Warren Buffett On Exposing Business Frauds And Deception

Fraudsters and untrustworthy people reveal themselves through behavioral tells: the specific things they talk about, what they regard as important or unimportant, and their subsequent behavior patterns all contain clues to their character.

“people give themselves away fairly often and maybe it does help to been around as long as we have in seeing the various ways they give give themselves away they when somebody comes to me with a business and I probably shouldn't tell this publicly because they'll probably tailor their approach subsequently but when when they come just the very things they talk about uh what they regard as important and not important there are a lot of clues that come as the subsequent Behavior”

Buffett and Munger use the poker concept of 'tells'—observable behavioral indicators—as an analytical framework for assessing the trustworthiness and future behavior of business partners when acquiring businesses.

“I don't know we can't identify 100 of the frauds or 90 or 80 but there's certain ones that jump out to you just people give themselves away a lot too I mean in poker they talk about tells and Charlie and I bought a lot of businesses and it's uh it's very important when we buy those businesses that we assess the individuals that we're buying from uh with some degree of accuracy because you know they hand us the stock certificate and we hand them a lot of money and then we count on them to run the business with as much enthusiasm after they have the money uh as they did before and so we are assessing people”

Buffett and Munger reject approximately 90% of propositions presented to them, viewing the goal not to accurately assess all propositions but to ensure the ones they do accept are correct.

“the truth is we we rule out ninety percent of the times and and we may be wrong about a fair number that we're ruling out the important thing is whether the ones we're ruling in were right about and so we don't mind we're looking for the obvious cases of people you can trust”

When the insurance company denied Munger's legitimate Fidelity Bond claim, Munger wrote a letter to the insurance company chairman proposing to increase the claim amount from $12,000 to $120,000 and structure it as a bet where the loser would pay the higher amount, reasoning that this would make the claim valuable enough for the company to settle rather than deny it and force Munger to litigate.

“Charlie writes a letter to this very well known big name uh person that runs the insurance company and he said look it he said we have this twelve thousand dollar claim and he said this guy stole the money uh and we thought we had a insurance policy against people's people stole money and he said he said we're in this very interesting position because you've got a bunch of people on the payroll and they're going to get their weekly check or monthly check whatever they do so they just say we're not going to pay and Life Goes On whereas I'm sitting here and I've got my time I've got to work on this thing and it isn't worth the twelve thousand dollars for me to fool around with us claim against the company and they'll appeal it and all these things so he said I know that you would be offended by the thought that you might be using this inequality a bargaining position to avoid playing at the claim that never could be your intention so what I suggest in order to really live up to your code of behavior is why don't we make the twelve thousand dollar claim business we'll just multiply it by 10 and call it 120 000 either way and if you lose you pay me 820 000 if I lose I'll pay you 120 000 now it's worth my while”

Insurance companies in particular have been caught manipulating loss reserves to artificially inflate earnings when preparing for public stock offerings or when selling the company to other insurance companies.

“similarly in looking at financial statements uh for example in in the insurance field we've we've seen some frauds and they're you can see things being done with lost reserves occasionally we saw it back in won't name any names unlike Charlie I don't we'll call them call them company A's and B's instead of naming names but you would see companies that when they were offering stock to the public you know a year or two before that the reserves would go down very suspiciously and you know then and uh or or even when they were selling them uh uh to other insurance companies uh uh they were buying in stock they might be building the reserve”

When a business owner or promoter comes to Buffett, the specific topics they emphasize, what they regard as important or unimportant, and their behavior patterns all provide diagnostic clues to their trustworthiness, and Buffett explicitly acknowledges these methods may not be publicly disclosed because it would cause fraudsters to alter their approach.

“I probably shouldn't tell this publicly because they'll probably tailor their approach subsequently”

Munger's letter to the insurance company chairman worked: the company sent a $12,000 check by return mail, settling the original claim after the chairman received the proposal.

“he addresses the letter to the chairman and says that's the guy he gets a twelve thousand dollar check by return mail it's not a bad lesson”

Buffett and Munger are deeply suspicious of investment propositions that are framed as being too easy or guaranteed to be profitable, as these framings signal the proposition is likely fraudulent or dishonest.

“partly we're deeply suspicious when the proposition is too good to be true Warren once introduced me to a gentleman promoter who wanted a bagel us into an insurance program and he said we only write fire Insurance on concrete bridges that are covered by water he says it's like taking candy from babies”

Buffett received an email from a private equity firm that was accidentally sent to him (meant for a company manager) instructing the manager to add 15% to earnings projections because 'Buffalo discounted by 15 or 20 anyway' to offset the manager's conservatism.

“we also had one that came in from a private Equity Firm and by a mistake we got the email that was sent to the manager from the email from the private Equity firms owned a manager in terms of making projections for it and they told them to add 15 because they said Buffalo discounted by 15 or 20 anyway so just just add 15 to offset his conservatism”

Frictional costs and dishonest charges in financial transactions harm consumers, and this is a widespread problem that Buffett hears about regularly from people who have been victimized.

“I get letters all the time and I hear from people who have been taken advantage of in financial transactions and you know it really is it's sad and a lot of it isn't even uh it's not fraud or anything for one thing I mean just the charges involved the frictional costs and the the baloney that is is presented uh is is tough”

Buffett and Munger have achieved a batting average well above 90% in their people assessment and business partnerships, meaning they correctly identify trustworthy partners more than 90% of the time despite acknowledging it has not been 100%.

“we've really had a a batting Outreach I wouldn't have thought we would have had uh in you in the people that we've joined with but it hasn't been a hundred percent uh it's it's been well above 90”

In the 1960s, Charlie Munger's investment firm Wheeler-Munger (later renamed as something else) was required by Fidelity Bond insurance to cover dishonest employees, and when an employee stole approximately $12,000, the insurance company initially denied the claim by arguing the employee didn't actually exist or wasn't employed.

“Charlie had this tiny little operation which he ran his fund also had a seat down the Pacific Coast Soccer shakes the perm was called wheeler monger it was called wheeler mugger at first later it changed itself to Margaret wheeler and Jack Wheeler said well pretty soon it'll be a bugger and Company but that's okay they Jack Wheeler was a very interesting guy and he had the specialist position in General Motors and a few things and some employee stole like I don't know 12 000 bucks or something like that... Charlie's firm we learned marker was required to have a Fidelity Bond and all these things that covered dishonest employees and all of that sort so this guy's clearly dishonest he's clearly stolen the money so Charlie puts in a claim for twelve thousand dollars or something like that whatever the loss was and sends it to this very big and prestigious Insurance Company and of course the insurance company denies this claim they say you know the guy really wasn't employed he doesn't exist you don't have a dog”

Investment bankers and business sellers frequently propose accounting adjustments and earnings manipulations to make acquisition targets look more valuable, a common and troubling pattern.

“the accounting games that are played all the adjustments are why the place should really be we'll be earning more than before it's it's it's a business”

A private company earning $100 million annually was presented to Buffett with a proposal that he should value it at $110 million in earnings by treating employee stock options as non-expensed compensation (unlike cash salaries paid by the private company), effectively using accounting adjustments to inflate reported earnings.

“received a proper position the other day and I'll disguise the numbers a little bit so nobody uh can pick it out but it was a private company and we'll say it was earning 100 million dollars a year but the seller of the business and the investment banker suggested that we should look at the earnings as being a hundred and ten million dollars a year because as a private company they had to pay their top people in cash which was expensed but we could pay them in stock options and things like that which weren't expensed or were explained as not really counting and therefore we would could report 110 million dollars if we gave away something we didn't want to give away but by essentially by why sort of lying about our accounting we could add 10 million dollars in earning”

Buffett acknowledges he and Munger cannot identify 100% or even 80-90% of frauds, but focus on identifying and avoiding the obvious ones that 'jump out' through clear signals.

“I don't know we can't identify 100 of the frauds or 90 or 80 but there's certain ones that jump out to you just people give themselves away”

Buffett has seen many different methods by which fraudsters manipulate financial numbers, and while he doesn't claim to know all of them, he has developed pattern recognition for spotting people who are 'playing games with the numbers.'

“there's a there's a million different ways and I don't claim I know all the ways obviously but I have seen enough situations over the years and I've seen how promoters Act uh and you can you can spot certain people who uh you know are one way or another playing games with the numbers”

Buffett and Munger have been 'overwhelmingly' successful in their business acquisitions and partnerships with people because they carefully filter and select partners, but they acknowledge this success requires filtering out many candidates.

“Charlie and I have had very good luck in terms of buying businesses and putting our trust in people it's been just overwhelmingly good but we filter out a lot of people and then they say how well how do you filter them out”