is well liked and trusted by employees.
Before coming to Amex, he worked for two years as a consultant at Bain & Co. His sunny
personality and marketer's savvy are welcome contrasts to Golub's gloomy persona. But when
Golub's friend George "Chuck" Farr left McKinsey last May to join the CEO's office as another
vice chairman, employees wondered why. They questioned whether another consultant was what
Amex needed.

No matter what kind of leader Golub turns out to be, most everyone in the industry agrees that
his strategy to revive the brand basically makes sense. Says one consultant: "What I've picked up
working there is that compared with the old regime, people now have a clear sense of where they
are going."

Golub is convinced that Amex can clamber back to its former preeminence by adhering to a
starkly simple statement of strategy: "To become the world's most respected service brand."
Whether that turns out to be a rallying cry or just hubris, it has so far provided Golub & Co. with
a road map for revival. Says Farr: "The brand is the engine that will drive the business. If we
can't use the brand, we won't be in the business." Clearly words that would comfort Buffett.

Chenault leads the drive to beef up credit cards: If he plays his hand right, Amex's affable vice
chairman will expand the brand into many new niche markets around the world.

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If the brand is the strategy, the heart of the brand remains the American Express card. Amex
today consists of two main parts: Travel Related Services, including cards, traveler's checks, and
a travel agency business, which last year contributed 72% of revenues and 65% of pretax
earnings, and American Express Financial Advisors (formerly IDS), which sells mutual funds
and other financial products and accounted for 23% of revenues and 29% of earnings.

The good news for Golub is that the card market is booming. Credit cards -- think of them as a
pawnshop for yuppies -- have been a hugely profitable business. Last year Americans tallied up
$611 billion in card charges; that's $2,336 for every man, woman, and child, and 23% more than
the year before. This $611 billion represents only 10% of total consumer spending, so the
industry still has room to grow.

But American Express has mostly missed out on the best part, the business of financing credit
card loans. Its most obvious difference from such competitors as Visa and MasterCard is that you
must pay the entire balance each month. The competition's business is astonishingly lucrative
because of an equally astonishing spread; issuers today borrow at about 7%, then lend those
funds to cardholders at around 17%. Various bells and whistles like below-market teaser rates,
insurance, frequent-flier miles, and cash rebates eat into some of that lucre. Issuers must also
invest substantial sums in technology to keep track of all that business.

Why are consumers willing to pay an ungodly 17% to borrow money for things like White Sox
tickets and a night out at a Sizzler? This anomaly so mystifies University of Maryland economist
Lawrence Ausubel that he recently presented a paper on the subject to the National Bureau of
Economic Research. His conclusion: Issuers can get away with charging such steep interest rates
because consumers underestimate the amount they'll borrow. And once cardholders do borrow,
rose-colored glasses of denial prevent them from acknowledging how much debt they've
assumed. In a 1992 study, Ausubel reports, borrowers claimed to owe cumulatively $70 billion
in debt when in truth they owed $156 billion.

The bizarre consumer behavior doesn't stop there. Some people, not wanting to hassle with the
paperwork, don't bother to trade in their high-interest credit card for one with a lower rate. Others
just don't think about the financial ramifications. A woman in Westchester County, New York,
chalked up $4,000 on her Visa last month. Though she could afford to pay off the whole thing,
she cut a check for only $1,000. As she explains, "I wanted to keep a high balance so I wouldn't
be tempted to run up my card again." Understand? In any case, lucky Visa collects a handsome
17% annual interest on her balance.

This has been one great party that Amex came late to -- and now the party looks to be ending.
Michael Auriemma, a credit card consultant at a Westbury, New York, firm that bears his name,
thinks commoditization in the card business is only a matter of time, irrational cardholders
notwithstanding. The industry is shifting to a buyer's market as the 5,000 financial institutions
that issue Visas, MasterCards, and others scramble to grab customers by eliminating annual fees
and offering attractive initial interest rates. In the U.S. an incomprehensible 2.4 billion
preapproved credit card solicitations were mailed last year, enough for every family to receive
two a month.

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The landscape is becoming so treacherous that among the fastest-growing issuers today are four
barely known low-cost Visa/ MasterCard credit card companies: Advanta, Capital One, First
USA, and MBNA (For more, click here).

Commoditization is bad news for Amex because the American Express card has always been
marketed as a high-fee, high-prestige item -- $55 a year for a green card, $300 for a top-end
platinum. Although its corporate card business remains strong, many individuals are beginning to
doubt whether this privilege still merits a premium. Amex's share of the U.S. card market,
measured by dollar volume, has dropped from nearly 25% in 1990 to 16% this year, behind Visa
(49%) and MasterCard (27%). Explains MasterCard's Lockhart: "The consumer today simply
doesn't see the need to pay fees for a card that gives them no greater functionality than anything
we or Visa would give them."

Golub's challenge, then, is one of the trickiest in management -- to make his brand all things to
all people. "The company thinks of its brand as homogeneous," says Thomas O. Jones, a former
Amex executive: "But it's not. It is one brand internationally for the business traveler, one for the
general public that remembers Karl Malden and 'Don't leave home without it,' and one for the
merchants who accept it. It is a huge asset that needs to be watered properly, but I think the
company could be doing a much better job."

American Express targets college campuses: An American University student in Washington,

D.C., uses a new card that electronically stores a value of $100. With it he can buy books or

Priority No. 1 is hanging on to its high-profit, high-rolling customers. Amex cardholders charge
on average $4,000 a year, vs. $1,500 for Visa and MasterCard, and Golub wants to offer them
more value through special services. American Express Platinum Card members, for instance,
now can get calls reminding them to buy a present for their mother's birthday -- which they can,
by the way, charge. He also wants to capitalize on the company's vast database of information
about customer purchases and retailers' sales. The company's goal is to glean from these records
individual tastes such as, say, a customer's predilection for Italian food. Armed with the
knowledge, Amex might run a promotion that offers the cardholder a free bottle of wine at a new
Italian restaurant opening in his neighborhood. Such customized rewards won't be widely
available until next year.

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When it comes to polishing the card's carriage trade image, Golub also needs to work on what
marketers call "the experience." This is the strategy that has helped companies like Disney (DIS)
and McDonald's (MCD) flourish. Disneyland, for example, is more than a theme park. It
provides a certain type of enjoyable and predictable experience for its little Mouseketeers.
Similarly, McDonald's is not just any fast-food restaurant. Diners know what to expect under the
golden arches. Ask a McDonald's executive what the company provides, and he'll give you the
official answer: "a consistent, family-oriented, convenient hamburger experience." Or as a Coke
(KO) exec would say: "a simple moment of refreshment."

In American Express's world, the card is supposed to offer a sense of financial security and
cachet -- an announcement that when you use this card, you've made it in the world. For years
that's what has made American Express cards and traveler's checks successful -- both products
projected the comforting image of Amex taking care of its members whether at home or
traveling abroad. Studies show that some 70% of cardholders feel that emotion is as important as
price when choosing a card. Some people believe that whipping out an American Express card
will impress a client -- will announce they've arrived.

To his credit, Golub is working hard to improve the Amex experience by making sure members
aren't treated like lepers when they pull out their platinum cards. By lowering merchants' fees
and making payments to restaurants and stores more promptly, Golub has multiplied the number
of places that accept his cards. In addition to the usual four-star restaurants and resorts,
consumers can now use American Express cards to buy plebeian items such as stamps at the post
office, eggs at ShopRite, socks at Kmart, a cup of coffee at Starbucks, and a movie at
Blockbuster. But the company still has a long way to go to build up the Amex experience
overseas, especially in Europe, where the card is not nearly as widely accepted for shopping as
Visa and MasterCard.

Just rebuilding the traditional Amex aura will be tough enough, but Golub must do it while
moving downscale to find more cardholders. Observes David Aaker, a U.C. Berkeley marketing
professor and author of the soon-to-be-published book Building Strong Brands: "When you
move down-market you run the risk of losing what you had, and then you don't have anything."
Adds Atlanta credit card consultant Bruce Brittain: "Can you maintain an upscale image while
you go after a downscale market?"

Amex plans to capture the downscale market by going mano a mano against Visa and
MasterCard with its Optima card. As with Visa and MasterCard, you must pay your Optima
balance each month or pay interest. Optima is what is known in marketing circles as a subbrand,
which means it capitalizes on the brand name but has a distinct identity of its own. That's why
the Optima card is blue, not green, and has a different name, though American Express is printed
prominently on the card. Says Aaker: "You use a subbrand to represent the mass market, while
still keeping your prestige brand. The problem is not losing the overall distinction of the brand."
It could happen. If the green-, gold-, and platinum-card members sense the brand is being
debased with Optima, they'll flee. Conversely, a brand with a history of snob appeal isn't
necessarily an easy sell to the masses in an increasingly egalitarian age.

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Amex knows it is plunging into a competitive inferno and is working hard to boost its appeal
with new services. Last year, for example, Amex successfully introduced a variation on Optima
called Optima True Grace. This card starts running the interest meter only after a grace period of
25 days has passed from the date of a purchase. True Grace was snatched up by an estimated 1.4
million users, about twice as many as the company says it predicted, in part because of an
effective $40 million ad campaign featuring that purveyor of Waspy lifestyles, magazine
publisher-cover model Martha Stewart. This summer Amex sewed up an important deal by
winning the right to issue a new Optima credit card jointly with Delta Air Lines (DAL), the last
big airline without its own card. The launch of Delta SkyMiles Optima is a coup for Amex, says
Card News editor Lurdes Abruscato, because at least 13 other competitors, including Chemical
Bank and Wachovia, lobbied hard for it.

Today, Amex is testing all manner of combinations -- cards with rebates, low rates, no fees, and
a card targeted at students. Among them is a so-called stored-value card, a handy plastic
substitute for quarters and dollar bills in various denominations, say, $25, $50, and $100. Armed
with this plastic, college students can call home, buy meals at their cafeteria, or purchase books,
and New Yorkers can pay for washing clothes in apartment laundry facilities. It's a great niche
for Amex since the company plans to invest the float, i.e., funds paid for the card but not yet
spent. Traveler's checks are such a stored-value product, and currently Amex carries a hefty $6.7
billion of these free funds on its balance sheet.

Is Golub up to bringing all this together? He thinks so. As he made clear in a recent talk to
students at New York University's Stern School: "To succeed, I believe an organization has to
change and adjust before it is forced to do so by external forces. It must reinvent itself and
become the very company that could put it out of business before somebody else does."

No matter how tough the challenges that lie ahead for Amex, it's rarely wise to bet against
Warren Buffett. After all, he has wagered on strong brands like Coke and Gillette and made a
bundle. He also invested successfully in auto insurer Geico, which, like Amex, has a strong cash
flow. When Buffett comes up aces, it's usually because he's backing a strong management hand.
What's hard to see this time around is how a bunch of consultants can rake in the pot in a truly
cutthroat game.


The 25 most powerful people in business

November 21, 2012: 11:28 AM ET

Email Print

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This story is from the August 11, 2003 issue of Fortune. It is the full text of an article excerpted in
Tap Dancing to Work: Warren Buffett on Practically Everything, 1966-2012, a Fortune
Magazine book, collected and expanded by Carol Loomis.

FORTUNE -- The golf course has been the stage for some
truly high-powered moments in business. Andrew Carnegie was on the links in 1901 when he
was persuaded to sell his empire to J.P. Morgan, creating the first billion-dollar corporation, U.S.
Steel. John D. Rockefeller was playing his personal 12-hole course when told of the Supreme
Court ruling that broke up Standard Oil. A game that took place in mid-July in Sun Valley,
Idaho, may not match those two games in historic import, but it may have set a new record for
aggregate economic might. The players included the CEO of the world's largest company, the
world's most successful investor, and the world's richest man. Picture all that raw clout piled into
one battery-powered cart, and you have the right visual to open this, Fortune's Power Issue.

Singling out "power" for a special issue of Fortune is a bit like Sports Illustrated devoting an
issue to "athletics." Power defines Fortune -- it's what we write about every issue, special or not.
Back in 1929, founder Henry Luce was even thinking of naming his new magazine Power.
While we're grateful he passed on that one (as well as Tycoon), Luce was onto something.
Business, like golf, isn't solely about power -- sinking those putts counts too -- but power is in
business's soul.

People acknowledge power's presence in ways we're not even aware of. Put two people in a
room, research by Steve Ellyson of Youngstown State University has found, and the less
powerful one seeks more eye contact while listening (See, I'm taking in everything you say, boss)
and less eye contact while speaking (I'm expressing my thoughts but am not a threat to you). The
more powerful one, other studies show, tends to smile less, sits in weirder positions, and does
more "steepling." Touching one's fingers together in a raised position -- Sherlock Holmes and
The Simpsons' Mr. Burns both do it -- turns out to be a dominance display that's most potent
"right at eye level," notes Ellyson, "so one person has to look through the other's hands."

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J.P. Morgan

It's difficult to look at Edward Steichen's 1903 portrait of J.P. Morgan and not think "power" and,
probably, "menace." The famous image, in which the most powerful businessman who ever lived
wields a penetrating scowl and what appears to be a gleaming dagger, is a photographic trompe
l'oeil: The dagger is the metal handle of his chair, the scowl a fleeting reaction to Steichen's
requests. Yet even knowledge of the illusion doesn't dilute its force. Here is Morgan -- a man
who controlled assets equal to two-thirds of the nation's output and stemmed a 1907 panic by
locking 50 bankers in his offices -- experienced as an elemental force, his gaze powerful enough
to part crowds.

But recognizing power is one thing. Ranking it is another. When Fortune set out to create a list
of the 25 most powerful people in business, our goal was simple: to provide a snapshot of who
controls the commanding heights of the American economy. Our definition of power was
straightforward: the ability to affect the behavior of other people -- whether in a company, an
industry, or the world at large. The simple part pretty much ended there. We soon came to
understand the four immutable laws of the quantification of power.

Law One. Power, like gravity, can't be observed directly. Only its effects can. If, for instance,
your corporate name is popularly used as a verb ("Have you Googled him yet?"), it's an
indication you have some power, but not proof positive. If it shows up in Eminem's lyrics ("I
watch TV/and Comcast cable"), you're getting closer. If you're able to get Jack Grubman's kid
into Manhattan's 92nd Street Y -- now we're in top 25 territory.

Law Two. Absolute power, though it may corrupt absolutely, doesn't exist in business. Instead,
everyone exerts power over someone else. The CEO who looks and acts like a captain of
industry often turns out to be a captive -- to Wall Street, to pensions, to lawyers, and especially
to the CEO's own workers. The power that subordinates hold over their bosses, notes West Point
leadership professor Col. Thomas Kolditz, is routinely underestimated. "I was interviewing Iraqi

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prisoners of war," he relates, "and most of them said that if their bosses had tried to make them
fight, they'd have shot them."

Law Three. Power flows from a variety of sources, as Samson (hair), Popeye (spinach), and
Mao (barrel of a gun) could have told us. There are those who are powerful among the Powerful
-- Rasputins, headhunters, and Herb Allens -- and those who change the behavior of the masses
(Starbucks' $3 coffee). There's the power of the disrupter -- the Napster that throws the game
board in the air just as your hotels on Boardwalk were making money -- and the power of the
chokeholder, who exacts tribute from all who pass through his Gates. Then there's that indirect
form of power known as "influence," which is how Steve Jobs manages to punch above his
company's relatively puny weight.

Law Four. Comparing Apples to Microsofts ain't easy, which makes for a lot of highly spirited
debate. (Also: fist banging.) It's like a game of rock-scissors-paper -- rocks smash scissors,
scissors cut paper, paper covers rocks. Which object is best to have? Well, is the most powerful
person: (1) the megacompany CEO whom 100,000 employees salute as boss, (2) the bond trader
who cuts the megacompany's value in half whenever he blows his nose, (3) the economist whose
ideas subtly dictate the bond trader's moves, or (4) Lockheed Martin (LMT) CEO Vance
Coffman, who has enough air power to ionize all of the above? Rock, scissors, paper, Hellfire

Picking through these intricate layers, one begins to see that the chest-thumping, Zeus-with-a-
thunderbolt notion of power is merely the cartoon version. "It's an art form," says the historian
Robert Caro, "a type of genius that's different from any other type of genius." Caro's two massive
biographies -- of Lyndon Johnson and New York's master builder Robert Moses -- are among the
most nuanced studies of power ever written. Both men were ruthless in their pursuit of it;
Johnson as he ascended to leadership in the Senate, Moses as he tore up whole swaths of
metropolitan New York for his roads and bridges. And yet their methods were different entirely.
Johnson, notes Caro, "saw every man as a tool," using the magnetism of his personality to pull
people close enough to find their weakness; once grasped, the weakness became the tool's
handle. The misanthropic Moses -- who hated to be touched -- couldn't see the leverage points in
men's psyches but worked the leverage points in New York's political system so single-mindedly
that for 40 years and five mayors, he was untouchable. Caro recalls watching Moses stand with
his pencil before a giant map of New York: "He was like an artist painting an entire urban and
suburban region -- one with 21 million or 22 million people -- and seeing it as a single canvas.
But of all the paints he used to paint that canvas, the most important was power. Without that,
none of it would have worked."

Caro's main point: "The acquisition of power is a creative act." It was a clich that no one could
lead the Senate; LBJ created a way to lead it. It was a clich that New York was ungovernable;
Moses invented a way to govern it. For that matter, it was a clich that nobody could make
money in the computer business; Michael Dell found a new way to do it.

After several rounds of internal debate about our power list, two things became clear: first, that
power is a really deep topic; second, that any list we published would provoke the same howls of
protest and counterprotest that filled our offices. ("How can the CEO of Pfizer not be in the top

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ten?!") And yet in one area a strange civility broke out: When it came to deciding the list's
highest slots, there was something close to unanimity. In fact, we'd narrowed the top three
contenders to the trio who, coincidentally (hand on the Bible here), were set to play golf in Sun

We had our three biggest fish. That left the question: Who's the kingfish?

There's no debating who runs the most powerful company. Lee Scott's Wal-Mart is reshaping
about 20 industries at once and would probably qualify for a spot on the UN Security Council if
that body's membership weren't limited to "countries." Yet Scott may also be the most
replaceable of the three. Bill Gates, as lead brain in a company powered by brainpower, is still
Mr. Microsoft -- and as Huck Finn might have said, he's got a powerful lot of green matter to go
with his gray. Yet the company's $46 billion war chest is only potential, unrealized power unless
it finds new behavior-changing ways to use it. Lately Microsoft has been parceling it out to
investors as dividends.

Which brings us to our third golfer. Besides overseeing an empire known as Berkshire
Hathaway, Warren Buffett has his finger in a lot of important pies (Coca-Cola (KO), Gillette, the
Washington Post Co. (WPO)) and a personal fortune second only to Gates'. But the most
arresting fact about Buffett may come from a recent Duke University survey of graduating
MBAs: After their own father, the person the graduates admire most -- more than the President,
more than the Pope, more than Gandhi -- is Warren Buffett. That remarkable stature gives him a
power of moral suasion that's been made all the stronger by his sparing use of it. It's the ability to
shape the behavior of people far beyond his direct reach merely through his words, and it's added
to Buffett's image as American capitalism's unofficial Lord Protector.

He's got the rock, the scissors, and the paper. And now he's got something else: the top spot on
our list. --Jerry Useem

And now, for our list of the 25 most powerful people in business:

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No. 1 Warren Buffett
Berkshire Hathaway (BRKA)

The most powerful businessperson in America is famously understated about his station in life.
Sure, Warren Buffett enjoys some of the trappings that come from being the second-richest man
in the world, such as winging around in one of his Netjets and playing bridge with pal (and No. 2
on our list) Bill Gates. Mostly, though, the 72-year-old brushes aside the notion that he is the
Atlas of American business. "It really just means that if I do something dumb, I can do it on a
very big scale," he says with his trademark chuckle. "It means you could add a lot of zeros to the

There haven't been many of the latter. Buffett's company, Berkshire Hathaway, has become an
all-American juggernaut, with multibillion-dollar interests in everything from insurance -- where
Buffett is one of the world's leading players -- to newspapers, carpets, and cowboy boots. In
racking up compound annual returns of 21% over the past 15 years (vs. the market's 11%),
Buffett has proved himself the world's greatest investor. As such, his influence on stocks and the
market is unparalleled. Word that Buffett is buying or selling certain shares (be it fact or fiction)
will move a stock like a pinball, which is why he is extra-guarded when it comes to discussing

One of the few places where he does talk about investments -- his annual letter to shareholders --
is far and away the most widely read communication from a CEO in the world. When former
Chinese President Jiang Zemin discussed the mystifying nature of the U.S. stock market with a
visiting Bill Gates, Gates told him that there was really only one guy who understood it: Warren
Buffett. Gates added that when he got back to the U.S., he would send Buffett's most recent
annual report to him. Which he did. (No word on whether Jiang is now long BRK.)

What's more, Buffett is without question the world's most sought-after businessman by other
CEOs who want guidance. "CEOs are surrounded by people who are getting paid," says Buffett.
"I'm getting nothing, so I can give them unbiased advice." Over the past five years dozens of

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CEOs have come to Omaha to visit the sage, including General Electric's Jeff Immelt (No. 7 on
our list). "I've been there two or three times to speak with him and have a steak," says Immelt.
"He's the world's most astute investor, and I'm trying to pick his brain."

The U.S. Congress hangs on Buffett's words too. On May 20, just days before lawmakers voted
on the Bush tax bill, Buffett wrote an op-ed piece in the Washington Post that pointed out what
he perceived as the folly of eliminating taxes on dividends. The tax cut, Buffett argued, would
mostly benefit the wealthy. Powerful stuff coming from Buffett -- powerful enough to persuade
certain members of Congress to water down the final version of the tax cut.

Quite simply, Buffett is respected and admired more than any other businessperson alive, not
only by others in business but by the general public as well. Now that's power. --Andy Serwer

No. 2 Bill Gates

Microsoft (MSFT)

While Microsoft's chairman and co-founder is no longer CEO, he remains the world's richest
man (estimated net worth: well over $30 billion) and as chief software architect, he wields
enormous power over how our computers behave. But it is his business acumen that gives Gates,
47, the most clout. More than anyone, he changed the economics of IT by creating software and
hardware standards that transformed computers into commodity products. Along the way he
achieved an effective monopoly in Microsoft's primary business of operating systems software,
and he weathered the most aggressive federal antitrust challenge in decades. Now he's out to
change the world another way: by throwing billions at eradicating infectious diseases. --Brent

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No. 3 Lee Scott
Wal-Mart (WMT)

Power isn't a word you'll hear much around Wal-Mart. Huge concentrations of it scare people,
and any superpower seen to be throwing its weight around is apt to lose some of it. Lee Scott
(right) seems to understand this. But despite his studiously low profile, the CEO of America's
biggest company (No. 1 on the Fortune 500 list, with $247 billion in sales and nearly 1.4 million
employees) can't help but be a powerful man. True, he's more the channeler of Wal-Mart's power
than its source. It was founder Sam Walton (above left) and successor David Glass (center) -- the
other two-thirds of retailing's holy trinity -- who built the machine and the culture underlying it.
But if you're at the controls of the biggest starship in the galaxy, you are, by definition, a Master
of the Universe. --Jerry Useem

No. 4 Sandy Weill

Citigroup (C)

He has orchestrated some of the biggest mergers in history, making Citigroup the world's largest
financial services firm ($1 trillion-plus in assets, market cap of $231 billion). And though Weill
has decided to step aside as CEO next year, he's kept the chairman title, made his right-hand man
his replacement and will maintain a firm grip on the company until he leaves for good in 2006 --
make that if he leaves for good then. Under Weill, Citigroup has become the king of one-stop
shopping, consistently topping its peers in lending, underwriting, and M&A advising. Weill and
Citi have come under tremendous regulatory scrutiny, but he still attracts a powerful crowd. He
recently threw himself a 70th-birthday party at New York City's Carnegie Hall. The event drew a
mayor, a governor, a Senator, and an ex-President. --Julie Creswell

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No. 5 Rupert Murdoch
News Corp. (NWSA)

His Fox TV network, which airs American Idol, is on a tear. His Fox News channel has a larger
U.S. audience than CNN. Murdoch, 72, has shaken up markets from satellites to newspapers
wherever in the world he has entered them. The authoritarian CEO doesn't practice or even feign
impartiality; he has made his sons his successors, and he zealously uses his properties to
disseminate his own conservative agenda. Since his recent acquisition of DirecTV, Murdoch has
the power to beam News Corp. content into hundreds of millions of homes. Opponents of the
FCC's move to relax media ownership restrictions made Murdoch the focal point of their
campaign. As CNN founder and archrival Ted Turner has declared, "He's the most dangerous
man in the world." --Nicholas Stein

No. 6 Lee Raymond

Exxon Mobil (XOM)

Lee Raymond isn't offering any apologies. He's not talking up green fuels, rhapsodizing about
alternative energy in the year 2063, or waxing environmental about how his company will help
solve the problem of global warming. What this man does is sell oil -- and make money, lots of
it, for shareholders. In the first quarter of 2003, Exxon Mobil earned $7 billion, more than twice
what Microsoft and GE earned in the same period. Raymond's power goes beyond the numbers.
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For ten years the 65-year-old has run a company that functions virtually as a nation-state,
hammering out deals with countries all over the globe (and drawing criticism for dealing with
unsavory regimes in places like Angola and Indonesia). But with Exxon Mobil having regularly
beaten the S&P 500 over the past 15 years, and poised to turn in a banner 2003, Raymond may
never to have to say he's sorry. --Nelson D. Schwartz

No. 7 Jeff Immelt

General Electric (GE)

When Jack Welch retired in 2001, Immelt won one of the toughest succession battles ever to
become the ninth CEO of the hugely respected 125-year-old corporate giant, beating out such
rivals as Bob Nardelli (now CEO of Home Depot (HD) and Jim McNerney (CEO of 3M
(MMM)). Immelt has big shoes to fill, and he has been dealt a tough hand. But he has gracefully
coped with problems from a choppy economy to Wall Street demands for greater transparency.
He ditched misfits like GE's Japanese life insurer and divided the once-opaque GE Capital into
four units, appeasing investors. Meanwhile, he has maintained the strength of key businesses like
NBC, which reaches 6.2 million viewers every morning -- more than any other network -- and
snagged the U.S. rights to air the 2010 and 2012 Olympic Games. All this, and he's only 47. That
means he has 18 years to catch up to Jack before hitting GE's traditional retirement age. --Julie

No. 8 Michael Dell

Dell Computer (DELL)

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Larry Ellison personally endorses his products. Carly Fiorina and Sam Palmisano wish he'd quit
working so hard. In the 19 years since Dell, 38, founded Dell Computer in his University of
Texas dorm room, he has exploited the Net and just-in-time manufacturing to fundamentally
reshape a commodity business. He has proved that anything his competitors can do, he can do
cheaper. Dell -- whose net worth is estimated at more than $17 billion, making him by far the
richest self-made American under 40 -- sells more PCs and workstations than anyone else. No
wonder his methods are studied across industries and around the world. --Noshua Watson

No. 9 Hank Greenberg


Greenberg has been at the helm of AIG for 36 years. He built it into the world's largest insurance
company: AIG's net income last year was more than that of the top 18 U.S. property-casualty
firms combined. Though he's 78 now, Greenberg has hardly slowed down. In 2001 he single-
handedly hung up China's entry into the WTO until he won his company an exemption on
foreign-ownership rules. ("He's one of the only people who can knock on the door of the Premier
of China and have the guy answer it," says an analyst.) That same year he outmaneuvered
Prudential U.K. to snag life insurer American General for $23 billion. Now he's tackling the tort
system, lobbying Congress to restrict the size of plaintiffs awards. Don't bet against him. --J.C.

No. 10 Bill Gross


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The Bond King moves markets. As founder and chief investment officer of money-management
firm Pimco, Gross, 59, controls $360 billion in fixed-income assets -- more than anyone else on
the planet. His Total Return mutual fund is bigger than Fidelity Magellan. Despite that girth,
Gross nimbly plays global debt markets. Much of the financial world follows his every move --
though usually a step or two behind. Merely a rumor that he is selling or buying a sector can
create a frenzy. His public criticisms of the way companies like General Electric use debt have
sent stock prices plummeting. And his predictions that bonds will give stocks a run for their
money over the next decade have lured hordes of investors to the sector. It's completely
understandable that they'd listen to this soft-spoken, yoga-practicing Californian: Gross has made
money for clients in 27 of the past 30 years. --David Rynecki

No. 11 Hank McKinnell

Pfizer (PFE)

McKinnell, 60, is the corporate world's surgeon general. As CEO of the globe's largest drug
company (Pfizer now has the third-largest market capitalization after Microsoft and GE), this
powerful lobbyist holds sway over the world's medical-research agenda. McKinnell is
exceptionally good at making revenue-enhancing deals too. He brought about Pfizer's $84 billion
merger with Warner-Lambert in 2000 and $60 billion acquisition of Pharmacia in 2002. When it
comes to power, he says, he likes to push it down the ranks. "Quite often I'm asked, 'What are we
going to do about this or that?' My response is 'Understand the vision and values of the
organization. Then you figure it out.'" --John Simons

No. 12 Franklin Raines

Fannie Mae

His rsum is enough to inspire old-fashioned awe: Harvard undergrad, Rhodes scholar, Harvard
Law, Lazard Frres partner, board member at Pfizer, PepsiCo (PEP), and AOL Time Warner,

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stints in both the Carter and Clinton administrations -- including one as director of the Office of
Management and Budget at that magical (and fleeting) moment when the nation's accounts
moved from deficit to surplus. But that's not why Raines is on this list. Nor is he here because
he's a particularly glamorous, dynamic, attention-grabbing CEO. Says the man himself: "What is
it -- a top 25? I should be 26."

No, the 54-year-old makes the cut because he runs Fannie Mae, the government-agency-turned-
corporate-juggernaut that is the heart of the American economy. Fannie Mae, with its $924
billion in assets, is the nation's second-largest financial institution, trailing only Citigroup. More
to the point, it dominates the mortgage market that has kept the U.S. economy afloat for the past
two years. By buying mortgages at a record pace, Raines and Fannie helped bring rates down to
their lowest level in 40 years. That kept the housing market going strong and stimulated an
unprecedented wave of refinancing that pumped hundreds of billions of much-needed dollars
into the economy. What's more, Raines has successfully staved off new regulation in the wake of
recent accounting difficulties at Freddie Mac, Fannie's younger brother. That may be, in the end,
the best explanation of Franklin Raines's power. Official Washington is afraid that, if it messes
with his company, it will destroy the housing market and with it the U.S. economy. How many
other CEOs can say that? --Justin Fox

No. 13 Sam Palmisano


He dissolved a clubby 92-year-old executive-management committee, asked the board to cut his
bonus and redistribute the money to others, and reached far down the organizational chart for
fresh ideas. That might sound like a corporate fairy tale, but in fact it's a few pages out of the
first chapter in Sam Palmisano's tenure as CEO of the $81 billion behemoth. The 30-year
company vet -- who took the reins early last year -- isn't resting on predecessor Lou Gerstner's
laurels. Instead, he thrives on shaking things up. Palmisano, 52, has snatched up
PricewaterhouseCoopers' consulting arm for $3.5 billion, helping shift Big Blue's focus from
selling hardware and software to selling IT and consulting services. He has also promised to
revolutionize the IT world with "on-demand" technology. If only sales and stock performance
were better. --J.S.

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No. 14 Craig Barrett
Intel (INTC)

Computers built with his company's semiconductors are changing modern life more than any
other product. What's good for Intel, one might say, is good for the world. And in chips, where
$27-billion-a-year Intel is by far the dominant force, CEO Barrett is the undisputed industry
heavyweight in a way his illustrious predecessor Andy Grove never was. While Intel once
merely built chips for PCs, Barrett, 63, is moving it toward powering all the world's computers.
When his company embraced Linux, that operating system became a bigger threat to Microsoft.
Rare is the head of state who hasn't lobbied him. Each year Barrett visits 30 countries; in many
he's a top employer. His legendary one-hour-of-sleep stamina leads staffers to call those trips
"death marches." But few work harder -- and with more impact -- to keep the world's economy
alive. --David Kirkpatrick

No. 15 A.G. Lafley

Procter and Gamble (PG)

Since taking over P&G in 2000, this 56-year-old former Navy man and company lifer has quietly
skippered the $43 billion colossus back to profitability. But you won't hear him constantly
bragging about it. Lafley's unassuming mien, openness, and authenticity have endeared him to
Wall Street and employees alike. "Despite his doing nothing to create it," says CEO guru Jeffrey
Sonnenfeld, "a sudden mythology has grown up around him that's almost Jack Welch-like." That
might explain why he sits on the boards of two of the five largest companies in the country
(General Motors and GE). His real power is in his reach. Five billion people across 130 countries
use the nearly 300 brands he controls, including Tide, Pampers, and Crest, two billion times a

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day. This year Lafley is ramming home the $7 billion acquisition of German hair-care giant
Wella, the largest in company history. --Matthew Boyle

No. 16 Ken Lewis

Bank of America (BAC)

This low-key 56-year-old possesses a simple but vitally important kind of power: the power to
make money. Lewis is a new-breed CEO. He doesn't grandstand. He just quietly focuses on
wringing profits out of the megabank (the third-largest commercial bank in the country by assets,
behind Citigroup and J.P. Morgan (JPM)) that his larger-than-life predecessor Hugh McColl
created in a binge of acquisitions. BofA's stock has appreciated 51% since Lewis's arrival in
April 2001. He grew earnings 23% last quarter by driving big gains in mortgage and credit card
banking. And he's brilliant at sussing out what customers want (and will pay for). So what if
Lewis doesn't ooze charisma? His investors like him just the way he is. --J.S.

No. 17 Sumner Redstone

Viacom (VIA)

Let's hear it for Sumner Redstone. He may wear cheap-looking sports coats, have trouble sharing
credit for his company's triumphs, and refuse to name a successor. But the 80-year-old CEO
doesn't have to defer to anybody. He owns $8 billion of Viacom stock (market cap: $77 billion),
including enough super-voting shares to control its board of directors, not to mention assets like
MTV, CBS, Paramount Pictures, and Simon & Schuster. And Redstone -- who recently married
a woman half his age -- is showing no signs of slowing down as a dealmaker. He's snapped up
assets from debt-laden competitors like AOL (Comedy Central). Now he's eyeing Vivendi's Sci
Fi Channel. But the most impressive thing Sumner has done this year is negotiate a deal to keep

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Viacom's respected COO Mel Karmazin -- a guy with whom he has a famously tense
relationship -- from jumping ship (see No. 18). Investors swooned. Mel even went to Sumner's
wedding. Now here's the question: Can they keep dodging divorce? --Devin Leonard

No. 18 Ivan Seidenberg

Verizon (VZ)

If anyone on this list could go unnoticed in a roomful of big-name executives, it would be Ivan
Seidenberg. What he lacks in star power, though, he makes up in market might. Seidenberg, 56,
runs the nation's tenth-largest company, providing mission-critical phone lines to many parts of
the U.S. government, the city of New York, and the New York Stock Exchange -- not to mention
dial-tone and cellular service to scores of VIPs all over the country. His influence extends far
beyond telecom. When a feud between Viacom's Sumner Redstone (No. 17) and Mel Karmazin
became public last summer, sources say it was Seidenberg, a longtime Viacom board member,
who persuaded the executives to resolve their issues in private. That kind of power certainly
should make a crowded room take notice. --Stephanie N. Mehta

No. 19 Carly Fiorina

Hewlett Packard (HPQ)

The wire-service photo from the World Economic Forum's recent Global Reconciliation Summit
beside the Dead Sea in Jordan was a tutorial in power: Carly Fiorina leaning in close behind
Colin Powell, whispering in the Secretary of State's ear. It's a scene she repeats over and over:
Carly schmoozing with President Bush on economic issues; Carly giving Tom Ridge an earful on
how to integrate large organizations; Carly making playful small talk with Nelson Mandela. This
is a global stateswoman masquerading as a Fortune 500 business executive, so well known that

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just her first name suffices. (She was born, by the way, as Carleton, a male name passed down
through generations of her father's family.)

Fiorina, 48, does much more than globetrot. This former English teacher, the first nonengineer to
run Hewlett-Packard, arguably started the consolidation of the computer industry with the 2002
acquisition of Compaq for $19 billion. Critics ridiculed her for the move -- one bad PC business
merged with another bad PC business does not a good PC company make, they said -- but she
persevered in the face of a grueling shareholder battle. And whaddya know, with HP's
profitability improving and its stock price finally inching over its pre-deal level, Fiorina is
beginning to taste vindication. With tech-industry consolidation all the rage (think
Oracle/PeopleSoft, Yahoo/Overture), she's even become something of a visionary. Says John
Chambers (No. 21), CEO of Cisco Systems, where Fiorina has a board seat: "She's potentially
one of the top CEOs of all America." --Adam Lashinsky

No. 20 Stan O'Neal

Merrill Lynch

By turning once-softhearted "Mother Merrill" into a lean, mean high-margin machine -- and by
navigating regulatory probes of its research unit -- O'Neal restored luster to one of the great
names on Wall Street. His traders dominate the market as middlemen. His investment bankers
are once again landing big-dollar deals. His 14,000-stockbroker army is capturing wealthy
individual investors. Insiders say O'Neal, 51, is too tough. He's certainly determined. He won a
brutal succession battle for CEO, has maintained close ties to key board members, and has
assembled a kitchen cabinet -- called the "junta" by some -- that follows his commands with
precision. Love him or hate him, the results speak for themselves: Merrill earned $2.5 billion in
2002 and stands to do even better this year. --D.R.

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No. 21 John Chambers
Cisco (CSCO)

Listening to a John Chambers speech today is an astonishing experience. The world couldn't be
more different from what it was three years ago, when Cisco briefly had the biggest market
capitalization of any corporation on the planet ($531 billion). But in fundamental ways, the
CEO's speeches haven't changed at all. They're still about the power of the Internet to
revolutionize the business world, and implicitly about how Cisco makes out like a bandit selling
the gear that enables all that. Chambers still sprinkles his remarks with references to top
bureaucrats and heads of state who have signed on to his vision. And he still encourages the rest
of the business world to look to Cisco as the best example of what will be possible. It's hokey,
self-serving, and sanctimonious at the same time. It also happens to be right. Internet traffic
continues to double every year, and Cisco dominates the market for corporate networking gear in
ways that only two other corporations, IBM in the 1970s and Microsoft, have been able to
muster. Its $127 billion market cap remains the 14th biggest in the U.S. While Chambers is
indisputably less powerful than he once was -- his shtick has certainly worn thin with investors
who bet on Cisco in 2000, before the stock fell by 90% -- he's still here. Get used to it. --F.V.

No. 22 Henry Paulson

Goldman Sachs (GS)

Of all the CEOs on Wall Street, only Paulson has been secure enough to speak out against
corporate malfeasance. At a June 2002 speech to the National Press Club on the firestorm of
criticism leveled against American business, Paulson famously said, "To be blunt, much of it is
deserved." Maybe it follows, then, that of the big investment banks, Goldman is the least tainted
by scandal. Paulson, 57, a tall and steely Midwestern type, outmuscled then-CEO (and now U.S.

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Senator from New Jersey) Jon Corzine to grab the top spot shortly before the blue-chip bank
went public four years ago. Since then GS stock has beaten the market, as well as that of
archrivals Merrill Lynch and Morgan Stanley (MS). During a visit to New York last year,
China's President Hu Jintao asked Paulson to host him at the New York Stock Exchange and
accompany him on his visit to ground zero with Mayor Bloomberg, making him the only Wall
Street CEO so honored. Though Goldman is smallish relative to competitors like Citigroup and
CSFB, the firm's influence in sectors like mergers and acquisitions and underwriting far
outweighs its size. --A.S.

No. 23 Brian Roberts

Comcast (CMCSA)

His cable company pumps music videos to more than 21 million homes and delivers fast Internet
service to four million users, making Roberts, 44, a very important man to the MTV set.
(Eminem even raps about watching Comcast in "Criminal.") But what makes this CEO really
powerful is the growing clout he wields over grownups such as AOL's Dick Parsons (No. 24),
Disney's (DIS) Michael Eisner, and Viacom's Mel Karmazin: Roberts is seeking volume
discounts on the programming he buys from those media moguls. Given Comcast's incredible
market strength, many industry insiders are betting Roberts gets his way. A former squash All-
American, Roberts is relentless when he puts his mind to something. He never flagged in his bid
to acquire AT&T's (T) cable assets, for example, a $51 billion transaction that turned No. 3
Comcast into the largest cable operator in the country. And because his family has 33% voting
control, Roberts has something many of his rivals don't: job security. --S.N.M.

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No. 24 Dick Parsons
AOL Time Warner (TWX) (AOL)

Not only does Parsons sit atop the world's largest media company -- an empire that includes
movies, music, television, cable and online services, and Fortune publisher Time Inc. -- it looks
as if he may have the power to turn around the wounded giant. In his 14 months as CEO, he's
managed to stabilize the $42 billion company, in part by telling division heads to focus on
running their businesses instead of fretting about merger synergies. And Parsons, 55, has quietly
exercised his authority in the boardroom, securing the chairmanship following last May's
resignation of Steve Case. Despite his strong start, this consummate diplomat -- unlike his
higher-ranked fellow moguls -- is still grappling with some tough problems, including an
ongoing SEC investigation, sluggish performance at AOL, and a delayed IPO of Time Warner
Cable (TWC). --S.N.M.

No. 25 Rick Wagoner

General Motors (GM)

Affable and engaging in private, Wagoner, 50, is Detroit's new tough guy. His message to
competitors whose customers are fleeing to foreign makes: "Stop whining." If $4,000 worth of
incentives on GM cars pushes less-efficient automakers to the brink, Wagoner doesn't care: He's
going to do what makes sense for his company. Despite GM's size, Wagoner is hemmed in by
union contracts, government regulations, and giant health-care and retiree costs. And he hasn't
yet succeeded in getting GM's stock price to stay up: Even though it ranks second in revenues,
GM is just No. 94 in market capitalization. Still, Wagoner has more clout than any American in
the industry. --Alex Taylor III


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Much of their work is done behind the scenes. But this plugged-in foursome are Grade A
movers and shakers: They have the power to make other people powerful.

Herb Allen The guest list at the billionaire investment banker's annual
Sun Valley, Idaho, confab reads like a Who's Who of our most powerful: No. 1 Warren Buffett,
No. 2 Bill Gates, and No. 3 Lee Scott all attended this year.

Joe Bachelder This 70-year-old lawyer makes the rich richer. He has negotiated more megabuck
CEO contracts (for folks like IBM's Lou Gerstner and Honeywell's (HON) Larry Bossidy) than
anyone else.

Tom Neff CEO headhunter and Spencer Stuart's U.S. chairman, Neff, 65, edges out longtime
rival Gerry Roche thanks to recent successes: placing Jim Kilts at Gillette and Hugh Grant at
Monsanto (MON).

Franklin Thomas If real clout lies in the boardroom, then 69-year-old nonprofit consultant
Thomas has it: He's lead director of powerhouse Citigroup, plus a director at Lucent
Technologies, PepsiCo, Cummins (CMI), and Alcoa (AA).


The Disrupters
"In disruptive innovations ... [there are] strong first-mover advantages," wrote Harvard
professor Clayton Christensen in his 1997 bestseller, The Innovator's Dilemma. These
seven innovators built their power on exactly that principle: developing a novel concept
that shook an industry.

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Jeff Bezos You don't go from obscurity to Time's person of the year in four
years -- Jeff Bezos made it in 1999 -- unless you're causing quite a stir. Nearly a decade since he
started Internet retailing pioneer (AMZN), Bezos, 39, remains one of the most
controversial figures in business. Large chunks of the investment community still think his is just
an online-catalog company. But Amazon's results -- the stock has more than doubled over the
past 12 months -- increasingly demonstrate that Bezos has found a more powerful formula.
Amazon makes money selling its own merchandise, and it makes money selling competitors'
wares too. --Fred Vogelstein

Sergey Brin and Larry Page The tech world hardly noticed when this duo
quit Stanford five years ago to start an Internet search engine. Now Brin, 29 (near right), and
Page, 30, sit atop Google (GOOG), a company that processes 250 million searches a day, or
2,900 searches a second, in 88 languages in 32 countries. By deciding what information gets
featured where, they may be the new kings of content. And their coming IPO will probably make
them very rich. --F.V.

David Neeleman He started fare wars in New York from the moment he
launched JetBlue (JBLU) at JFK in February 2000. Neeleman's idea: Offer passengers
convenient long-haul routes that bypass the major airlines' hub-and-spoke systems while
undercutting on price by using nonunion employees (who sometimes find their hyperkinetic 43-
year-old CEO pitching in to help). In a year when the airline industry lost $11 billion, JetBlue
made $55 million. --John Helyar

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Fred Smith He founded FedEx (FDX) in 1971 with a revolutionary concept:
Deliver packages reliably overnight. In doing so, he created an industry. Smith, 59 -- the only
boss the $22.5 billion company has ever had -- has shrewdly diversified, expanding beyond his
flyboy roots into ground-package delivery beginning in 1998. He knows his way around D.C.,
where he speaks out on tax and trade policy. And his mantra -- information about the shipment is
as important as the shipment itself -- has been adopted by thousands of businesses. --A.T. III

Linus Torvalds Twelve years ago he wrote the Linux computer operating
system so that he could use his home PC to write programs that would also run on his
university's Sun workstations. Today Linux allows CIOs to replace multimillion-dollar
proprietary systems with cheap commodity servers. Torvalds hasn't gotten rich from it because
the guts of the code are free. But the 33-year-old Finn still oversees key elements of its
development -- which makes him a leader of one of the greatest power shifts in the computer
industry since the birth of the PC. --F.V.

Meg Whitman The lone adult supervisor when she took the helm of eBay
(EBAY) in 1998, Whitman, 47, now oversees a multinational corporation that's causing a ruckus
far beyond the world of Beanie Babies collectors. She is seriously shaking things up in markets
as diverse as electronic payment processing and auto sales. And she has changed the way office
workers waste time -- perhaps forever. --A.L.


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Some people have an uncanny ability to influence what others think (and, by extension, do).
Here are five.

Jim Collins The writer of such bestsellers as Built to Last and Good to
Great, Collins, 45, is the most influential management thinker alive.

Steve Jobs Every move of Apple's (AAPL) 48-year-old founder and creative force is aped, from
the eclectic designs and materials he incorporates into his computers to the cutting-edge
animation from his Pixar Studios.

Howard Schultz Starbucks' (SBUX) 50-year-old chief global strategist has the power to make
us all think it is perfectly normal to plunk down $3 for a cup of coffee. (And last week 20 million
of us did.)

Paul Steiger As editor of the Wall Street Journal -- the paper that posts the agenda for American
business -- Steiger, 60, can move markets and strike fear into the hearts of CEOs everywhere.

Oprah Winfrey The merest nod from the daytime talk queen, 49, can launch a national trend --
or a book-buying binge.


People who (we fervently hope) know what they're doing

Put away your leadership gurus and your office-politics visionaries. Sometimes you just
want to know who really has his finger on the button. Here are half-a-dozen little-known
players who speak softly -- but carry some awfully big sticks.

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David Blitzer It's up to Blitzer, 54, chairman of the Standard & Poor's
Index Committee, to decide which companies go on and off S&P's benchmark 500-stock index.
The committee adds or drops about 25 a year. For the lucky ones, the ramifications are massive -
- such as a 5% to 8% stock price bump within the first week, mostly due to buying by huge index

William Chandler III Chandler, 52, is the law of the land in business -- and that land is
Delaware. That's where more than half of the Fortune 500 are incorporated. As a judge at the
state Court of Chancery, he has issued key rulings that permitted the merger of Hewlett-Packard
and Compaq and a shareholder lawsuit against Disney for Mike Ovitz's huge severance package.

John Crain The backbone of the Internet is run by 13 "root servers" around the world. At the
Internet Corporation for Assigned Names and Numbers (ICANN), John Crain, 37, heads the tech
team that keeps them up and running. "The entire Internet eventually comes through" these
machines, he says. Where in Los Angeles is his root server located? Luckily Crain's not telling.

Gamal Helal Remember that photo of Clinton and Arafat at Camp David? Or the one of Cheney
and Amir Hamad bin Khalifa Al-Thani in the Wajbah Palace in Qatar? That's Helal, 49, in the
middle of both. The chief White House translator for 22 countries across the Middle East and
Africa, he bears the burden of making sure George W.'s "strategery" comes across clearly in

Peter Niculescu You probably owe him your house. Niculescu, 43, who's from New Zealand
and used to work at Goldman Sachs, manages Fannie Mae's $812 billion mortgage portfolio
business. It brings in two-thirds of the revenues for a company that guarantees 25% of the
mortgage debt outstanding in the U.S. Oh. Well. Thanks, Peter.

Mike Pereira The NFL's 53-year-old officiating director does his best to teach 119 part-time
employees to make split-second decisions that affect hundreds of players and coaches (and
millions of fans) every football Sunday. Which doesn't make it easier when a zebra has to stick
his head into that black box to replay and review a call -- in the spotlight, alone.

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--Grainger David and Jeffrey Birnbaum


Golden Geese
You don't have to run a company to be essential to its success. These folks are worth a
boatload of MBAs.

Roger Ailes He made Richard Nixon telegenic (as much as anyone

could). He made CNBC the official channel of the stock market boom. Then Ailes, 63, built Fox
News Channel into an inescapable political and societal force.

Chris Albrecht Eight years, 82 Sex and the City and 52 Sopranos episodes after Albrecht, 50,
was put in charge of programming at HBO, the cable channel is TV's gold standard.

Tom Ford No designer on earth has more influence than Gucci Group's preposterously talented
41-year-old creative director.

Spongebob Squarepants It's not just that this sweet-tempered cartoon sponge's show airs 26
times a week on Viacom's Nickelodeon. It's that at this very moment your kid has a SpongeBob
Band-Aid on his elbow and is scarfing SpongeBob-shaped macaroni and cheese. And wait -- is
that a SpongeBob tie you're wearing?


Foreign powers
Our list of the 12 most powerful business leaders outside the U.S. is made up of seven
Europeans, four Asians, and a Middle Easterner. What's missing? There's no one from
Africa or Latin America.

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1. John Browne CEO Browne, 55, transformed Britain's BP (BP) from an also-ran
into a global oil power (and the world's third-largest oil company) with the purchase of Amoco
in 1998 and Arco in 2000. In Russia, he has formed the largest joint venture of any Western
investor. He's a favorite with women's groups and the green lobby.

2. Nobuyuki Idei The 66-year-old Sony (SNE) lifer, a cosmopolitan sort who
serves on the boards of General Motors and Nestle, is the architect of the $61 billion Japanese
company's global electronics dominance. Idei's next task: Mix the company's strengths in
innovation and technology with movies, games, and multimedia.

3. Shoichiro Toyoda Fujio Cho runs day-to-day operations. But founding-family

patriarch and honorary chairman Toyoda, 78, is the ultimate authority at Japan's Toyota Motor
(TM), which earned more money last year ($7.8 billion) than any other automaker.

4. Jurgen Schrempp It was Schrempp, 58, who rammed the 1999 DaimlerChrysler
merger through. And though it has been a rocky ride, the German remains firmly in control after
replacing most of Chrysler's senior management.

5. Josef Ackermann The Swiss-born CEO of Germany's largest bank, Ackermann,

55, has cut costs, raised profits, and streamlined operations -- making Deutsche Bank (DB) one
of Europe's best hopes to rival the power of the U.S. investment banks.

6. Li Ka-Shing Want to ship goods through the Panama Canal? Li leases ports at
both ends. Want to get stuff out of China? Likely it will go in one of his containers. Chairman of
Hutchison Whampoa, Hong Kong's biggest conglomerate, Li, 74, has become Asia's richest man.
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7. Silvio Berlusconi As founder and deputy chairman of Mediaset, Berlusconi owns
three of the country's TV networks. As Prime Minister of Italy, he controls all three of the state-
owned stations. Unsurprisingly, the 66-year-old billionaire gets the most timid domestic media
coverage of any Western leader.

8. Claude Bbar "The Crocodile" retired in 2000 as CEO of AXA, the global
insurer he built from a clutch of obscure financial companies. But as chairman, Bbar, 67,
remains the most powerful figure in French business. Last year he engineered the removal of
Jean-Marie Messier as CEO of Vivendi.

9. Jorma Ollila Since becoming CEO in 1992, Ollila has turned Nokia into
Europe's most innovative and best-run telecom outfit. Though many markets are close to
saturation, the Finnish company's share of the mobile-phone business is a commanding 38%.

10. Carlos Ghosn This Brazilian-born Frenchman of Lebanese descent has turned
Japan Inc. inside out. Ghosn, 49, took over as CEO at troubled Nissan in 1999. Last year Nissan
recorded the industry's highest profit margins, making $4.1 billion on revenues of $56 billion.

11. Abdallah Jum'ah The global economy runs on oil, and since 1995, Jum'ah, 63,
has been the man with his hand on the tap. As the CEO of Saudi Aramco, which is owned by the
Saudi Arabian government, he controls a quarter of the planet's estimated reserves.

12. Yun Jong Yong Yun says his mission as CEO of Samsung Electronics is to
remind managers "we could go bankrupt any day." Since 1997 he has transformed the Korean
giant from a corpulent also-ran to an agile competitor against the likes of Nokia and Sony.
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Riders on the storm
November 21, 2012: 11:25 AM ET

Email Print

Wells Fargo avoided the reckless tactics of other banks and

quietly built a powerhouse in the West. Now its takeover of
Wachovia makes it a national force, but how much toxic
waste is aboard the stagecoach?
By Adam Lashinsky

This story is from the May 4, 2009 issue of Fortune. It is the full text of an article excerpted in
Tap Dancing to Work: Warren Buffett on Practically Everything, 1966-2012, a Fortune
Magazine book, collected and expanded by Carol Loomis.

Pardners: Stumpf, with strongbox, took over as CEO last year, succeeding Kovacevich, who
built the empire and plans to retire as chairman.

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FORTUNE -- Dick Kovacevich ought to be happy. The sun is shining in San Francisco on an
early April morning, shares of Wells Fargo, where Kovacevich is chairman of the board, have
almost doubled in a month, and Wells appears to have survived the worst of the banking crisis
with its reputation intact (so far). Yet Kovacevich, at 65 a pugnacious and famously outspoken
banker, is peeved, to put it mildly. He's miffed at short-sellers who have hammered Wells Fargo
as if it were one of those troubled-asset repositories. He bemoans the media for failing to
recognize Wells Fargo's achievements. Most of all, he's seething with anger at Washington for
all sorts of bad decisions, from making a show of big-bank stress tests (which he has publicly
called "asinine") to giving him exactly one hour to accept a $25 billion investment in October
from the controversial Troubled Asset Relief Program, or TARP. "I'm willing to say the emperor
has no clothes," Kovacevich says, his face reddening as he loudly denounces the government's
behavior. "The facts are so obvious," he booms. "It's just not credible that you would give $25
billion to someone who didn't need it."

In the financial crisis, however, the facts often support clashing theories. Wells Fargo (WFC) is
emerging as one of the best banking franchises in the country. Thanks to its core strength and
acquisition of rival Wachovia, Wells for the first time is a coast-to-coast player, comparing, often
favorably, with J.P. Morgan Chase (JPM) and Bank of America (BAC). But the $12.5 billion
acquisition of troubled Wachovia has provoked serious and legitimate doubts as to whether
Wells needs even more capital on top of the TARP money it received. Its stock price has
skidded, along with that of every other big bank, on fears of everything from an inadequate
capital cushion and hidden credit risks to the possibility of banking nationalization.

The Wachovia purchase has injected a note of tension into the story of Wells Fargo, which in
every other way has been a rare upbeat tale amid the banking wreckage. Simplicity explains its
success. Among the big banks, Wells has one of the lowest cost of funds, a steady stream of
nonbanking revenue (from businesses like insurance brokering and mortgage-loan servicing),
and, most of all, a history of avoiding the rest of the industry's dumbest mistakes. It never got
into the type of structured investment vehicles, or SIVs, that tripped up Citigroup (C), for
example. (Says John Stumpf, Wells Fargo's CEO, who succeeded Kovacevich in that position
last year: "When I first heard about an SIV, I thought it was a four-wheel-drive vehicle.
Honestly.") Despite having a major position in mortgage underwriting, Wells refused to join the
crowd in offering no-documentation (or "liar") loans and option ARMs that let borrowers
determine how much they'd pay each month. (Wachovia's 2006 purchase of Golden West
Financial, which popularized option ARMs with its infamous Pick-A-Payment program, crippled
Wachovia and led to its purchase by Wells.) As a result, Wells lost significant market share in
the mortgage business from 2003 to 2007 -- a setback that is now a sign of virtue. Such
discipline makes Wells consistently more profitable than its peers, an enviable place to be --
provided its uncharacteristic fling with risk by buying Wachovia doesn't prove its undoing.

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A higher profile: Wells CEO Stumpf (above left), presents a token to Wachovia's Robert Steel
last October.

Warren Buffett delights in telling an anecdote about Wells' banking relationship with his own
company, Berkshire Hathaway (BRKA). In 2001, when Berkshire and a partner bought Finova, a
bankrupt lender, it solicited banks to become part of a loan syndicate. "Wells wasn't interested,"
says Buffett, who is Wells' largest shareholder, with 315 million shares, or a 7.4% stake. The
others offered to lend Berkshire money at the ultralow rate of 0.2 percentage points above its
cost, a loss leader intended to win follow-on investment-banking business from Berkshire. Not
Wells. "I got a big kick out of that because that was exactly how they should think," says Buffett,
with a hearty guffaw.

The tale speaks volumes about why, despite its size -- second by market capitalization ($83
billion) and deposits ($800 billion), and fourth-ranked in terms of assets ($1.3 trillion) -- Wells
Fargo is so often overlooked. The tall and imposing Kovacevich, a pro-baseball prospect in his
youth, gets downright defensive, blaming "you guys in the media" for not paying attention to
banks "west of the Hudson." But that doesn't really explain the bank's low profile. In fact, Wells
is less known because it concentrates on bread-and-butter banking rather than sexier activities
like investment banking and trading for its own account. "The real insight you get about a banker
is how they bank," says Buffett. "Their speeches don't make any difference. It's what they do and
what they don't do. And what Wells didn't do is what defines its greatness."

Wells, more than any big bank, makes its money by lending. It focuses on consumers and
midsize businesses, which tend to be more profitable customers than Fortune 1,000 corporations
that can raise money from many sources. And Wells relentlessly cross-sells everything, including
credit cards and mortgages (to consumers) and treasury-management services and insurance (to
businesses). Wells persuades each retail customer to buy an average of almost six products,
roughly twice the level of a decade ago. Business customers average almost eight products per

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The combined bank will have more than 12,000 ATMs.

This type of banking pays in two ways: Retail customers, once satisfactorily hooked, tend not to
take their business elsewhere unless they relocate. Similarly, smaller companies tend to rely on
their bankers for services that big corporations more often buy from specific consultants. A case
in point is Morning Star Packing, a tomato processor in California's Central Valley with about
$700 million in annual sales. Chris Rufer, its owner, has banked with Wells since 1983. His
company has no board of directors and doesn't hire fancy-pants management consultants. That
makes him appreciate Wells all the more, especially a Harvard MBA named Ken McCorkle, who
runs the Wells agriculture industries group. "They've got people who are competent to
understand our business," says Rufer.

Wells is consciously contrarian. About a decade ago it bought a large business-insurance

brokerage, and since then it has been busy snapping up smaller agencies to complement its
offering. (As a broker, Wells doesn't underwrite insurance, so it isn't a source of risk. Instead,
insurance is simply another product Wells offers its business customers.) In 2008, when Wells'
overall revenues grew 6%, to almost $42 billion, its insurance line jumped 20%, to $1.8 billion,
making it the fourth-largest business-insurance broker in the country. One important component
of the uptick was a thriving crop-insurance business that spiked with the rise in commodity

Where Wells has truly distinguished (and differentiated) itself is in mortgages. Run out of offices
in Des Moines -- far from the California headquarters of the industry's two biggest blowups,
Countrywide Financial and Golden West -- the business began in 1906 as Iowa Securities Corp.
Though a national force, the mortgage arm began losing ground to competitors in 2003 because
it stayed away from the industry's riskiest products. It also alienated brokers by calling attention
to what Wells saw as abusive practices. Cara Heiden, co-head of the mortgage operation, says
Wells' computer programs began flagging subprime mortgage applications from customers who
could qualify for prime-priced loans. (Subprime loans carry higher rates and therefore pay higher
fees to brokers.) "We would send the borrowers a prime-priced product -- and cc the broker," she
says. Predictably, Wells lost share, though its business continued to grow. Wells also

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dramatically cut back its roster of brokers, from a high of more than 25,000 in 2006 to just 8,100
today. Last year Wells regained the No. 1 position in the market for U.S. mortgage originations,
with a 16% share. That should grow with the purchase of Wachovia, whose share, excluding the
Pick-A-Payment business, was about 3%.

In the banking industry, loyal customers translate into cheap

sources of capital. A family with a mortgage, a checking account, and a brokerage account is less
likely to leave to chase higher CD rates, for example. As a result, Wells excels at making money
the old-fashioned way, on the spread between deposit and lending rates. (Think: Borrow cheap,

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lend dear.) Its average cost of funds in the fourth quarter was just over 1.5%, compared with an
industry average of 2.1%. "If you're the low-cost producer in any business -- and money is your
raw material in banking -- you've got a hell of an edge," says Buffett, who caused a 20%-plus
jump in Wells shares in March simply by expressing confidence in the bank on TV. "If you have
a half-point edge -- and they get that edge now on the Wachovia assets as well -- half a point on
$1 trillion is $5 billion a year."

Whether Wachovia's assets give Wells a critical edge or irreparably dull its momentum has been
the biggest question mark surrounding the San Francisco bank for months. It is fitting that an
epic acquisition would define Wells Fargo's future, because it has been a bank-buying machine
for years. Founded in 1852, the modern Wells became takeover bait itself. In 1998, Norwest, the
Minneapolis bank then headed by Kovacevich, bought Wells Fargo, assumed its name, and
moved the headquarters to San Francisco. Kovacevich had once been a hotshot banker at
Citibank, but after CEO John Reed passed him over for a key promotion, he moved to Norwest
in 1986. The Minnesota bank bought more than 150 community banks, often in bad economic
periods, in places like Colorado, Texas, and Arizona. Despite persistent speculation that he
would pounce again after buying Wells, Kovacevich didn't make another big move, preferring to
solidify his position west of the Mississippi.

Then came the crisis of last autumn, beginning with the collapse of Lehman Brothers and the
government-arranged sales of Washington Mutual and Merrill Lynch. On the last weekend of
September the FDIC conducted a forced auction for Wachovia, with Citigroup and Wells Fargo
as the two bidders. Citi won that round, agreeing to pay $2 billion for Wachovia's banking
franchise, with the government guaranteeing a portion of the losses Citi would assume. Wells
thought it could pay more, so after two days, with Kovacevich in Manhattan negotiating with
regulators and Stumpf in San Francisco leading a team of 300 numbers crunchers, Wells offered
to pay $15.4 billion for all of Wachovia -- without any help from Washington. Or so they

Two weeks later, on Oct. 13, Kovacevich was sitting at a long conference table with eight other
bank chiefs in Washington, listening to Treasury Secretary Hank Paulson tell them why they
should take the government's money. Kovacevich says he protested, telling Paulson that
compelling banks to accept TARP funds would lead to unintended consequences. It would erode
confidence in the banking sector by making investors question the healthiest banks rather than
instilling confidence in the neediest. Other industries undoubtedly would come to expect a
bailout themselves. Still, Kovacevich took the money.

His displeasure leaked to the public, but what hasn't been reported is exactly how Paulson
flipped the seasoned banker so quickly. In what an observer in the room describes as a "true
Godfather moment," Paulson told all the assembled bankers, "Your regulator is sitting right
there" -- actually the industry's two biggest overlords were in attendance: John Dugan,
comptroller of the currency, and FDIC chairwoman Sheila Bair -- "and you're going to get a call
tomorrow telling you you're undercapitalized and that you won't be able to raise money in the
private markets." For Kovacevich this broadside was the horse's head on his pillow. He and his
bank were in an unfamiliar position of vulnerability. Wells had just agreed to buy Wachovia, a
bank it had coveted for years, and it needed the government's approval -- and, critically, the

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ability to raise money -- to complete the deal. Reflecting on the episode with righteous
indignation, Kovacevich points out that each of his warnings to Paulson was later validated. Yet
he turns sheepish in explaining his decision. "You want to do what your country and your
regulators want," he says quietly in his office, decorated with miniature replicas of Wells Fargo's
iconic stagecoaches. "There was no ambiguity," he says, as to what was expected of him.

Gold rush: Founded in 1852 by Henry Wells and William Fargo, the company built offices all
over the West -- like this one in Pescadero, Calif.

As the autumn progressed, the markets had begun to lump Wells Fargo in with every other big
bank, and justifiably so. Investors were concerned that Wachovia's problems were so severe that
Wells had bitten off more than it could chew. Wells Fargo set out to raise equity to finance the
deal, but potential investors wanted to know why, if the government had just injected $25 billion
into Wells, it needed additional money to buy Wachovia. It was a good question. Kovacevich
says the bank's regulators specifically asked Wells to go ahead with the fundraising so that Wells
would have a bigger capital cushion. At $12.6 billion, Wells raised more money than any non-
IPO on record, but less than the maximum $20 billion target it had set. The Wachovia deal
closed on the last day of the year (for $12.5 billion, nearly $3 billion less than the original offer
price), and Wells that day wrote down $37 billion of a $94 billion Wachovia loan portfolio.

The large write-down, a banking term referring to the reduction of the value of an asset, removed
a significant amount of risk from Wells Fargo's balance sheet -- but not enough for Wells' critics.
The write-down had the effect of weakening what had become a key ratio investors had begun to
watch called tangible common equity, or TCE. It measures a bank's capital cushion without
giving it any credit for ephemeral assets like goodwill. As a result of the deal, Wells had a TCE
ratio of 2.7%, less than the 3% that many banking investors consider a bare minimum for healthy

As recently as October, Wells had claimed it didn't need additional capital. Yet here it was, a
recipient of the government's money and still undercapitalized by one important measure. The
new burden of TARP began to chafe in February, when word got out that Wells was hosting its

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annual "recognition event" for top-performing mortgage brokers in Las Vegas. A populist rage
ensued at the boondoggle by a TARP recipient, and Wells promptly canceled the event. CEO
Stumpf wrote a defiant letter to employees, which Wells published as an ad in national
newspapers, saying that the real victims of the controversy were the hospitality-industry workers
of Las Vegas. If Wells hadn't been on the map before, its gestures of rebellion were starting to
draw attention and curiosity: Just who are these cowboys?

By late February the heat grew more substantial. The Treasury Department announced it would
conduct confidential stress tests of the country's 19 biggest banks to understand how well they
could survive an even deeper recession. (Kovacevich earned headlines weeks later for his
remarks calling the move "asinine" on the grounds that regulators routinely conduct stress tests at
banks.) Suddenly no bank was considered safe. Wells shares briefly fell below $8 -- from more
than $40 in the fall -- and after relatively healthy competitors J.P. Morgan, U.S. Bank (USB), and
PNC Financial (PNC) all cut their dividends, Wells did too, by 85%.

The bank integrator: Callahan is in charge of merging Wells and Wachovia. "No time for
partying," she says. "No spa, no golf, no cream cheese on the bagels."

The dividend cut exposed a chink in Wells Fargo's armor. It had said repeatedly that it needed no
new capital. But if that were true, it wouldn't have needed to slice the payout. By way of
explanation, Stumpf, a 55-year-old Minnesotan who hails from a farming family and bakes bread
as a hobby, says, "We're going through unprecedented times, and more capital is better than less
capital." It's a fair argument but not entirely persuasive. The dividend cut, announced in early
March, should generate capital at a rate of $5 billion per year. Add that savings, the private
fundraising of almost $13 billion, and the $25 billion in TARP money, and Wells will have
accumulated $43 billion since October (not including earnings), about $23 billion more than it
had said it needed to fund the Wachovia acquisition. Yet it still isn't in a position to repay the
Treasury. Investors worry that Wells has kept certain Wachovia portfolios off the combined

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bank's balance sheet. Frederick Cannon, an analyst with banking specialist Keefe Bruyette &
Woods, highlights two potential problems, a $355 billion batch of commercial mortgages and
$137 billion of exposure to credit derivatives. Were those assets added to Wells' balance sheet,
the bank's need for capital would be even greater, says Cannon, who in a worst-case scenario can
see Wells needing to raise another $25 billion. "They've built a great franchise," he says.
"Wouldn't it be great if they just had a bigger cushion of capital?"

On April 9, Wells at least temporarily quieted its critics by pre-announcing first-quarter earnings
of $3 billion, twice what Wall Street had expected, but without providing much in the way of
operating metrics. Wells said the Wachovia integration was ahead of schedule, that it had funded
$100 billion in mortgages, and that its tangible common equity ratio had hit 3.1%. The stock
price surged 32%, to almost $20, and Wells Fargo single-handedly sparked a 246-point rally in
the Dow. For a day, at least, the markets were paying attention to a suddenly very large bank
with headquarters west of the Hudson River.

There would be far fewer questions about Wells Fargo, of course, if it had simply ceded
Wachovia to Citi. But for all the factors Wells Fargo can't control, successfully integrating
Wachovia is one it can. The monumental task has been entrusted to executive vice president
Patricia Callahan, a 31-year Wells veteran who has worked at the bank (including a San
Francisco predecessor) her entire career -- in commercial lending, in compliance, and as head of
human resources. The project will be grueling, creating a combined entity out of a network of
11,000 branches, 70 million customers, 12,000-plus ATMs, and 281,000 employees. Fortunately
for Callahan, she recently completed a six-month sabbatical and says she returned refreshed.
"This integration is complicated in terms of timing, systems, training, and logistics," she says.
Through her efforts, Wells plans to slice $5 billion in annual operating costs from the combined
banks' budgets by 2011, a 10% reduction.

Wells has a playbook in these matters, namely Norwest's three-year, painstaking acquisition of
Wells Fargo a decade ago. Callahan says 21 business-unit and staff-function integration teams,
and many more sub-teams, are at work mapping a calendar they intend to complete by the end of
April. An all-hands integration team meeting in San Francisco in March drew 150 attendees in
person and another 200 on the phone and went from 7 a.m. to 6 p.m. "No time for partying," she
says, in a nod to the still-hurt feelings over the canceled "recognition event" in February. "No
spa, no golf, no cream cheese on the bagels."

Though Wells and Wachovia operated largely in different parts of the country, overlap is a cost-
saving opportunity. Each had significant operations in five states: Colorado, Arizona, Nevada,
California, and Texas. Callahan says those states will get the makeover treatment first, with the
bank converting no more than a few hundred branches at a time. The plan is to rebrand
everything Wells Fargo; the Wachovia name is destined for the trash heap of bank brands.

In most areas Wells considers itself Wachovia's better. For example, Wells ATMs have
capabilities that Wachovia's don't, like envelope-free deposits that customers love. So every
Wachovia ATM will be upgraded. Stumpf ticks off the opportunities Wells will have with
Wachovia's customer base, which before the merger was similar in size to Wells Fargo's. "We
have twice the number of online customers that they do," he says, online banking representing a

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significant cost savings. "Thirty-eight percent of our customers carry our credit card. Eleven
percent of theirs carry their credit card. Our debit-card penetration is much higher here. Our
mortgage penetration is much higher here." And so on.

Wachovia had some advantages over Wells. Its wealth-management and brokerage arms are
stronger, featuring a highly skilled sales force in the image of Merrill Lynch's. That unit, the
remnant of Wachovia's acquisition of brokerage A.G. Edwards, will survive and be run by a
Wachovia executive, David Carroll, the sole officer from the vanquished company to join the
Wells executive management team. Wachovia also ranks higher than Wells on customer-
satisfaction surveys, and some Wells customers chafe at constantly being asked to buy additional
products. Wells says it will try to learn from Wachovia in this regard: for example, by adopting
Wachovia's customer-tracking software.

At least one Wells Fargo "team member," as the San Francisco bank refers to its employees,
certainly won't be around to see the Wachovia integration through. Kovacevich says he'll retire
for good "by year-endish or early next year-ish," and maybe sooner. Though Wells doesn't
provide golden parachutes, Kovacevich already has done just fine. His pension is worth $30
million, and in 2006 and 2007 he exercised and sold stock options worth $77 million. He insists
he'll take no other banking job, including the CEO position at Citigroup, which passed him over
all those years ago. "I would never compete with Wells Fargo," says Kovacevich. "This has been
my life." For years it was accepted in banking circles that Kovacevich coveted the Citi job, but
that was before the bank's financial and leadership challenges. Then again, his demurral is far
more believable today, considering that when Citi completes an exchange offer it has announced,
the U.S. government could own as much as 36% of the company. Kovacevich working for the
government officials he has so loudly criticized is a tough one to imagine.


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