Warren Buffett's Berkshire Hathaway SUED
Warren Buffett, Charlie Munger, and Berkshire Hathaway have a rather warm and cuddly image. Warren Buffett comes across as jovial, jolly, and friendly. Thus, perhaps it’s a surprise when Berkshire Hathaway plays hardball and ends up being sued. That might be what has happened here, as argued in a recent court filing.
So, what is all this about?
This concerns a company called Pilot, founded by Jim Haslan II in 1958. It is a series of truck stops, gas stations, and convenience stores. It was the fifth largest privately held company in 2023.
Several years ago, Berkshire Hathaway entered into a purchase agreement with Pilot Flying J and the Haslan family. In October 2017, Berkshire Hathaway agreed to buy 80% of Pilot. This has operated in several tranches. On October 3 2017, Berkshire Hathaway bought 38.6% of Pilot for $2.758 billion. Then, on January 31 2023, they bought 41.4%.
This leaves 20% in the hands of the Haslan family. The Haslan family has a put option over this 20%. This enables them to sell the 20% to Berkshire Hathaway at a predetermined price – or pricing formula – and during a set window. They can exercise the option within 60 days of the end of each fiscal year. They would be able to sell their stake for ten times EBIT, with adjustments for debt and cash.
The sticking point is the pricing. The price is based on 10x EBIT, adjusted for debt and cash. But, accounting rules can change EBIT and how the debt and cash is recorded. Berkshire has been accused of changing this accounting treatment, allegedly in violation of Section 8.08(i) of the merger agreement, which bars “select[ing] or chang[ing] the accounting policies of the Company, except as required by Applicable Law or GAAP”.
The relevant changes include a shift to using “pushdown accounting”. What this basically means is that in an acquisition, an acquirer acquires the target. Typically, it will pay a premium over the target’s book value. This is because book values are often stale and do not reflect future growth prospects. This premium manifests in ‘goodwill’. Under ordinary acquisition accounting, this goodwill sits on the parent’s balance sheet. However, where, as here, the target has its own set of books, the acquirer may use push down accounting. Under ‘pushdown’ accounting, this is pushed down onto the target’s balance sheet. This places the goodwill on the target’s balance sheet. This must then be amortized over time, thereby reducing the target’s earnings as amortization is an expense.
Pushdown accounting can also influence things in other ways. In an acquisition, the acquirer might incur debt and expenses, such as investment banking fees. One way to approach these is to leave them on the acquirer’s balance sheet. However, under pushdown accounting, these are recorded on the target’s balance sheet. In so doing, it can depress the target’s EBIT by increasing expenses and can increase the recorded debt, which itself would have expenses associated with it.
As far as I can tell, the issues with debt and acquisition expenses appear to be tangential to this case.
The Haslan family argues that the switch in accounting method will grossly devalue their put option, thereby enriching Berkshire Hathaway at their expense, and enabling Berkshire Hathaway to acquire them for an undervalue.
The resolution is likely going to be complicated. The plaintiffs have filed a 28 page court filing. However, it is insufficient for us to know precisely how the court will decide. It will likely turn on two parts:
(1) whether there was an actual or implied term in the contract to not use pushdown accounting. We do not have the entire contract. However, my intuition is that switching accounting policies would be a violation. My intuition is that it would be implied that a constant accounting policy would be used to value Pilot. However, this will depend on all terms of the contract. If the contract does not define EBIT, it is very likely to be EBIT for Pilot as a stand alone entity.
(2) Fiduciary duties are important. Haslan has alleged that Berkshire and its representatives have breached their fiduciary duties with respect to minority shareholders. This could certainly be a live issue. It appears that the change benefits one set of shareholders at the expense of the other set and there is unlikely to be a genuine corporate purpose for this. Therefore, this could violate the duty to act in the best interests of shareholders as a whole, which would include not favoring one category of shareholders. This would especially be the case when directors represent that shareholder.
This is related to the bar on majority shareholders oppressing minority shareholders by, for example, enriching themselves at the other shareholders’ expense.
What is clear, however, is that valuations should not be based on accounting rules, such as 10x EBIT. And, these matters should be very clearly specified in advance.