BEST
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Inside −
The Debt Ceiling Deal: The Case for Caving
Can Brian Moynihan Save Bank of America?
The God Clause and the Reinsurance Industry
Taco Bell and the Golden Age of Drive-Thru
The Big Business of Synthetic Highs
How Baidu Won China
Knut, the $140 Million Polar Bear
From Mao Jackets To Silk Suits
The Scent of Fast Money—and Tuna
August 8 — August 14, 2011
Bloomberg Businessweek
Opening Remarks
Compromise
HoLD oUT
Compromise
Deal no
one likes
Political
victory
HoLD oUT
Gop options
White house options
Political
victory
Financial
armageddon
The Case for Caving
Washington’s debt ceiling deal
satisfied no one. Game theory
explains why it couldn’t have
turned out any other way
By Brendan Greeley
Game theory does not concern itself
with good and evil. It seeks to predict
not which strategies are just, but which
are most effective. John von Neumann,
a Hungarian-born polymath with a sideline in predicting the blast radius of an
atomic bomb, co-authored the discipline’s seminal work, Theory of Games
and Economic Behavior, in 1944. He then
began thinking about war-game scenarios that weighed the likelihood of an exchange of nuclear weapons. “Early in nuclear negotiations,” says Steven J. Brams,
a New York University professor of poli-
2 | Bloomberg Businessweek’s Best of
tics who worked under former Defense
Secretary Robert McNamara during the
1960s, “we didn’t know that they were
not meant to be used. It took a few years
before strategists digested this.” At the
height of the Cold War, the application
of game theory convinced leaders of the
two nuclear-armed superpowers “that if
we’re thinking of using them, we’re in
deep s--t.”
This summer’s negotiations over
raising the debt ceiling seemed to present Democrats and Republicans with a
similar dilemma. Failure to reach a deal
threatened to bring on the economic
equivalent of a nuclear winter. The leaders of the two parties, Barack Obama
and Speaker of the House John Boehner (R-Ohio), appeared to grasp this, but
a vocal band of “Tea Party hobbits,” as
their fellow Republican, John McCain
of Arizona, dubbed them, refused to go
along. They made it clear they were not
only willing to bear the catastrophic consequences of a U.S. default, but that they
might actually welcome it. Trapped in a
classic game of “chicken”—a term game
theorists use, too—in which both players
entertain the option of killing everyone,
the President did what game theory suggests a rational actor would do. He recognized his potential maximum losses were
greater than his opponent’s. He caved.
Obama’s decision to agree to a deal
that calls for $2.1 trillion in spending cuts
over 10 years, with no increases in revenue, was greeted with scorn among his
own supporters and disdain from global
markets, which plunged at news of the
accord. Meanwhile, Tea Party Republicans
complained that the agreement didn’t go
far enough. The outcome of the debt ceiling talks left everyone in a foul mood, not
least the President himself, who signed
August 8 — August 14, 2011
Bloomberg Businessweek
the final legislation on Aug. 2 in the Oval
Office, alone and grim-faced.
And yet for all the collective self-loathing that attended the debt ceiling talks,
it’s important to remember that, like just
about everything in human behavior, it
was still reducible to a game. Looked at
through the prism of game theory, it’s
hard to see how the outcome could have
turned out any other way.
Biologists have adopted game theory
to describe successful adaptations. Labor
arbitrators have used it to ease negotiations. And Brams, who has many books
on game theory to his credit, has drawn
a decision tree for God’s last discussion
with Cain in which Cain can choose to
admit, deny, or defend his crime and
God, in turn, can choose to kill or punish
him. Looking back over the Summer of
Debt, Brams can’t find a single move by
any party that’s inconsistent with predictions from his discipline. Crucially, game
theory assumes that no one is crazy, and
it’s true in life that almost no one ever is.
There’s also a pragmatic reason to treat
your opponents as sane: You can’t make
predictions about their behavior unless
you do.
Almost everyone—even members of
the Tea Party—knows a hawk from a handsaw, and the best strategy is to assume
the other player has a rational goal and
try to figure out what it is. People act
crazy, but they’re at their craziest when
they want something. All you can do in
response is to make your most honest estimate of what the crazies actually want,
and respond as if they are methodically pursuing it. There is no advantage to
be gained, for example, in pointing out
that Kim Jong Il is a potbellied nut job in
a bad suit. Everything he’s done during
his reign as North Korea’s leader suggests
he’s an amoral, but sophisticated, negotiator. Unpredictability, says Brams, can
be a smart strategy.
Game theorists distinguish between
“cooperative” and “noncooperative”
games. A cooperative game looks to
divide a pie in a way that leaves both
sides with trust in the process. Binding
arbitration, where two sides are obliged
by law to submit to a judge’s decision, is
a cooperative game.
The two parties in Washington pretended to be playing a cooperative game
this summer. At one point, the President
and Boehner simultaneously urged the
other to get “serious” and behave like an
“adult.” The object of the game, as each
leader described it, was about how best
to divide the pain of closing the deficit, in
the same way a family sits down to a pile
of bills on the kitchen table.
The President’s bipartisan commission on deficit reduction, set up late last
year and chaired by Democrat Erskine
Bowles and Republican Alan Simpson,
also played a cooperative game. The rules
were clear and the game was closed, designed only for one iteration: a single
budget, to be sent to Congress if 14 of its
18 commission members approved it. The
commission produced the kind of document you’d expect from a well-designed
game, a series of compromises and innovations designed to distribute pain and
create trust in the result. But it failed, ultimately, because it couldn’t draw enough
votes to be turned into legislation. Six of
the seven who voted against it were sitting legislators. This is not a coincidence.
Washington, as a game theorist would describe it, is noncooperative.
A noncooperative game lacks a higher
authority to impose agreements on both
sides. In Washington, no politician is
bound to reach a compromise to solve
any long-term problem. Everyone, however, is playing a game called “election,”
and the only possible goal in that game is
to win the next one. If you hear someone
in Congress say, “Senator X is just playing
politics,” a perfectly legitimate response
is, “She has to. Those are the rules of the
Constitution.” If we grumble, as voters,
that we need to throw the bums out, all
we’re doing is subjecting a new set of
bums to the same game. Anyone who
promises to fix or change Washington is
merely attempting to impose a cooperative game on a town that, by design, can’t
play one.
Obama and the House Republicans,
says Steven Brams, were playing chicken this summer, a noncooperative, nonzero-sum game in which both players
can lose. A compromise outcome is difficult to achieve in chicken, because it’s
not stable. Brams says that each player
has an incentive to dissemble, because
There’s a pragmatic reason
to treat your opponents as
sane: You can’t predict their
behavior otherwise
he will achieve a better outcome for himself if he does.
A game theorist would say that the
President is trying to play a cooperative
game in a town that can’t play along with
him. The trouble for the White House is
that the Republicans aren’t playing a game
called “fix the budget deficit.” They’re necessarily playing one called “defeat Barack
Obama.” A reasonable offer seldom works
in a divorce; there’s no reason to expect it
would in Congress.
Obama and the Democrats should recognize that anger, too, is a tactic. Brams
argues that there’s no value in trying
to determine whether anger is real or
feigned; it has the same effect either
way. Anger comes of frustration, he says,
which in turn comes of a sense of powerlessness. But frustration can actually
turn a noncooperative game cooperative.
In the Aristophanes play Lysistrata, the
women of Athens and Sparta withhold
sex until their men sue for peace. Intermittent hostility among Greek city-states,
a noncooperative game, was bound into
the cooperative game of a negotiation,
brokered by thwarted lust.
The Tea Party, in this sense, has succeeded by adopting a rational frustration
strategy. Like the women in Lysistrata,
the Tea Partiers, in effect, have withheld
their affections from both the Democrats
and the Republican leadership. That has
forced Congress into what may prove to
be a cooperative game: the next round
of deficit negotiations, with a super
committee composed of members from
both parties charged with finding consensus —enforced by triggers that would
cause pain to both sides if they don’t.
You can find fault with the Tea Party’s
prescription for balancing the budget—
most economists do—but if they hadn’t
come to Washington last year, Congress
would have waited for a real bond crisis,
five or 10 years from now, to create its
super committee.
In a new book, Game Theory and the
Humanities, Brams offers another case
study in frustration strategy: Shakespeare’s Lady Macbeth, who is desperate to see her husband crowned, but
fears he is too kind. And so she pours
her spirits into her husband’s ear, demanding that he murder King Duncan.
We will know, at the close of the next
round of negotiations, which game the
Tea Party has been playing: Balance the
Budget or Kill the King. <BW>
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Businessweek.com | 5
the Countryw
On the afternoon of Aug. 23, Gary G. Lynch, the global chief of
62
legal, compliance, and regulatory relations for Bank of America, was attending a meeting in Washington when the floor
heaved. Although Lynch, a lanky 61-year-old attorney with
swept-back white hair, had never experienced an earthquake,
he possessed the good sense to get beneath a sturdy conference table, along with several other people. “If the ceiling
came down,” he recalls, “I thought we were dead.”
The ceiling held, despite the magnitude 5.8 quake rippling
from its epicenter in Virginia. Minutes later, Lynch pulled out
his BlackBerry and discovered another startling development:
a rumor rattling Wall Street that Bank of America might get
swept into an involuntary, government-orchestrated rescue
by its smaller rival JPMorgan Chase. “This is really getting
nuts,” he thought.
Lynch, who as the head of enforcement at the Securities and Exchange Commission in the late 1980s brought
Ivan Boesky and Michael Milken to heel, knew he’d come
under heavy fire when he parachuted into BofA this July. His
assignment: Defend against a seemingly endless barrage of
multibillion- dollar lawsuits and government investigations
concerning defective mortgage-backed bonds manufactured
at the height of the real estate bubble. No sooner did one
liability bomb explode than it was followed by another. Now
Lynch was doing duck-and-cover for real, while the bank’s
share price was pounded to within a whisker of $6, down
more than 50 percent since Jan. 1. The wild speculation about
a forced merger combined ominously with financial analyst
chatter that the mortgage onslaught would drain BofA’s capital, requiring it to sell more stock in desperation. Would Bank
of America, which just weeks earlier had reported a record
second-quarter loss of $8.8 billion, go the way of Bear Stearns
or Lehman Brothers?
It was starting to smell like 2008. Hotshot BofA investment
bankers gaped at $14 restricted stock units, granted in 2010 and
early 2011, which on paper had lost half of their value. They
began thumbing smartphones for contact info of potential alternative employers. Managers interrupted vacations to rush
into the office and calm valuable dealmakers.
Calm of a temporary sort returned two days later, thanks
to a theatrical Buffett-ex-machina intervention. Three years
ago, Bear was sold for scrap, while Lehman was allowed to
collapse into bankruptcy, setting off a global financial crisis
and recession. Announced on Aug. 25, Buffett’s purchase of
$5 billion in BofA preferred stock—on typical only-for-Warren
terms, including a $300 million annual dividend—allowed the
bank to edge back from the abyss, much as Buffett’s $5 billion
vote of confidence arrested a run on Goldman Sachs stock in
2008. On Sept. 6, only hours after he sat for an exclusive interview with Bloomberg Businessweek, BofA Chief Executive
Officer Brian T. Moynihan grabbed attention again by reshuffling his management ranks, elevating a pair of new co-chief
operating officers and ousting Sallie Krawcheck, the high-profile head of wealth management. After all the excitement, the
bank’s shares were up 19 percent from their nadir.
For now, Bank of America will not go the way of Lehman or
Bear. It has $400 billion in cash and liquid investments and,
more important, with $2.3 trillion in assets, it exemplifies
the sorry concept of “too big to fail.” No matter what anyone
says to the contrary, the U.S. government cannot afford to
6 | Bloomberg Businessweek’s Best of
there aren
’t
ide acquisitio
n,” says
allow a financial institution of that size to go down and drag
the rest of the country with it. BofA’s difficulties are too complex, however, to be solved by Buffett swashbuckling, executive replacements, or the retention of a really sharp lawyer.
America’s biggest bank is inextricably intertwined with a stilldebilitated U.S. housing market and an unemployment rate
stuck painfully above 9 percent.
“Bank of America is the purest reflection of the United
States economy of any of the largest financial institutions,” observes John A. Kanas, the chief executive officer of BankUnited.
BofA owns or services one in five home loans in the U.S., operates more than 5,700 retail branches, and serves 58 million
customers. “As America goes,” says Kanas, “so will Bank of
America.”
Then there’s Countrywide Financial, the worst corporate
acquisition in living memory. BofA’s former CEO, Kenneth D.
Lewis, bought the California subprime cesspool in 2008; its
stench has permeated the Charlotte-based bank ever since.
Rampant fretting over whether BofA has sufficient capital and
needs to sell more stock traces primarily to fear that it can’t
quantify its mounting write-offs and losses connected to hundreds of thousands of mortgages gone bad. So far, the aggregate Countrywide damage exceeds $30 billion.
“Obviously there aren’t many days when I wake up and think
positively about the Countrywide acquisition,” Moynihan said
on Aug. 10 during a conference call arranged to reassure anxious investors. Even some of his loyal aides concede that the
call, like a series of other pronouncements he has made this
year, didn’t comfort many uneasy money managers. Moynihan
received his CEO stars in a battlefield promotion in December
2009, after Lewis was perceived as losing investor confidence.
A compact 51-year-old former rugby player at Brown Univer-
BreNDaN HoFFmaN/BloomBerg
“Obvious
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September 12 — September 18, 2011
Bloomberg Businessweek
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The C o
untrywid
sity, he has admirers who praise his herculean work ethic and
intelligence. Charismatic he is not. Moynihan displays little if
any humor in public and swallows many of his words. His outof-earshot nickname within the bank, according to several employees, is “the Mumbler.” Asked for a self-evaluation during the
Aug. 10 conference call, he said: “I think my performance with
the management team in terms of transforming the company,
I think, has been strong. Our performance on the share performance has not been strong.”
More serious than his bouts of verbal artlessness, Moynihan
has overpromised on critical occasions, most notably in predicting prematurely that he would raise the bank’s penny-a-share
dividend this year. Such mistakes have obscured his reasonable
attempt to remake the bloated organization he inherited. To his
credit he is different from the generation of hubristic bankers
typified by Lewis, 64, and former Citigroup CEO Sanford I. Weill,
78. During a prolonged era of bipartisan antiregulatory ideolo�y, the Lewis-Weill cohort built the behemoths that were too
big to manage and ultimately too big for Washington to allow to
go under. The instability of those institutions contributed to the
panic of 2008 and its messy, unfinished cleanup.
Moynihan, who for six years toiled as Lewis’s lieutenant,
seems determined to learn from his former boss’s mistakes.
The younger man came into his job planning to sell off extraneous assets acquired by Lewis. In the process he has made the
bank a more focused institution that in the long run ought to
be less dangerous to the financial system. Whether he has the
dexterity to survive the current crisis and complete the task is
an open question.
In the space of only a dozen years, Bank of America transformed itself from an unremarkable regional business into a
financial supermarket of gargantuan proportions. Charlotte,
in turn, grew into the country’s second-biggest banking center
after New York.
Lewis, who never concealed his Southerner’s disdain for
hifalutin Wall Street types, capped an extraordinary acquisition spree in 2008, first by absorbing Countrywide, a subprime-mortgage factory on the verge of bankruptcy. Then,
with encouragement from the Bush Administration, he took
over Merrill Lynch, the faltering brokerage and investment
bank. Merrill turned out to be Lewis’s undoing; he lost his job
in 2009 when questions arose over whether he fully disclosed
its precarious financial condition as he pushed BofA shareholders to approve the $29 billion deal.
Moynihan had joined the ballooning BofA in 2004, when
Lewis paid $47 billion for FleetBoston Financial, itself the product of rapid-fire mergers and acquisitions. The Fleet executive
had a law degree from the University of Notre Dame but set his
sights higher than the legal department. Many of his Bostonbased former colleagues couldn’t—or chose not to—adjust to
life under the notoriously demanding Lewis. Moynihan adapted. Years later, in his 2005 book Winning, former General Electric Chief Executive Officer Jack Welch held him up as a model
of corporate stamina: “He showed exactly what you should
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show if you want to survive a merger—enthusiasm, optimism,
and thoughtful support.”
At Bank of America, Moynihan didn’t specialize. Like a
leather-helmeted footballer of yore, he played offense and defense and, in a pinch, came in to punt. To make absolutely
sure he got no sleep, he often commuted to BofA’s large New
York outpost from Boston, where his family—wife, Susan Berry,
an attorney, and three young children—remained. His dedication inspires awe in the office. “Flash or pizzazz isn’t what clients want,” says Purna Saggurti, Bank of America’s chairman
of global corporate and investment banking. “Clients want content and a trusted adviser.”
As Lewis’s grip on his empire loosened in 2009, Moynihan, lacking deep roots in Charlotte or a proven CEO’s credential, was a dark horse candidate to succeed him. But the
bank’s directors were feuding, and other candidates fell away.
In December, Moynihan walked into a New York hotel room
to meet with the board of directors’ search committee. He
held a single sheet of paper on which he had written a strategic vision that actually could have fit on a note card: enough
already with the acquisitions, let’s get back to banking (or
words to that effect). He got the job.
Lewis hosted a large ceremony in Charlotte to introduce
the new CEO. “Many of you know him,” the outgoing chief
executive said of Moynihan, “because he’s been in so many
different jobs. And so, hopefully, he’ll be in this job much
longer than the last three or four.” The audience of Bank of
America employees, many wearing the company’s red-whiteand-blue flagscape lapel pin, laughed. Standing to the side
of the auditorium stage, Moynihan smiled tightly. The backhanded compliments continued. “Another unique characteristic about him,” Lewis noted, “is that he wanted the job.”
With that inauspicious endorsement, Moynihan took control
of a vast assemblage of businesses, which collectively had
received federal cash injections totaling $45 billion and appeared to be on life support.
Then, with miraculous speed, Merrill began to recover. The
acquisition that brought down Lewis became a surprise turnaround story. Federal bailout money was repaid. In April 2010,
to everyone’s relief, the rookie CEO announced a first-quarter
profit of $3.2 billion.
On a less happy note, Countrywide, a relative detail in
2008, was metastasizing into a disaster. When speaking privately, Bank of America executives will now acknowledge that
Countrywide behaved deplorably during the real estate frenzy.
In June 2010, BofA agreed to pay $108 million to settle federal
charges that Countrywide overcharged mortgage customers.
The firm “profited from making risky loans to homeowners
during the boom years, and then profited again when the loans
failed,” the Federal Trade Commission asserted. As a
➡
formal matter, BofA didn’t admit or deny the allegations,
63
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modifications a month by late 2010. Contrary to expectations,
though, home prices continued to slump in many areas, and
overall economic growth remained weak, despite the Federal
Reserve’s policy of keeping interest rates essentially at zero.
New threats came into focus. Even as state and federal
prosecutors revved up investigations of fraud in the issuing
and servicing of loans by Countrywide and its former competitors, other antagonists filed complaints. Fannie Mae and Freddie Mac, the quasi-governmental housing finance companies,
argued that millions of mortgages they bought as part of their
mission to spur homeownership were turning out to be rotten.
Fannie and Freddie wanted Bank of America (and other lenders) to buy back billions in defective loans. In addition, there
were unhappy institutional investors that had purchased mortgage-backed securities, a type of bond assembled from bundles
of home loans. When broke borrowers stopped paying on the
mortgages, the bonds defaulted. Investors wanted compensation. On Oct. 18, 2010, one bondholder group led by BlackRock
and Pacific Investment Management (Pimco) sent BofA a stern
letter demanding the bank buy back mortgages packaged into
$47 billion of bonds. There was no reason to think the BlackRock demand would be the last of its kind.
A day later, BofA announced an $872 million third-quarter
2010 provision to resolve mortgage repurchase claims. That
compared with $1.25 billion in the second quarter and $526 million in the first. Moynihan tried to allay nervousness over a perpetually open spigot. “It’s a half billion, half billion, half billion,” he said during an investor conference call. “Those are
the kinds of numbers that would be more recurring.” In other
words: Half a billion dollars per quarter may seem like a lot to
ordinary folk, but we can handle it.
Not that Bank of America would surrender those half-abillions without a fight. “It’s day-to-day, hand-to-hand combat,”
Moynihan told an investor conference in New York in November 2010. All the same, he said in December, the bank planned
to increase its dividend as fast as possible—a signal that its capital levels were sound. “I don’t see anything that would stop
us,” he added. In January 2011, he had yet more encouraging
news: The bank would take an additional $3 billion provision
8 | Bloomberg Businessweek’s Best of
to settle claims from the government-sponsored enterprises
(GSEs) Fannie and Freddie. “We are pleased to put the GSEs
behind us this quarter,” Moynihan said on Jan. 21.
He spoke too soon. “Brian, while he is a very experienced executive, is an inexperienced chief executive,” notes
BankUnited CEO John Kanas, a Moynihan fan. “He has made a
couple of political mistakes, overpromising.”
On Mar. 23, Bank of America admitted in a regulatory filing
that the Federal Reserve had rejected its request for a dividend
increase in the second half of 2011. Among the four largest U.S.
lenders, a group rounded out by JPMorgan, Citigroup, and Wells
Fargo, BofA was the only one that didn’t announce a higher dividend after the Fed reviewed the companies’ financial health in
March. In an interview with Bloomberg News, Jonathan Hatcher,
a credit strategist at Jefferies in New York, called the Fed action
“a soft warning shot” across Bank of America’s bow.
More warnings followed. In April, BofA announced a $1.6 billion deal with Assured Guaranty to resolve claims tied to tainted mortgage-backed securities the insurance company had
covered. Outstanding mortgage-buyback demands climbed to
$13.6 billion, the bank said the same month. Then, in May, it
conceded in a regulatory filing that the cost of private-investor
demands might rise to between $11 billion and $14 billion, or
$4 billion more than the previously publicized range. Later
in May, Moynihan said that the settlement with Fannie Mae
might have sprung a leak, as the larger GSE stepped up its buyback demands. “We still have some work to do” on resolving
Fannie Mae demands, Moynihan conceded. In June, BofA said
it agreed to pay $8.5 billion to settle claims by the BlackRockPimco group of bondholders.
Bank of America generates an enormous amount of
revenue—$111.2 billion in 2010—so it can afford to settle a lot
of liability claims. “The problem,” says William B. Smith, the
CEO of Smith Asset Management, a New York hedge fund,
“is the unknown.” By midsummer it became apparent that
no one, including Bank of America, understood the ultimate
damage attributable to Countrywide.
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Smith Asset Management, nevertheless, owns BofA stock.
“For those of us who are bullish, we don’t believe the mortgage hit is crippling,” William B. Smith says. “Those who are
bearish believe it is.” Like a number of other investors, he
takes solace from market analysis showing that BofA’s breakup value exceeds its current market value of about $76 billion.
“Tear this thing apart after you get down the road a bit,” says
Smith, and the stock could triple in value.
That’s not what Bank of America’s management or its
285,000 employees want to hear. Nor does the notion that
Bank of America might be worth more dismembered provide
any consolation to hundreds of thousands of homeowners
behind on their mortgage payments, some of whom accuse
BofA or its blacksheep subprime-mortgage unit of mistreating
them. “They were greedy. … It was a bad decision [to acquire
Countrywide],” says Don Barrett, a plaintiffs’ lawyer in Lexington, Miss., who is representing allegedly defrauded borrowers. “If Bank of America is going to survive, they’d better
get closure. They need closure with investors, but they also
need closure with the legitimate borrowers.”
Brian Moynihan’s private conference room on the 58th floor
of the Bank of America Corporate Center in downtown Charlotte has the usual photo of its occupant with the incumbent
President, along with other CEO knickknacks. Moynihan has
draped a canary-yellow T-shirt where every visitor can see it.
“Grind Together, Shine Together,” the black lettering on the
shirt instructs, and Moynihan presents himself as a grind-itout kind of guy.
M
es
ffl
u
sh eck
e
r
n
iha the d
oyn
He recognizes that he sees one company, while Wall Street
lately sees another. “We have the strongest capital we’ve ever
had in the company for decades,” he says. “We have the strongest liquidity.” He sounds frustrated. The bank has $115 billion
in what is known as Tier One common equity, which translates
to a capital ratio of 8.2 percent under today’s rules. That’s more
than enough to meet current requirements and puts BofA well
within shooting distance of tougher international standards
that will be phased in over coming years, Moynihan says. (“Litigation aside, there’s nothing wrong with this company,” says
Paul Miller, a former examiner for the Federal Reserve Bank
of Philadelphia who is now an analyst at FBR Capital Markets
in Arlington, Va.)
How will Moynihan close the perception gap?
“We have to keep educating and pounding and pounding and pounding,” he says. “The No. 1 thing for me was
to make the company clearer, more focused, get away from
the acquisition heritage of big is great, as opposed
➡
to great is great.”
Businessweek.com | 9
66
No question he’s slimmed the bank down. He has sold
off assets worth nearly $40 billion. These include stakes in a
bank in Brazil ($3.9 billion) and one in Mexico ($2.5 billion); a
$10.9 billion investment in BlackRock; a $2.3 billion portion
of an insurance company; more modestly valued credit-card
portfolios in the U.K., Spain, and Canada; and, most recently,
half of Bank of America’s stake in China Construction Bank,
which sold for $8.3 billion. The Lewis-era binge left BofA with
all kinds of pointless overhead. “Nobody sat down and said,
‘We want 63 data centers.’ We inherited 63 data centers,” says
Moynihan. He intends to get that down to the single digits.
He frames the Sept. 6 management shake-up as a streamlining maneuver. Where there had been no chief operating
officer, now there will be two, promoted from within: David
C. Darnell will oversee businesses responsible for serving
individual customers, including deposits, credit cards, home
mortgages, and wealth management. Thomas K. Montag will
supervise operations related to corporations and institutional
investors. “They are accountable now for delivering our entire
franchise to all our customers and clients,” Moynihan said in a
written announcement. Joe Price, who had been president of
consumer and small business banking, was ousted along with
Sallie Krawcheck, the former wealth-management chief.
Moynihan is in no mood, however, to apologize. He says he
has no regrets about promising to raise the dividend and then
not being able to follow through. He waves off the criticism as
missing the larger point that shareholders will benefit in the
long run from a stronger, better capitalized bank. Similarly, he
dismisses suggestions that he’s an ineffective public communicator. His job is to make sure that every employee understands
that at all times they should be serving one of the bank’s three
customer groups: individuals, companies, and institutional investors. Because he has pounded this home so consistently, he
adds, “There’s 285,000 people could probably give that speech
right now.” (Or maybe fewer. Moynihan has announced 6,000
layoffs so far this year, with more to come.)
The CEO doesn’t utter the word “Countrywide” voluntarily.
He won’t comment on one option—putting the unit into bankruptcy—and he refers to the mess in shorthand: “We have to
keep taking uncertain risks and eliminate them, and that’s
what we’ve been doing in the mortgage area.” For Countrywide details, he recommends talking to Gary Lynch.
Bank of America’s top in-house lawyer works in a serene
sanctum high above Sixth Avenue in New York. The room features cool white marble and white leather. Lynch has made
a career of remaining unruffled—at the SEC during its 1980s
insider-trading investigations, later as a partner at the New
York corporate law firm Davis Polk & Wardwell, and then as
the senior-most attorney at investment banks Credit Suisse
First Boston and Morgan Stanley.
It’s no wonder that Moynihan hired Lynch, but is the attorney still glad he moved over to Bank of America? Lynch laughs, a
public relations man holds his breath, and the lawyer says yes.
With professorial precision he proceeds to sort the categories of legal risks facing BofA into three “buckets.” Over
time, he explains, the bank can gradually empty each bucket.
First, there are “representations and warranties” claims, such
as those made by the GSEs and the BlackRock-Pimco bondholder group. Those parties want BofA to buy back mortgages
allegedly based on false information about borrowers or property. Bank of America has negotiated compromise payments
for most of the reps-and-warranties claims.
Bucket No. 2 contains fraud lawsuits filed by investors who
bought mortgage-backed securities, which have lost value. A
lawsuit filed Aug. 8 by American International Group, the New
York-based insurance giant, sits in that bucket; AIG seeks damages of $10 billion. Lynch says the bank will fight the vast majority of such suits. “I’d much rather be sued by AIG than by
someone who has never purported to be an expert on mortgages and risk management,” he notes. His point is that AIG is
a sophisticated financial player that should have known that
subprime-backed bonds could explode.
Finally, there’s a bucket for government allegations that
Countrywide generated fraudulent foreclosure documents.
BofA and other large lenders are skirmishing with the 50 state
attorneys general in hopes of reaching a mass settlement whose
collective price tag has been estimated at $20 billion.
Sweeping a long arm over his imaginary litigation receptacles, Lynch seems sure of himself. Statutes of limitation are
running out, and that’s why so many lawyers rushed to the
courthouse this summer, he says. “We’re comfortable that
these securitization cases will go away or be settled for cents
on the dollar,” he adds. “At the end of the day, do we
➡
have ample capital to get through this? Absolutely.”
ry Lynch
Legal ace Ga
’s risks
divides BofA
ckets
into three bu
,” says Lynch
olutely
s
b
A
?
is
th
h
g
u
ro
capital to get th
le
p
m
a
e
v
a
h
e
“Do w
$8.5b
$10b
$20b
Loan Origination
In 2008, Bofa bought subprime home
lender Countrywide Financial, a firm whose
lax underwriting led to soaring defaults on
mortgages and “putback” claims from those
who bought or insured them. In one proposed
settlement, the bank would pay private
investors $8.5 billion.
Mortgage-Backed Securities
Bank of america is accused by the insurer
american International group and other
investors of bundling shoddy loans into
securities while grossly understating the
assets’ risks. aIg alone is seeking to recoup
more than $10 billion from the lender. Bofa
denies the charges.
Mortgage Servicing
Bank of america and other mortgage
servicers are accused by state and
federal investigators of employing
“robosigners” to submit improper
foreclosure documents; a settlement
could cost the five biggest firms
$20 billion.
10 | Bloomberg Businessweek’s Best of
BUCKet: DaNNY SmYtHe/alamY; lYNCH: rICK maImaN/BloomBerg
September 12 — September 18, 2011
Bloomberg Businessweek
September 12 — September 18, 2011
Bloomberg Businessweek
September 12 — September 18, 2011
Bloomberg Businessweek
many day
h n I wake
“For thossew
of ue
s who are buu
pllais
ndht,h
wien
dk
onp
’t bo
elie
vteith
CEO Moyniha
em
s
ortgage hit is crip
i
ve
l
n of thsays
y
pling,”
about
e winves
orstor
t mBill
“Tho
se
who
erSmit
are
bear
ish
gerh.
belie
ve
it
is.
The Co in living memory. triple
untvalue
stock could
rywof
Tear this thing apart,” and the
idthe
ed
68
sity, he has admirers who praise his herculean work ethic and
intelligence. Charismatic he is not. Moynihan displays little if
someone
is going
say, ‘O.K.,
Counselor,
tell meHis
exactly
any “If
humor
in public
andtoswallows
many
of his words.
outwhat you’re
going towithin
pay out,’
I can’taccording
do that, and
I wouldn’t
of-earshot
nickname
the bank,
to several
emtry,” Lynch
acknowledges.
What’s
he says, theduring
mortgage
ployees,
is “the
Mumbler.” Asked
formore,
a self-evaluation
the
litigation
won’t getcall,
resolved
in three
months
or six months
or
Aug.
10 conference
he said:
“I think
my performance
with
a year.
“Past cases
of this
type have
been working
the
the
management
team
in terms
of transforming
thethrough
company,
forbeen
years.”
Iprocess
think, has
strong. Our performance on the share perforThehas
problem,
his clients’ perspective, is that even
mance
not beenfrom
strong.”
when
Bank
of America
says itofhas
something
resolved,
new
More
serious
than his bouts
verbal
artlessness,
Moynihan
doubts
clutter the
The state AGs’
seems,
has
overpromised
onbucket.
critical occasions,
most settlement
notably in predictin broad
outline,that
likehe
a reasonable
Big lenders
fork
over
ing
prematurely
would raiseidea.
the bank’s
pennya-share
cash to make
borrowers
whole
andobscured
modify his
thereasonable
terms on
dividend
this year.
Such mistakes
have
some mortgages
keep theirhe
homes.
But To
lately,
attempt
to remakeso
thepeople
bloatedcan
organization
inherited.
his
attorneys
Newthe
York,
Delaware,
and Nevada
have
credit
he isgeneral
differentinfrom
generation
of hubristic
bankers
broken
ranks,
saying
theyformer
don’t want
to rush
toSanford
a truce because
typifi
ed by
Lewis,
64, and
Citigroup
CEO
I. Weill,
they’re
notathrough
investigating
lenders’
misbehavior. ideolMore78.
During
prolonged
era of bipartisan
antiregulatory
over,the
the
New Yorkcohort
prosecutor,
Eric
T. Schneithat
derman,
has
o�y,
Lewis-Weill
built the
behemoths
were too
challenged
the
propriety
oftoo
thebig
$8.5
settlement
with
big
to manage
and
ultimately
forbillion
Washington
to allow
to
private
uncertainty
that pact,to
too.
go
under.bondholders,
The instabilitycasting
of those
institutionson
contributed
the
panic of 2008 and its messy, unfinished cleanup.
ForMoynihan,
all the angst
Bank
of America
on Wall lieutenant,
Street and
whoover
for six
years
toiled as Lewis’s
in the determined
media, regulators
at the
Federal
Reserve
andmistakes.
Treasury
seems
to learn
from
his former
boss’s
Dept.,
speaking
because
are not
to
The
younger
manprivately
came into
his jobthey
planning
to authorized
sell off extracomment
onacquired
particular
saythe
they
have he
watched
Moynineous
assets
by banks,
Lewis. In
process
has made
the
han’saperformance
are mostly
by what
they’ve
bank
more focusedand
institution
that pleased
in the long
run ought
to
seen.
fact they applaud
his shrinking
the
company
be
lessIn
dangerous
to the financial
system.
Whether
heand
has simthe
ilar moves
some the
of his
competitors.
dexterity
toby
survive
current
crisis and complete the task is
One of
the paradoxes of the 2008 crisis has been that, in
an open
question.
its aftermath, a U.S. financial industry overpopulated with
institutions
too big
to failBank
became
even more
conIn
the spaceconsidered
of only a dozen
years,
of America
transsolidated.
Mergers
such
as Bank of America’s
acquisition
formed
itself
from an
unremarkable
regional business
into of
a
Countrywide,
and JPMorgan’s
absorption
of Bear
fiMerrill
nancialand
supermarket
of gargantuan
proportions.
Charlotte,
Stearns
and into
Washington
Mutual
have produced
a quartet
of
in
turn, grew
the country’s
second-biggest
banking
center
megabanks
that together hold $7.7 trillion in assets, or 56.8 perafter
New York.
cent
of thewho
U.S.never
total, concealed
compared with
45.2 percentdisdain
of the total
Lewis,
his Southerner’s
for
before the
crisis.
hifalutin
Wall
Street types, capped an extraordinary acquiEven
with
added
the potential
risk
sition
spree
inthis
2008,
firstconsolidation,
by absorbing and
Countrywide,
a subit perpetuates in factory
the event
a true
investor
or depositor
run
prime-mortgage
onofthe
verge
of bankruptcy.
Then,
on any
of the megabanks,
regulators
say there has not
been
with
encouragement
from the
Bush Administration,
he took
muchMerrill
for them
to do
about
Bank ofbrokerage
America’sand
difficulties.
New
over
Lynch
, the
faltering
investment
oversight
tools
created
financial
reform
legbank.
Merrill
turned
outbytothe
beDodd-Frank
Lewis’s undoing;
he lost
his job
islation
enacted
in 2010arose
are still
crafted.
Anddisclosed
industry
in
2009 when
questions
overbeing
whether
he fully
lobbyists
are fistill
trying
to bluntasrules
on how
much
capital
its
precarious
nancial
condition
he pushed
BofA
shareholdbanks
must hold,
howbillion
they sell
mortgages, and what kind of
ers
to approve
the $29
deal.
trading
they can
for their
accounts.
To avoid
future
taxMoynihan
haddojoined
theown
ballooning
BofA
in 2004,
when
payerpaid
bailouts,
the law
major
banks toitself
submit
Lewis
$47 billion
forrequired
FleetBoston
Financial,
the“living
prodwills,”
or plans
how they
be efficiently
dismembered
uct
of rapid-fi
re for
mergers
and could
acquisitions.
The Fleet
executive
in dire
circumstances.
ButUniversity
details on of
theNotre
living-will
are
had
a law
degree from the
Dameprocess
but set his
still being
debated;
nolegal
willsdepartment.
have been submitted
to Washingsights
higher
than the
Many of his
Bostonton. (Regulators
say Bank
of Americachose
hasn’t
gotten
into livbased
former colleagues
couldn’t—or
not
to—adjust
to
ing-will
territory,
becausedemanding
the bank has
cashMoynihan
on hand and
the
life
under
the notoriously
Lewis.
adaptability
tolater,
borrow
more.)
far the
Dodd-Frank
perverse
ed.
Years
in his
2005So
book
Winning,
formerlaw’s
General
Eleceffect
hasExecutive
been to heighten
uncertainty
without
disentangling
tric
Chief
Officer Jack
Welch held
him up
as a model
thecorporate
combinations
of investment
banking
with
consumer
and
of
stamina:
“He showed
exactly
what
you should
amages?
$30b-pl
us
commercial banking that proved so perilous in the wake of the
housing bubble.
One
positive
is that
there are more cops walking
the
show
if you
wantchange
to survive
a merger—enthusiasm,
optimism,
banking
beat. About
30 examiners from the Fed’s Richmond
and
thoughtful
support.”
(Va.)
areAmerica,
assigned Moynihan
full-time to monitoring
Bank ofLike
AmerAt branch
Bank of
didn’t specialize.
a
ica, up from 14 in footballer
2007. Fed of
staff
members
say off
they
areand
able
to
leather-helmeted
yore,
he played
ense
degive closer
to the
bank’s
securities
and
loanabsolutely
portfolios,
fense
and, scrutiny
in a pinch,
came
in to
punt. To
make
as well
associated
its assets
thelarge
adequacy
sure
he as
gotthe
norisk
sleep,
he oftenwith
commuted
toand
BofA’s
New
of itsoutpost
capital.from
In early
summer,
when
Fed officials requested
opYork
Boston,
where
his family—wife,
Susan Berry,
tions
BofA might
consider
if overall
economic conditions
serian
attorney,
and three
young
children—remained.
His dedicaously
eroded,
theinbank
responded
that
one possibility
would
tion
inspires
awe
the offi
ce. “Flash
or pizzazz
isn’t what
clibe towant,”
issue asays
separate
of shares
linked
to the performance
ents
Purnaclass
Saggurti,
Bank
of America’s
chairman
ofglobal
Merrillcorporate
Lynch, according
to BofA.
Moynihan
doeswant
not think
of
and investment
banking.
“Clients
consuchand
a step
will be
needed and similarly has no plans to sell
tent
a trusted
adviser.”
more
BofA common
his aides
say.
As Lewis’s
grip onstock,
his empire
loosened
in 2009, MoyniFeddeep
examiners
supposed
be keeping
ancreeye
han,While
lacking
roots inare
Charlotte
or to
a proven
CEO’s
out for reckless
practices
within BofA,
there’s ahim.
danger
dential,
was a dark
horse candidate
to succeed
But that
the
other government
officials
andand
politicians
could hasten
fresh
bank’s
directors were
feuding,
other candidates
fellaaway.
financial
meltdown
as they
seekinto
their
pound
of hotel
assetsroom
from
In
December,
Moynihan
walked
a New
York
Bank
of with
America.
The state-AG
foreclosure
has identito
meet
the board
of directors’
searchprobe
committee.
He
fied troubling
pastofpractices,
thehe
handful
of prosecutors
held
a single sheet
paper onbut
which
had written
a strateholding
a resolution
could have
jeopardize
prize
theyenough
desire.
gic
visionup
that
actually could
fit on athe
note
card:
Likewise,
Fannie
Mae and Freddie
two to
of banking
BofA’s other
already
with
the acquisitions,
let’s Mac,
get back
(or
main antagonists,
areHe
each
words
to that effect).
gotalmost
the job.80 percent-owned by U.S.
taxpayers
as a result
of rescues
at the
depths ofto
the
financial
Lewis hosted
a large
ceremony
in Charlotte
introduce
crisis.
The
GSEs
are “we
if they
take Bank
of
the
new
CEO.
“Many
of the
youpeople”;
know him,”
thehelp
outgoing
chief
America down,
will“because
have to mop
Onin
Sept.
2, the
executive
said oftaxpayers
Moynihan,
he’sup.
been
so many
Federal
Finance
Agency, the
Washington
of
diff
erentHousing
jobs. And
so, hopefully,
he’ll
be in thisregulator
job much
Fanniethan
and the
Freddie,
joined
fray.
In its
own brace
of lawlonger
last three
orthe
four.”
The
audience
of Bank
of
suits, theemployees,
FHFA accused
Bank
of America
and 16 other
lenders
America
many
wearing
the company’s
red-whiteof misleading
Fannie
andpin,
Freddie
aboutStanding
billions of
of
and-blue
flagscape
lapel
laughed.
todollars
the side
mortgagebacked securities.
of
the auditorium
stage, Moynihan smiled tightly. The backThe problem
for Moynihan,
says
Lou Barnes,
“ischaracterthat everyhanded
compliments
continued.
“Another
unique
one is
suinghim,”
him, Lewis
he can’t
know“is
when
will the
stop,job.”
and
istic
about
noted,
thatthe
hesuits
wanted
meanwhile—hello?—the
economy isn’tMoynihan
bouncing back,
and it’s
With
that inauspicious endorsement,
took control
damned
to get aof
home
loan approved
here.” Barnes,
of
a vast tough
assemblage
businesses,
whichout
collectively
had
a banker federal
and credit
analyst
at Premier
Mortgage
Groupand
in Boulreceived
cash
injections
totaling
$45 billion
apder, Colo.,
argues
that
Moynihan “looks to be doing as well as
peared
to be
on life
support.
anyThen,
little with
Dutch
boy can—sticking
his fingers
into
the
dike.” The
miraculous
speed, Merrill
began
recover.
But more
cracks
keep
opening
Barnes
ticks off
the
acquisition
that
brought
down
Lewis up.
became
a surprise
turnlatest statistics
frombailout
Lender
Processing
Services,
a major
around
story. Federal
money
was repaid.
In April
2010,
home-loan
4.1rookie
million
loans
nationwide
are 90 or
to
everyone’sservicer:
relief, the
CEO
announced
a first-quarter
moret of
days
delinquent
profi
$3.2
billion. or in foreclosure; delinquency rates are
twice
norm;
foreclosure rates
are eight
times
On their
a lesshistorical
happy note,
Countrywide,
a relative
detail
in
higherwas
than
the historicalinto
average;
moreWhen
than 40
percent
of
2008,
metastasizing
a disaster.
speaking
pri90-days-plus
loans have
made
a payment
in
vately,
Bank ofdelinquent
America executives
willnot
now
acknowledge
that
more than a behaved
year.
Countrywide
deplorably during the real estate frenzy.
BofA2010,
is more
exposed
scary
figurestothan
any
other
In June
BofA
agreedto
tothose
pay $108
million
settle
federal
bank. Moynihan
“has got toovercharged
know there are
more losses
ahead,
charges
that Countrywide
mortgage
customers.
enough
kill ated
bank,”
says
Barnes.
“Noloans
model
for what
The
firmto“profi
from
making
risky
to exists
homeowners
——With
reporting
by Max
Cristina
happens
during
thenext.”
boom<BW>
years,
and then
profited
againAbelson,
when the
loans
Alesci, Roben
Farzad,Trade
Cheyenne
Hopkins, Robert
Schmidt,
failed,”
the Federal
Commission
asserted.
As a Hugh
➡
Son, Craig
Torres,
and
Karen
Weise
formal
matter,
BofA
didn’t
admit
or deny the allegations,
63
Businessweek.com | 11
the riSk buSineSS CAn tell
uS A lot About CAtAStropheS.
why don’t we liSten?
the god
12 | Bloomberg Businessweek’s Best of
ClAuSe
by brendAn greeley
Businessweek.com | 13
September 5 — September 11, 2011
Bloomberg Businessweek
60
At 9:03 A.m. on September 11, 2001,
britt newhouSe Stood in the lobby on
the 52nd floor of the South tower of the
world trAde Center. After united AirlineS
flight 175 bAnked Above the hArbor behind
him, it wAS pointed At the 50th floor. if
not trimmed CorreCtly, An AirplAne will
riSe AS it ACCelerAteS, And the mAn who hAd
killed And replACed the AirplAne’S pilot
Added power until he hit the South
tower 24 floorS Above newhouSe. he
doeSn't remember the Sound of the impACt.
At the time, Newhouse ran Guy Carpenter’s Americas operation. Guy Carpenter brokers reinsurance treaties, which
protect insurers when a catastrophe—a hurricane or an
earthquake—causes losses on a large number of policies. Reinsurance, in essence, is insurance for insurers.
Consumers don’t tend to know what reinsurance is because it never touches them directly. Reinsurers, massively capitalized and often named after the places where they
were founded—Cologne Re, Hannover Re, Munich Re, Swiss
Re—make their living thinking about the things that almost
never happen and are devastating when they do. But even
reinsurers can be surprised. And the insurers who make up
their market put them on the hook for everything, for all the
risks that stretch the limits of imagination. This is what the
industry casually refers to as the “God clause”: Reinsurers are
14 | Bloomberg Businessweek’s Best of
ultimately responsible for every new thing that God can come
up with. As losses grew this decade, year by year, reinsurers
have been working to figure out what they can do to make the
God clause smaller, to reduce their exposure. They have billions of dollars at stake. They are very good at thinking about
the world to come.
Lloyd’s, the London-based company that invented the
modern profession of insurance, publishes a yearly list of
what it calls “Realistic Disaster Scenarios.” The list imagines
such events as two consecutive Atlantic seaboard windstorms
or an earthquake at the New Madrid fault in the Mississippi
Valley, either of which could strain or break an insurer’s balance sheet. By 2001, Lloyd’s had already envisioned two airliners colliding over a city, launching claims on hull insurance
for the planes, property insurance and workman’s comp on
oPEnIng SPrEAd: doug KAntEr/AFP/gEtty ImAgES; tHIS PAgE: lAmbErt/ArcHIVE PHotoS/gEtty ImAgES
September 5 — September 11, 2011
Bloomberg Businessweek
the ground, and life insurance everywhere. But even Lloyd’s
lacked the imagination to anticipate September 11. “People
find it hard to believe in a risk unless they can see it in their
mind,” says Trevor Maynard, head of exposure management
for Lloyd’s. “When you try and describe a risk like this—some
terrorists are going to teach themselves how to fly a plane,
they will fly into property, the buildings will be weakened—by
the time you get to your third point, peoples’ eyes are glazing over.”
Floors 49 through 54 of the south tower housed Guy
Carpenter’s home offi ce and its 750 employees. To any of
Newhouse’s clients—insurers—professional employees in an
office tower would have presented an attractive bet in terms
of risk and reward. There are few slips and falls in white-collar
work and not much dangerous equipment lying around. Newhouse indulges in mild profanity and, thinking like a broker,
often lapses without warning into the voice of his customers
as they think about risk. “If I insure 40 of these firms in two
towers across 200 floors, probably the worst is that eight of
them, maybe six of them, could be involved in the same loss,”
he says. “Because the fire department can get there ... usually
a fire never spreads, historically, beyond six floors.”
The insurance industry describes these kinds of risks as
“high frequency”: The more often a kind of accident occurs,
the easier it is to guess its chance of happening and the easier
it is to price insurance coverage. For slips, lawsuits, and fires,
historical trends predict future probability. “What they hadn’t
imagined,” says Newhouse, picking his words carefully, “was
an intentional act of human causative agency.”
Guy Carpenter lost 29 employees on September 11. When
the plane hit his building, most of Newhouse’s employees were
well below him or out of the tower already. Guy Carpenter’s
chief executive officer had traveled to an annual conference in
Monte Carlo, leaving Newhouse as the most senior manager.
After American Airlines Flight 11 hit the north tower, he told
everyone to leave. The company had been in the World Trade
Center in 1993 when a bomb exploded below the north tower.
His employees did not need to be reminded that the world
was a dangerous place, even if the building’s collapse still lay
outside of the realm of imagination. By the time Newhouse
reached the plaza level, a cordon of police officers waited to
direct him through the mall below. When he got back to street
level both towers were still standing. The hole in the north
tower glowed, he says, like a dragon in a cave.
He saw the chaos on the ground beneath the towers and
looked for a Hudson River ferry. He had no trouble getting
on board; there was no rush. “There were people hanging
around,” he says, “working their cell phones and watching.”
They were still there in the streets, watching, when his ferry
backed out and the floors of the south tower began to collapse
and accelerate down. Until that second, they hadn’t believed
that anything more could happen to them. No experience of
fear drove them to get far away, as fast as they could, until it
was too late.
I was standing there, too. I survived by dumb luck.
for cyclonic storms. No, he explained, little of that value was insured. “Honestly,” said someone else, “I’ve never understood
why those people don’t just leave. It’s a dangerous place.”
By definition, reinsurers work at the edge of suffering, and
so have developed euphemisms to help them stand at a distance. A catastrophe is called a “loss event.” A catastrophe big
enough to affect several reinsurers is called an “industry loss
event.” Reinsurers both need and fear these. The first dedicated reinsurer, Cologne Re, formed after a fire leveled about a
quarter of the city of Hamburg, Germany, in 1842. A loss event
reminds insurers of the value of the product; reinsurers can
raise rates, and the higher rates attract new capital. According
to Dowling & Partners, an investment adviser for the insurance
industry, after Hurricane Andrew ran across southern Florida in 1992, eight new reinsurers entered the market, together
valued at $2.9 billion. Although hurricanes seem frequent, the
insurance industry defines them as “low frequency” events;
there are perhaps 10 a year and not tens of thousands. Unlike
car accidents, you cannot look at the last decade of hurricane
results and predict this year’s losses with any accuracy.
Andrew’s $25 billion in losses, along with the then-new
availability of cheaper computing power, helped push insurers and reinsurers toward computer-driven modeling, which
leaned on meteorology and seismology to more precisely
define potential losses by estimating storm paths and categories and fault lines and tremor strengths. The models are
sophisticated, but reality is wily.
After September 11, another eight new reinsurers followed
the higher rates and entered the market, together valued at
$8.6 billion. Hurricanes Katrina, Rita, and Wilma lured five
more new reinsurers with $5 billion in capital. Between catastrophes, the new capacity drives premiums back down
➡
and reinsurers are forced to undervalue risks to stay in
61
In the fall of 1998 I started a job in New York with one of
the world’s largest reinsurers. Soon after, at a meeting in a conference room above Park Avenue, someone complained that the
market for reinsurance had gone soft. “What we need,” he said,
“is a good catastrophe.” It was a joke, but true, too. I offered
that a cyclone had hit Bangladesh and it had been an active year
Businessweek.com | 15
September 5 — September 11, 2011
Bloomberg Businessweek
“nothing SAyS there
CAn’t be 10 world trAde
Center eventS in A yeAr,”
SAyS trilovSzky.
“there CAnnot be A
mAthemAtiCAl model for
people like bin lAden”
be one of them. Most reinsurance treaties renew on Jan. 1 and
the meeting oriented itself around a new question: What do
we do on 1/1/2002? “There were 15 managers, all with a background in property,” says Trilovszky. “We had flip chart paper
and we put it on the floor. We were kneeling on the floor, working out concepts, brainstorming ideas … that was the Munich
Re strategy for terrorism risk in the first days after 9/11.” In
Could we intereSt you in A poliCy?
InSurEd loSSES*
BY caTEgorY
For the insurance industry at least, you can put a price on tragedy: According to
Swiss re’s catastrophe statistics, nature’s wrath and man-made disasters cost
society approximately $218 billion in 2010.
$80b
$40b
While the Indonesian earthquake
and tsunami of 2004 claimed more
than 220,000 lives, Hurricane
Katrina was far more costly to
insurers at $72.3b.
September11 cost
insurers around $23.1b
in property and business
interruption coverage.
2001
2002
2003
2004
$10b
Explosions or fires, including
at a sugar refinery, oil pipeline,
and mattress factory, amounted
to more than $5.3b in insured
damage.
2005
2006
2007
$1b
In the year that included Air
France 447’s loss over the Pacific,
insurers paid out around $2.1b in
transit damage.
2008
2009
2010
KEY: ● Storms/floods ● Earthquakes/tsunamis ● Transit/shipping/aviation accidents ● Major fires/explosions ● Terrorism/crime/misc.
16 | Bloomberg Businessweek’s Best of
*ProPErty And buSInESS IntErruPtIon, ExcludIng lIAbIlIty And lIFE InSurAncE loSSES dAtA: SWISS rE
62
the market. Vincent J. Dowling of Dowling & Partners refers to
this as the “cheating phase” of the cycle. That is, even though
catastrophes present an existential threat to insurers, and the
sober assessment of risk is a firm-defining competency, insurers, like people, can get complacent.
“The psychology piece dominates, even in boardrooms,”
says David Bresch. “People measure against the perceived reality around them and not against possible futures.”
Bresch is in charge of sustainability and risk management
for Swiss Re, founded in 1863 after a city fire in Glarus, Switzerland, and now the world’s second-largest reinsurer. “If the
gap between modeled reality and perceived reality is too big,”
says Bresch, “that tells you something about the market share
you’d like to achieve.” In other words, what the models show
as a best guess of a risk may not be what the insurers perceive
the risk to be, and it can take more than just data alone to scare
insurers into paying for risks at a rate that keeps reinsurers
solvent over the long term. That takes an industry loss event.
It takes a catastrophe.
Heike Trilovszky runs corporate underwriting for Munich
Re, the world’s largest reinsurer. The afternoon of September 11, the press and the company’s shareholders needed to
know what Munich Re’s losses would be. “To get answers we
had to ask the brokers,” she says. “Aon Benfield, Guy Carpenter, they had offices in those buildings. It was odd. Is my counterpart still alive?” Before the end of the week, Munich had
an initial estimate. In October, Trilovszky was at an off-site
meeting when a board member arrived late. He had seen the
revised loss estimate and he was pale. “We will survive,” he
said, “but it’s serious.” Munich Re’s losses after September 11
ultimately came to $2.2 billion.
Reinsurance treaties are full of exclusions, but before September 11 terrorism was not considered significant enough to
JIJI PrESS/AFP/gEtty ImAgES
September 5 — September 11, 2011
Bloomberg Businessweek
2002, together with the rest of the industry, the company They remind him when approaching a reinsurer about a client
wrote terrorism risk out of any treaty with an insured value to hear, speak, and say no evil. The monkeys are all gifts, given
of greater than $50 million. Terrorism is what Trilovszky calls to him to rebuild a much larger collection that was lost when
“nonfortuitous.” It stems from a few angry, motivated people, his last office disappeared.
and nothing says there can’t be 10 World Trade Center events
in a single year. “There cannot be a mathematical model,” she Swiss Re’s global headquarters face Lake Zurich, oversays, “for people like bin Laden.”
looking a small yacht harbor. Bresch and a colleague, Andreas
Reinsurers prefer to underwrite risks they
Schraft, sometimes walk the 20 minutes to the
can name; such a treaty is called a “named
train station together after work, past more
perils” cover. Far more often, however, the
yachts, an arboretum, and a series of bridges.
market forces them to sign an all-perils cover.
In September 2005, probably on one of these
Although reinsurers can exclude risks they alwalks, the two began to discuss what they now
ready know about from an all-perils treaty—an
call “Faktor K,” for “Kultur”: the culture factor.
act of terrorism, for example—they cannot exLosses from Hurricanes Katrina, Rita, and
clude what Donald Rumsfeld might call an unWilma had been much higher than expected
known unknown. That’s the God clause.
in ways the existing windstorm models hadn’t
Models exist for some low-frequency risks
predicted, and it wasn’t because they were far
Top 10 costliest
such as hurricanes, earthquakes, and oil spills,
off on wind velocities.
disasters Since 1970
but they don’t exist for every one. Trilovszky
The problem had to do more with how
①
doesn’t have a model for airplane crashes.
people on the Gulf Coast were assessing wind2011 earthquake,
“Would it hurt us if crashes became more frestorm risk as a group. Mangrove swamps on
tsunami, nuclear
quent? It would,” she says. “As it is now, I’m
the Louisiana coast had been cut down and
disaster
not sure we ever had a property loss from an
used as fertilizer, stripping away a barrier
$235 billion
Japan
aircraft crash. It’s theoretical. It lives within
that could have sapped the storm of some of
the error of the models we have.” The second
its energy. Levees were underbuilt, not over②
something unexpected happens, though, it’s
built. Reinsurers and modeling firms had fo2005 Hurricane Katrina
$72.3 billion
no longer theoretical or unimaginable.
cused on technology and the natural sciencu.S.
“The history of the industry,” says Newes; they were missing lessons from economists
house, the broker, “is we cover everything in a
and social scientists. “We can’t just add anoth③
1992 Hurricane andrew
catastrophe until after the catastrophe. Then
er bell and whistle to the model,” says Bresch,
$24.87 billion
we rewrite it.” Until the Sixties there was no
“It’s about how societies tolerate risk.”
u.S. and bahamas
hours clause—a time limit—on damage that can
“We approach a lot of things as much as
④
be claimed to be from a hurricane. Now the
we can from the point of statistics and hard
September 11
standard is 96 hours. Newhouse has been a redata,” says David Smith, head of model devel$23.13 billion
insurance broker for 35 years. Every new inopment for Eqecat, a natural hazards modu.S.
dustry loss event—every new catastrophe—is
eling firm. “It’s not the perfect expression.”
⑤
the biggest in his career, he likes to say, and he
The discrepancy between the loss his firm
1994 northridge
knows by now that every catastrophe teachmodeled for Katrina and the ultimate claimsearthquake
es the industry something. “If you want to be
based loss number for his clients was the larg$20.6 billion
able to price [an event], if you want to be able
est Smith had seen. Like others in the industry,
u.S.
to build an industry and a capital base that can
Eqecat had failed to anticipate the extent of
⑥
handle it … then you’d better figure out a way
levee failure. Construction quality in the Gulf
2008 Hurricane Ike
to define it. Then capital can be accumulated
states before Katrina was poorer than antici$20.48 billion
to deal with it.”
pated, and Eqecat was surprised by a surge
u.S.
I ask him why the reinsurance industry
in demand after the storm that inflated prices
⑦
failed after the World Trade Center bombfor labor and materials to rebuild. Smith rec2004 Hurricane Ivan
ing of 1993 to either raise prices for terrorism
ognizes that these are questions for sociolo$14.87 billion
coverage or to exclude acts of terrorism from
gists and economists as well as engineers, and
u.S., caribbean,
coverage altogether. He looks at me as if he
he consults with the softer sciences to get his
barbados, et al
would like for me to figure it out for myself so
models right. But his own market has its de⑧
he doesn’t have to say it. “Because it wasn’t
mands, too. “The more we can base the model
2005 Hurricane Wilma
big enough,” he says, pausing before adding,
on empirical data,” he says, “the more defend$14.02 billion
u.S., mexico,
“economically.” The cost of an event, he exable it is.”
Jamaica, Haiti, et al
plains, dictates how much the industry spends
After their walk around the lake in 2005,
on understanding and preventing it. “I’m not
Swiss Re’s Bresch and Schraft began meeting
⑨
2005 Hurricane rita
saying people didn’t react to it,” he adds, “but
with social scientists and laying out two goals.
$11.26 billion
you know, if your company’s life is threatened
First, they wanted to better understand the culu.S., gulf of mexico, cuba
by the size of the loss, you’re going to react
ture factor and, ultimately, the risks they were
⑩
much differently.”
underwriting. Second, they wanted to use that
2004 Hurricane charley
Newhouse keeps in his office a collection of
understanding to help the insured prevent
$9.29 billion
plaster monkeys, the kind that come in sets of
losses before they had to be paid for.
➡
u.S., cuba, Jamaica, et al
three with hands over ears, mouths, and eyes.
The business of insurers and reinsur-
63
damage estimates for 2011 Hurricane Irene have not yet been totaled
Businessweek.com | 17
September 5 — September 11, 2011
Bloomberg Businessweek
64
ers rests on balancing a risk beTop 10 deadliest
tween two extremes. If the risk
disasters Since 1970
isn’t probable enough, or the
①
potential loss isn’t expensive
1970 Bhola cyclone
enough, there’s no reason for
300,000 deaths
anyone to buy insurance for it.
bangladesh
If it’s too probable and the loss
②
too expensive, the premium will
1976 Tangshan
be unaffordable. This is bad for
earthquake
both the insured and the insur255,000 deaths
er. So the insurance industry has
china
an interest in what it calls “loss
③
mitigation.” It encourages poten2010 earthquake
tial customers to keep their prop222,570 deaths
Haiti
erty from being destroyed in the
first place. If Swiss Re is trying to
④
affect the behavior of the prop2004 Boxing day
tsunami
erty owners it underwrites, it’s
220,000 deaths
sending a signal: Some behavior
Indonesia, thailand, et al
is so risky that it’s hard to price.
⑤
Keep it up, and you’ll have no in2008 tropical
surance and we’ll have no busicyclone nargis
ness. That’s bad for everyone.
138,300 deaths
To that end, Swiss Re has startburma
ed speaking about climate risk,
⑥
not climate change. That the cli1991 tropical
mate is changing has been estabcyclone gorky
lished in the eyes of the industry.
138,000 deaths
“For a long time,” says Bresch,
bangladesh
“people thought we only needed
⑦
to do detailed modeling to truly
2008 great Sichuan
understand in a specific region
earthquake
how the climate will change. …
87,449 deaths
You can do that forever.” In many
china
places, he says, climate change is
⑧
only part of the story. The other
2005 Kashmir
part is economic development. In
earthquake
73,300 deaths
other words, we’re building in the
wrong places in the wrong way, Pakistan, India, Afghanistan
so wrong that what we build often
⑨
1970 ancash
isn't even insurable. In an interearthquake
view published by Swiss Re, Wolf
66,000 deaths
Dombrowsky, of the Disaster RePeru
search Center at Kiel University
⑩
in Germany, points out that it’s
2010
northern
wrong to say that a natural disasHemisphere summer
ter destroyed something; the de55,630 deaths
struction was not nature’s fault
russia
but our own.
In 1888 the city of Sundsvall
in Sweden, built of wood, burned to the ground. A group of
reinsurers, Swiss Re among them, let Sweden’s insurers know
there was going to be a limit in the future on losses from
wooden houses, and it was going to be low. Sweden began
building with stone. Reinsurance is a product, but also a carrot
in the negotiation between culture and reality; it lets societies
know what habits are unsustainable.
More recently, the company has been working with McKinsey & Co., the European Commission, and several environmental groups to develop a methodology it calls the “economics of
climate adaptation,” a way to encourage city planners to
➡
build in a way that will be insurable in the future. A study
dAtA: SWISS rE; PHoto: olIVIEr lAbAn mAttEI/AFP/gEtty ImAgES
18 | Bloomberg Businessweek’s Best of
September 5 — September 11, 2011
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65
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of the U.K. port of Hull looks at potential losses by 2030 under
several different climate scenarios. Even under the most extreme, losses were expected to grow by $17 million due to climate change and by $23 million due to economic growth. How
Hull builds in the next two decades matters more to it than the
levels of carbon dioxide in the air. A similar study for Entergy,
a New Orleans-based utility, concluded that adaptations on
the Gulf Coast—such as tightening building codes, restoring
wetlands and barrier islands, building levees around chemical plants, and requiring that new homes in high-risk areas be
elevated—could almost completely offset the predicted cost of
100-year storms happening every 40 years.
As with Sweden’s stone houses, all of these adaptations cost
more money in the short run, but reinsurers must take the
long view, and they can drag development along with them.
The public, whom the reinsurers refer to as “the original insured,” should be concerned by these hints. Even when they
are forced to sign all-perils covers, reinsurers are writing more
known risks out of their treaties. Swiss Re publishes an annual
report on catastrophe losses; since the 1970s losses have been
increasing exponentially. It’s this graph that gives reinsurers
pause. The God clause includes less each year because every
loss event—every catastrophe—reminds them of the hubris of
thinking God doesn’t have any surprises left.
Munich Re’s Trilovszky offers a similar point from a differ-
ent perspective: The companies that buy insurance are complaining, she says, that insurers and reinsurers have capital but
aren’t willing enough to take on new business risks, such as the
risk of a compromised brand or stolen intellectual property.
Like many reinsurers, Munich Re underwrites a line called
“contingent business interruption.” Essentially, if for some
reason a supplier fails to produce a crucial part for a factory,
business interruption insurance covers the factory’s owner.
The earthquake off the coast of Japan this March happened
on a Friday; on Saturday, Trilovszky was doing research on an
initial loss assessment when she discovered that a technology
company in Louisiana had already stopped operations. It had
run out of chips. “That,” she says, “was my eye-opener.”
Reinsurers are already exposed to a loss after a natural
catastrophe. But given the complexity of global supply chains,
it’s hard to tell exactly how much more loss will come from
business interruptions elsewhere in the world. Two seemingly
uncorrelated risks—an earthquake in Japan and a tech firm in
Louisiana—are now related. Losses gather mass and complexity on their way toward reinsurers, which serve as a garbage
bin for systemic risk. Reinsurers haven’t yet figured out how
to respond to the problem of contingent business interruption
after a catastrophe. “The easy thing to do is, we don’t cover
this,” Trilovszky says. “The question is to adjust the product so
it’s still useful for the insured but possible for the insurer.”
66
a Japanese soldier rescues an elder in natori after the March 2011 earthquake and tsunami
20 | Bloomberg Businessweek’s Best of
September 5 — September 11, 2011
Bloomberg Businessweek
in JApAn, Stone tAbletS mArk the high-wAter
mArkS of pASt tSunAmiS. they All Send the
SAme meSSAge: when we Are gone, remember
thiS flood. And prepAre for the next one
Str/AFP/gEtty ImAgES
You could think of politicians as underwriters, too. Like
Bresch and Trilovszky, they must compare the probabilities of
low-frequency events, weighing the risk of a downturn against
a sovereign default, or of Chinese imperial ambition against
more small wars in the Middle East, or of climate change
against the cost of regulation.
Reinsurers, however, have no incentive to mislead. Their
choices on risk, with billions of dollars at stake, are necessarily
aligned with the pursuit of truth. If a reinsurer is more scared
of a risk than it should be, its shareholders will punish it. If
it is less scared than it should be, the world, eventually, will
break it. There are rewards for politicians, corporations, think
tanks, and activists who dissemble about risk. There are none
for reinsurers. If they’re taking on less of it than their insurers would like them to, then the world is more dangerous than
we’re willing to admit. What a reinsurer will underwrite, then,
offers a marker, one edge of what Bresch calls the gap between
modeled and perceived reality. For instance, no event of the
last 10 years—the invasion of Iraq, the reelection of George W.
Bush, the surge, the election of Barack Obama, or the death
of Osama bin Laden—has persuaded the reinsurance industry
to budge from its stance on terrorism risk on Jan. 1, 2002. For
those with billions waged on getting it right, terrorism is now
a constant, and almost impossible to cover.
By 2001, I was working as a consultant for another reinsurer,
Converium. The company kept its U.S. front office on the 47th
floor of One Chase Manhattan Plaza at the corner of Nassau
and Cedar streets. I did several stupid things on September 11.
I already knew an airplane had hit a tower when I got on the
subway to go to work. I learned of the second plane while I
was still on the train, got off at my stop, and walked four blocks
closer. I bumped into my 9 a.m. meeting in the lobby of One
Chase. He told me we had been sent home and started walking
north. I rode the elevators 47 stories up, since I figured I would
need my laptop. I called my mother and told her I was safe.
I rode the elevator back down and walked a block closer
until I was separated from the south tower by a small park. As
Newhouse stepped onto a boat for New Jersey, I stood and listened to news on the radio of a limousine parked with its windows down, and I watched. When the south tower began to
fall the ash was thick, black, and moving fast, and I assumed,
briefly, that I was going to die. And then I didn’t. Maps of September 11 victims show bodies recovered on that block at the
corner of Cedar and Broadway. I ran, found a hole in the dust
that was the door to Two Chase Plaza, and I lived. Until the
tower began to fall, it just didn’t occur to me that anything
worse could happen. It’s a simple story. I wasn’t worried about
terrorism. And now I am.
In December 2001, I was working late, back up on the 47th
floor, when the fire alarm rang. I bolted from my desk and
past a break room where two janitors were still sitting. “Don’t
we need to leave?” I asked. “They’ll tell us if we have to,” they
said. I ran, alone, down 47 flights of stairs and emerged on the
street without wallet, coat, or keys. There was no fire. I spent
the night with friends. I had overpriced the risk of terrorism.
Catastrophes do not surprise all societies equally. Greg
Bankoff, an historian at the University of Hull in Britain, has
defined for the Philippines a “culture of risk,” a set of adaptations built around the constant threat of natural disaster. Agricultural systems in the Philippines focus on minimizing loss
rather than maximizing yield. The islands developed a kind
of low, buttressed “earthquake baroque” style for stone buildings. Communities are quick to relocate out of danger.
In a paper this year on risk culture in Western Europe, historian Christian Pfister of the University of Bern in Switzerland
details how towns pass on memories of disaster. A stone house
in Wertheim, Germany, sits on the Tauber River, painted with
the dates and levels of floods back to 1621. Storm tide markers
dot the North Sea coast. In 1606 the farmers of Italy’s Aosta
Valley built a chapel near the glacier that delivered regular
floods and began a procession to it every July. And on Japan’s
east coast, stone tablets mark the high-water marks of tsunamis. They all send the same message: When we are gone, remember this flood. And prepare for the next one.
From Newhouse’s office you can see, near the receptionist, a monument to the 29 Guy Carpenter employees who were
killed on September 11. It stands about five feet high, in polished wood, inscribed with 29 names and topped with a crystal flame. Newhouse is now Guy Carpenter’s CEO. When I tell
him that I was downtown on September 11, he reaches into a
box below his desk and gives me a pin he’d had made for staff
and clients: the towers of the World Trade Center, wrapped
in a single black ribbon. I mention the tsunami stones, many
of which had been ignored in the burst of economic activity
in Japan that followed World War II. Commerce grows along
dangerous places, on rivers and coastlines. Is it possible, I ask,
that there’s a value to forgetting? He pauses. “If the stone is
there the stone is there,” he says, “but 500 years of upside,
with the absolute certainty that it’s going to be the generation
after me, not me, that gets drowned—that’s human nature,
isn’t it?” <BW>
67
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May 9 — May 15, 2011
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22 | Bloomberg Businessweek’s Best of
d
s
May 9 — May 15, 2011
Bloomberg Businessweek
order
The Steamer reads the
on the
and puts the tortilla
grill for 20 seconds
0:36
The Steamer ladles
in some beans
0:15
I
t must always be, “Hi, how are you
today?” Never, “Hi, how are you?” “Hi,
how’s it going?” or “Welcome to Taco
Bell.” Never, “What will it be today?” or,
even worse, “What do you want?” Every
Taco Bell Service Champion memorizes
the order script before his first shift. The
folks who work the drive-thru windows at
the Taco Bell here in Tustin, Calif., about
35 miles south of Los Angeles, and everywhere else, are called Service Champions.
Those who work the food production line
are called Food Champions.
You think you know it—“Hi, how are
you today?” It seems easy enough. And
you follow that with, “You can order when
you’re ready,” never “Can I take your
order?” The latter puts pressure on the
driver, who might be a distracted teenager busy texting her BFF or a soccer mom
with a half-dozen kids in the van. “They
don’t need the additional pressure of a
disembodied voice demanding to know
their order,” explains Mike Harkins. Harkins, 49, is vice-president of One System
Operations for Taco Bell, which means he
spends all day, every day, thinking about
the kitchen and the drive-thru.
He has been prepping me for my debut
at the window. Getting ready, I wash my
hands, scrubbing for the mandated 20
seconds; slide on rubber gloves; and don
the three-channel headset that connects
me to the ordering station out in the lot,
as well as to my fellow Champions. I take
my place at the window. I hear the ding
indicating a customer has pulled into the
loop around the restaurant, and I immediately ask, “Hi, how’s it going?”
It gets worse from there. As a Service Champion, my job is to say my lines,
input the order into the proprietary point
of sale (POS) system, prepare and make
drinks like Limeade Sparklers and Frutista Freezes, collect bills or credit cards,
and make change. I input Beefy Crunch
Burritos, Volcano Burritos, Chalupas, and
Gorditas. My biggest worry is that someone will order a Crunchwrap Supreme, a
fast-food marvel made up of two kinds of
tortillas, beef, cheese, lettuce, tomatoes,
and sauces, all scooped, folded, and assembled into a hand-held, multiple-foodgroup package, which then gets grilled for
27 seconds. An order for a Crunchwrap
Supreme, the most complex item on the
menu, sometimes requires the Service
Champion to take up position on the food
production line to complete it in anything
like the 164 seconds that Taco Bell averages for each customer, from driving up to
the ordering station to pulling away from
the pick-up window.
Drive-thru is the operational heart
of the fast-food industry, as central to a
brand like Taco Bell as the kitchen itself,
maybe more so. According to the National Restaurant Assn., the fast-food
industry will do $168 billion in sales for
2011, and about 70 percent of that will
come in through drive-thru windows.
The technology deployed at order sta-
tions and pick-up windows has evolved
to meet that demand. Every step is measured, every movement calculated, every
word scripted. Taco Bell, with more than
5,600 locations in the U.S., currently operates some of the fastest and most accurate drive-thru windows in the industry, at least according to QSR magazine’s
last survey, in 2009, though for years
they lagged. The system is the result of a
15-year-plus focus on the window as the
core of the business. Taco Bell’s pride in
moving from the bottom of the pack to
near the top is also part of the reason
it allowed a journalist, unsupervised by
public relations staff, to work the line.
Above me on the wall, a flat-screen
display shows the average time of the last
five cars at either the order station or the
pick-up window, depending on which is
slowest. If the number is red, as it is now,
that means one, or both, of the waits is
exceeding 50 seconds, the target during
peak periods. It now shows 53 seconds, on
its way to 60, 70 ... and then I stop looking. The high-pitched ding that announces
each new customer becomes steady, unrelenting, and dispiriting—85 cars will roll
through over the peak lunch rush. And I
keep blowing the order script.
I fall behind so quickly and completely that restaurant manager Amanda
Mihal, a veteran of 12 years in the QSR
business (Quick Serve Restaurant, the acronym for an industry that makes
➡
acronyms for everything), has to
65
Businessweek.com | 23
May 9 — May 15, 2011
Bloomberg Businessweek
The Steamer passes the
burrito to the Stuffer,
who scoops in some cheese
0:57
1:08
The Stuffer hits
ch
the Beefy Crun
uirt
Burrito with a sq
of sour cream
r”
from the “Goope
66
step in. “You’ll get it,” Amanda says as
she fixes an order that I have managed to
screw up. “Eventually.”
Go into the kitchen of a Taco Bell
today, and you’ll find a strong counterargument to any notion that the U.S. has lost
its manufacturing edge. Every Taco Bell,
McDonald’s, Wendy’s, and Burger King is a
little factory, with a manager who oversees
three dozen workers, devises schedules
and shifts, keeps track of inventory and
the supply chain, supervises an assembly line churning out a quality-controlled,
high-volume product, and takes in revenue of $1 million to $3 million a year, all
with customers who show up at the front
end of the factory at all hours of the day
to buy the product. Taco Bell Chief Executive Officer Greg Creed, a veteran of the
detergents and personal products division
of Unilever, puts it this way: “I think at Unilever, we had five factories. Well, at Taco
Bell today I’ve got 6,000 factories, many
of them running 24 hours a day.”
It’s as if the great advances of human
civilization, in everything from animal
husbandry to mathematics to architecture to manufacturing to information
technology, have all crescendoed with
the Crunchwrap Supreme, delivered via
the pick-up window.
“The most advanced operational thinking in the
world is going on in
the back of a QSR,”
says Mike Watson, a former senior vicepresident for operations at Wendy’s and
currently executive director of operations engineering at WD Partners, a consulting firm that works with QSR brands.
“If you have it laid out where it doesn’t
flow right, that means less order flow, less
product, lower sales.”
The big brands spend hundreds of
millions and devote as much time to
finding ways to shave seconds in the
kitchen and drive-thru as they do coming
up with new menu items. “The majority
of the business now happens around the
back of the building,” says Blair Chauncey, editor of QSR magazine. “So much
money and R&D go into perfecting the
production system because there is so
much money to be had.”
The development of new menu items
has become subservient to the need to
get food to drivers as quickly as possible.
At Taco Bell, for example, a 2006 decision
to add a new grill to the line—forcing thousands of franchisees to upgrade their kitchens, retrain staff, and modify the food preparation process—was far more momentous
than decisions about switching the marketing campaign from, say, “Make a run for the
Border” to “Think Outside the Bun.”
The food was designed for mass production almost from the start. Glen Bell,
Taco Bell’s founder, began experimenting in 1950 with what he called a tay-co,
trying to devise a crispy tortilla shell that
wouldn’t shatter when stuffed with ground
beef, lettuce, and cheese. He had watched
customers in Mexican restaurants eating
their soft tay-cos with their fingers, folding
the end with one finger to keep sauce from
dripping. Bell felt a hard shell would lend
itself to the assembly-line style of food
preparation pioneered by McDonald’s. He
invented a wire basket with six slots for
corn tortillas that could be dunked in boiling oil and then removed. To facilitate the
assembly process, he designed a rack that
allowed workers to slide the shells past the
trays of beef, lettuce, and cheese, the tacos
taking shape the same way a car does as
it rolls through the factory. Both those implements exist in every Taco Bell today.
The assembly line would increasingly determine the texture, shape, and taste of
the food as big brands made menu decisions based as much on what was operationally possible as on what tasted good.
Bell opened and closed several fastfood operations before launching Taco
Bell in 1962. Spurred by the success
of those hard-shell tacos, he would
franchise and eventually take Taco
Bell public in 1969, before resigning
from the board in 1975. Taco Bell
was acquired by PepsiCo in 1978,
then spun off with Pizza Hut and
d operational
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24 | Bloomberg Businessweek’s Best of
1:40
ents the
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ht name
paper so the rig
outside
will appear on the
1:23
the
es the burrito to
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apping
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KFC to form Tricon Global Restaurants in
1997, which became Yum! Brands in 2002.
None of that would have been possible
without coming up with a faster, easier
way to deep-fry tortilla shells.
M
ike Harkins started working at
7-Elevens when he was 15 and
spent 11 years at Southland Corp.,
putting himself through Grossmont College, where he earned a degree in accounting. Taco Bell recruited him in 1996
to be a market manager overseeing the San
Diego area. (Even his oldest son worked as
a drive-thru Service Champion for a year
and half.) Harkins managed restaurants as
well—it has become almost a requirement
that Taco Bell senior management put in
some time running an actual restaurant—
and as he shows me around the Tustin
Taco Bell, it’s obvious he knows where everything is without bothering to look. “I’ve
spent my whole life living in 7-Elevens and
Taco Bells and I’ve thought a lot about what
makes these kinds of operations go,” he
says, pulling on rubber gloves and pointing to the food production line. “You have
to have consistency. You walk into any Taco
Bell, and you see, roughly, this.”
Every Taco Bell has two food production
lines, one dedicated to the drive-thru and
the other to servicing the walk-up counter.
Working those lines is no easier than wearing the headset. The back of the restaurant
has been engineered so that the Steamers,
Stuffers, and Expeditors, the names given
to the Food Champions who work the pans,
take as few footsteps as possible during a
shift. There are three prep areas: the hot
holding area, the cold holding area, and
the wrapping expediting area. The Stuffer
in the hot holding area stuffs the meat into
the tortillas, ladling beef with Taco Bell’s
proprietary tool, the BPT, or beef portioning tool. The steps for scooping the beef
have been broken down into another acronym, SST, for stir, scoop, and tap. Flour
tortillas must be cooked on one side for 15
seconds and the other for five.
When I take my place on the line and
start to prepare burritos, tacos, and chalupas—they won’t let me near a Crunchwrap Supreme—it is immediately clear
that this has been engineered to make
the process as simple as possible. The real
challenge is the wrapping. Taco Bell once
had 13 different wrappers for its products. That has been cut to six by labeling
the corners of each wrapper differently.
The paper, designed to slide off a stack
in single sheets, has to be angled with
the name of the item being made at the
upper corner. The tortilla is placed in the
middle of the paper and the item assembled from there until you fold the whole
thing up in the wrapping expediting area
next to the grill. “We had so many wrappers before, half a dozen stickers; it was
all costing us seconds,” says Harkins. In
repeated attempts, I never get the proper
item name into the proper place. And my
burritos just do not hold together.
With me on the line are Carmen
Franco, 60, and Ricardo Alvarez, 36. The
best Food Champions can prepare about
100 burritos, tacos, chalupas, and gorditas in less than half an hour, and they have
the 78-item menu memorized. Franco
and Alvarez are a precise and frighteningly fast team. Ten orders at a time are
displayed on a screen above the line, five
drive-thrus and five walk-ins. Franco is
a blur of motion as she slips out wrapping paper and tortillas, stirs, scoops,
and taps, then slides the items down the
line while looking up at the screen. The
top Food Champions have an ability to
scan through the next five orders and
identify those that require more preparation steps, such as Grilled Stuffed Burritos and Crunchwrap Supremes, and
set those up before returning to simpler tacos and burritos. When Alvarez is
bogged down, Franco slips around him
and slides Crunchwrap Supremes into
their boxes. For this adroit time management and manual dexterity, Taco Bell
starts its workers at $8.50 an hour, $1.25
more than minimum wage.
67
C
hief Operating Officer Rob Savage’s office at Taco Bell’s headquarters, or, as they call it, the
Restaurant Support Center, in Irvine,
Calif., looks out over Interstate 405
toward the coastal mountains along the
Pacific. Savage and Harkins are explaining how Glen Bell never envi- ➡
Businessweek.com | 25
2:12
May 9 — May 15, 2011
Bloomberg Businessweek
The burrito is wrapped
so that it can be easily
opened at the optimal
consumption point
1:51
led by a Service
Payment is hand
pick-up window
the
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68
are
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in les
u memorized
the 78-item men
sioned a drive-thru when
he created his first Mission-style Taco Bells. As
the brand grew to more
than 6,000 locations by
the 1990s, the company
found itself struggling to
deliver on both speed and
accuracy, coming in close to the bottom
of QSR magazine surveys. “We were getting slammed,” says Savage. “We realized we didn’t have good systems. We
didn’t have good processes, training.”
In the early 1990s each Taco Bell location was coming up with its own responses to a drive-thru business already
delivering more than 50 percent of the
brand’s revenue. There was no order
script. Service Champions were constantly running back into the kitchen to
grab missing items. “We were getting the
speed part, but sacrificing accuracy,” says
Harkins. The response, of course, was to
create an acronym, TRED, which, after
much discussion among the operations
team seated in Savage’s office, is determined to stand for Target, Rush Readiness, Equipment Functionality, and
Deployment. What it meant was that
operations throughout the brand were
standardized, bottlenecks were identified, and staffing was optimized to deploy
enough bodies to handle the peak traffic periods. One of their discoveries was
that at some locations, 70 percent of the
26 | Bloomberg Businessweek’s Best of
business was coming through the drivethru, and 80 percent of that was coming
in about 90 minutes of peak time around
lunch. That meant that 56 percent of the
total business was being conducted at
one window in one and a half hours.
Through the mid and late ’90s, Taco
Bell designed and implemented the kitchen and drive-thru operation it still uses
today. It eventually got its speed and accuracy to where it consistently beat the
3-minute, 30-second target per order,
even during peak. Taco Bell does this
while serving a wider range of menu
items, and more complicated food, than
the hamburger chains.
The program was so successful that
in 2009 the brand was the first to finish
in the top five in QSR magazine’s DriveThru Performance Study in both speed
and accuracy, averaging 164 seconds per
vehicle with an accuracy rate of 93.1 percent. Wendy’s was fastest with an astonishing 134 seconds per vehicle, but
it didn’t crack the top five in accuracy.
Citing a need to protect “key secrets”
central to its business, Wendy’s declined
to provide access to its restaurants.
There is no secret
formula for Wendy’s success, says
former Vice-President Watson, other
than “a consistent
operating system and training, and measures to reinforce positive behaviors.”
Pretty similar, in other words, to Taco
Bell’s TRED system, though likely with
a different acronym.
Visit any kitchen in the QSR industry, and you will see certain similarities. The food production line will be
in a T-pattern, with the dine-in counter and the pick-up window at each end
of the top of the “T.” There have been
headsets since the 1970s, and a strict division of labor has been in place since
the 1960s, albeit with tweaks and modifications that have made it possible for a
McDonald’s employee to assemble a Big
Mac in 15 seconds. Screens throughout
the kitchen displaying orders and order
times have made the kitchen faster.
Drive-thru accuracy has improved
immensely. Much of the credit for that
goes to the verification board, first used
by McDonald’s in the ’90s, which let customers see their orders rather than just
hear them read back. This eliminated
the large percentage of order mistakes
that were actually customer errors and
not the result of a drive-thru worker putting the wrong thing into the POS or a
one
The total cost for to:
rri
Beefy Crunch Bu
99¢, plus tax
2:44
2:21
After 164 seconds,
lunch is served
food worker preparing the wrong item.
“That meant I knew if you understood
me and I understood you,” says Dennis
Lombardi of WD Partners. “That was
huge for customer satisfaction.”
The operations are now so fast and
so efficient that there may not be many
more seconds to be wrung out of the
current system. A human being can only
order so fast, drive so fast, and hand over
his currency or credit card so fast. “They
have gotten to a place where it is probably as fast and accurate as it is going to
be,” says Blair Chauncey, of QSR magazine, adding that this is one of the reasons her magazine stopped doing the
Performance Study after 2009. “We got
to the point where they were separated
by a few seconds and everyone’s accuracy was above 90 percent. Everyone has
gotten so good.”
W
e are all of us, right now, living
in the golden age of drive-thru.
That doesn’t mean the industry
doesn’t want to go faster. The two most
highly touted innovations of the past decade—side-by-side ordering, where two
order stations funnel to one pickup lane;
and call centers, which take orders from
a remote location—have both been tested
with varying degrees of success. While
McDonald’s rolled out the first side-byside ordering in 2005, the concept has
been limited by the cost and complexity
of retrofitting existing locations with multiple lanes. “The perception is that you
are faster,” says John Miologos, a former
corporate vice-president for architecture
and design at McDonald’s and currently a
consultant with WD Partners. “It speaks
to fairness, so you won’t get stuck in a line
behind a soccer mom ordering 14 meals
for the team.” Still, to make the concept
significantly faster, Miologos believes you
also have to add a second window, one
for the transaction and another to pick
up the food. “I could see this gaining traction, but the economics of this have to be
dealt with,” says Miologos.
The call center was yesterday’s big
idea in the QSR space. It was tempting
for companies to imagine the customer
pulling up to the speaker box and placing her order with someone in a country
where the minimum wage is lower than
it is in the U.S. Wendy’s tried the idea in
Lexington, Ky., with the help of Exit41,
an Andover (Mass.) technology consulting firm that specializes in the QSR industry. WD Partners’ Watson, who was a
Wendy’s senior vice-president at the time
of the testing, says the economics work
well when you are able to pool five or six
stores. “But you are still depending on
kitchen production,” he says, “so even if
it looks faster, if you don’t ramp up kitchen production you don’t improve sales.”
This year, Pollo Tropical and Taco
Cabana, fast casual restaurants with 275
locations, will be testing a platform that
allows customers to order via the web. If
this works, Chief Marketing Officer Jason
Abelkop believes the brands can explore
expanding into more crowded retail
spaces, i.e., those without surrounding
parking lots, which would change the
business completely. “Look, the drivethru exists in and of itself not because
people intrinsically love the drive-thru
experience, but because they love the
convenience of it,” says Abelkop. “In
some ways, this exceeds that.”
At the drive-thru window in Tustin, I
would have shaken off the headset many
orders ago had it not been for manager Mihal’s support, but I’m hanging in
there. After a while, I do begin to detect
a pleasing, steady rhythm to the system,
the transaction, the delivery of the food.
Each is a discrete, predictable, scripted interaction. When the order is input
correctly, the customer drives up to the
window, the money is paid, the Frutista
Freeze or Atomic Bacon Bombers (a test
item specific to this Taco Bell) handed
over, and you send people on their way
with a smile and a “Thank you for coming
to Taco Bell,” you feel a moment of accomplishment. And so does Harkins, for
it has all gone exactly as he has planned.
Then a ding in my headset.
“Um, hello?”
Idiot, I think to myself, I’ve blown the
script again. <BW>
69
Businessweek.com | 27
The
Drug
is
Fake
28 | Bloomberg Businessweek’s Best of
The
high
is
real
The
money
is
huge
The unlicenseD,
ingenious,
anD increasingly
scary worlD
oF synTheTic
Drugs.
By Ben PaynTer
PhoTograPhs By
jamie chung
Businessweek.com | 29
Packets of Pandora
Potpourri’s “incense”
60
t’s a Friday afternoon in April, and Wesley Upchurch, the 24-year-old owner of Pandora Potpourri, has arrived at his factory to fill some lastminute orders for the weekend. The factory is a
cramped, unmarked garage bay adjoining an auto
body shop in Columbia, Mo. What Upchurch and
his one full-time employee, 21-year-old Jay Harness, are making is debatable, at least in their
eyes. The finished product looks like crushed
grass, comes in three-gram (.11 ounce) packets,
and sells for about $13 wholesale. Its key ingredient is a synthetic cannabinoid that mimics tetrahydrocannabinol (THC), the active ingredient in
marijuana. Upchurch, however, insists his product is incense. “There are rogue players in this industry that make the business look bad for everyone,” Upchurch says. “We don’t want people smoking this.”
From the outside the place looks abandoned. The only sign
of life is a lone security camera. Inside, two flags hang above a
makeshift assembly line. One shows a coiled snake and reads
“Don’t Tread On Me.” The other has a peace symbol. The work
space consists of a long, foldout table containing a pile of lustrous, green vegetation, a pocket-calculator-size electronic scale,
a stack of reflective, hot-pink Mylar foil packets, and a heat sealer.
Each packet has the brand name, Bombay Breeze, and is decorated with a psychedelic logo featuring a cartoon elephant meditating among abstract-looking coils of smoke and stars.
Upchurch supervises as Harness weighs out portions of the
crushed foliage, dumps it into a packet, and slides the top
through the heating machine to create an airtight, tamperproof seal. He finishes about a dozen in 10 minutes, topping off
what they will need for their deliveries: two shipments of more
than 1,000 packets each. Upchurch points to a disclaimer near
the bottom right-hand corner of each package that reads, in
all caps: “NOT FOR CONSUMPTION.” Says Upchurch: “That’s
to discourage abuse.”
“This is a
markeTer’s Dream,”
says riggs.
“i unDerPromise
anD
iT oVerDeliVers”
30 | Bloomberg Businessweek’s Best of
upchurch in his
missouri factory
His protests and disclaimers to the contrary, Pandora is getting smoked—it’s being packed into bongs and reviewed on sites
such as YouTube—for its ability to alter the mind. Like many
others, Upchurch is repackaging experimental medical chemicals for mainstream store shelves, most often with some clever
double-entendre in the branding. He says he sells about 41,000
packets a month, delivering directly to 50 stores around the
country and shipping the rest to five other wholesalers, some of
whom use Pandora’s products to create their own brands. Upchurch says he ships mostly in bulk orders for larger discounts.
He projects his company will earn $2.5 million in revenue with
$500,000 in profits this year, depending on what federal and
state laws pass. “I think my business model is based less on
charts than it is on guts, or something,” he says.
“Incense” such as Upchurch’s, along with “bath salts” and
even “toilet bowl cleaner,” have been popping up at gas stations,
convenience stores, “coffee shops” that don’t sell much coffee,
and adult novelty stores. Today, Upchurch’s shipments—he uses
UPS—are headed to places called Jim’s Party Cabin in Junction
City, Kan., and the Venus Adult Superstore, in Texarkana, Ark. Instate, Upchurch sells to Coffee Wonk, a coffee shop in downtown
Kansas City, Mo. There, 28-year-old owner Micah Riggs writes the
names of his offerings in multiple colors on a dry erase board
near the register. The packets themselves are kept beneath the
counter. While Riggs doesn’t mind his customers talking about
how they will use the incense, he’s as circumspect about what
he is actually selling as Upchurch. Nearly everything he says is in
code. He’ll say things like, “Is this your first foray?” and “There
are different potencies of aroma.”
Customers report different reasons for trying Riggs’s products. Some say they need to pass a drug test; synthetics do not
show up in standard tests. Others are businessmen in khakis
who like the idea of buying from someone they trust. Riggs
claims to sell mostly to the military, soccer moms, teachers,
and lots of firefighters. “I don’t tell people what to do with it,”
Riggs says. “This is a marketer’s dream. I underpromise and
it overdelivers.”
Synthetic cannabinoids are the most common of an expanding array of drugs that mimic the effects of outlawed, mostly
farmed, substances but are based on manufactured and often
legal compounds. In just a few years a complicated global
supply chain, enabled by the Internet, has appeared to produce, package, and ship a multiplying variety of narcotics. It
is taking an increasing chunk of the market for recreational
drugs, estimated by Jeffrey A. Miron of Harvard and the Cato
Institute to be $121 billion in North America.
Scott Collier, a diversion program manager with the Drug
Enforcement Administration in St. Louis, estimates there are
Ben Paynter (4)
“incense” drying on racks
now at least 1,000 synthetic drugmakers in the U.S. Those are
only the ones with recognizable brands. “Factor in the number
of people using the Internet as a supply store and making stuff
out of their basement, and that number jumps considerably,”
he says. Many synthetics are not complicated to make; videos
detailing the process on YouTube run about ten minutes.
In the U.S., producers such as Upchurch have been making
millions, if not billions. With no penalties in many states, firsttime customers have been able to experiment with “incense”
or “bath salts” without fear of legal consequences. There’s not
even an age restriction.
While untracked in the U.S. until a few years ago, the
market for the kind of “incense” sold by Upchurch now generates close to $5 billion annually, according to Rick Broider,
president of the North American Herbal Incense Trade Assn.
(Nahita), which represents more than 650 manufacturers,
wholesalers, and retailers. (Broider says his number is based
on self-reported sales statistics from members.) Daniel Francis, executive director of the Retail Compliance Assn., another trade organization, founded to help inform and protect the
rights of merchants, says he hired an independent analyst who
came up with a similar figure.
Scrambling to control the synthetics, states are engaged in
an endless game of tag. As legislators outlaw synthetic compounds, manufacturers and packagers create or find new variations, scanning medical journals for clues about lesser-known
substances developed by legitimate researchers, often importing those compounds from labs in foreign countries. According to the National Conference of State Legislatures, at least 32
states have enacted legislation banning various types of synthetic cannabinoids. And another 18 have legislation pending
to enact new laws or increase the penalties.
In March the DEA banned five formulas from use in commercial products. These included JWH-018, JWH-073, JWH-200,
CP-47.497, and cannabicyclohexanol. JWH is named after John
W. Huffman, a chemistry professor at Clemson University in
South Carolina who developed it in the early 1990s. CP is code
for Charles Pfizer, a precursor of Pfizer.
Synthetic marijuana first gained popularity in the European
Union in 2006; at least 21 member countries reported its presence in 2009. (While the U.S. and many countries have begun
to outlaw these products, at least one, New Zealand, has gone
the other way. In March, government authorities announced a
plan to make the sale of products with JWH-018 and -073 legal
for anyone 18 and over.)
Synthetic drugs aren’t just limited to aping marijuana,
either. Those so-called bath salts or toilet cleaners are actually a second wave of synthetics: chemically based alternatives
that simulate the effects of harder substances—some organ-
The mixing station and stacks
of fresh Bombay Breeze
ic, some not—such as methamphetamines, cocaine, ecstasy,
lysergic acid diethylamide (LSD), phencyclidine (PCP), and
even cocktails of all those substances mixed together. At least
38 states have also banned or have pending legislation to
ban some synthetic cathinones, which mimic drugs such as
methamphetamines.
Society may just be beginning to understand the implications of a developing class of drugs that deliver highs like
the organic product without the hassle of farming, that can
be transported in small bricks and not bales, that dogs can’t
or don’t yet know how to smell, and that leave no trace on
drug tests. There is every indication that synthetic replicas of
farmed drugs, legal or not, have arrived for good. As Collier
puts it, “the race is on.”
Rusty Payne, a spokesman for the DEA, agrees that outlawing substances doesn’t mean they will disappear. Banned blends
might return to shelves or be sold underground. “A logical assumption is that the bad guys see this as a good market,” he says
of the synthetics. “If the way they can make the most money is
smuggling drugs, there’s going to be smuggling drugs.”
Paul Cary, director of the Toxicology and Drug Monitoring
Laboratory at University of Missouri Health Care in Columbia,
Mo., works as an expert adviser for the National Association
of Drug Court Professionals. While urine testing for some JWH
compounds was developed in late 2010, he says it remains expensive and is available at only a handful of specialized labs
around the country. “Most designer drugs are produced cheaply, extensively marketed, and quasi-legal. When the labs and
laws catch up, the chemists just move on,” he says. “The ability
of laboratories to detect designer drugs will always lag behind
these illicit chemists’ ability to produce them.”
Adds DEA spokesman Payne, “This stuff is not going away.
We are going to be dealing with synthetic use for a long time,
with new emerging chemicals coming up.”
Indeed, business is in full swing at Upchurch’s facility. Responding to the efforts of lawmakers, he’s been changing his
formulas as needed. He doesn’t want the exact name of the
chemicals in his recipe printed, but on that April visit his secret
ingredient sits on a back shelf at his headquarters: It’s a silver,
kilogram-size bag of a crystalline powder containing yet another
variant of a JWH-style synthetic cannabinoid.
61
Jeremy Morris, a senior forensic scientist with the Johnson
County Sheriff ’s Office in Kansas, brings out his research
stash—a lump of weed and an incense packet labeled Bayou
Blaster (its logo is a washboard-playing alligator)—and places it
on a sterile countertop alongside a microscope. It’s a Wednesday afternoon in April, and he is in his crime lab, an all➡
white work space in Mission, Kan.
Businessweek.com | 31
how To make marijuana: a Tour
oF synTheTic cannaBinoiDs
Compound
Δ9-tHC
(real pot)
JWH-073
JWH-018
JWH-019
JWH-020
Concentration needed to activate main
cannabinoid receptors (nanomolar)
Structure
CH3
H OH
H
H3C
H3C
39.0 – 42.4 nM
O
CH3
O
n
7.1 – 10.7 nM
CH3
O
4.0 – 14.0 nM
n
CH3
O
n
CH3
O
n
CH3
7.8 – 11.8 nM
111.0 – 145.0 nM
Synthetic Cannabinoid Legal Status
State Illegal?
aK
Ga
MD
nH
SC
aL
HI
Me
nJ
SD
ar
Ia
MI
nM
tn
aZ
ID
Mn
nV
tX
Ca
IL
MO
ny
Ut
CO
In
MS
OH
Va
Ct
KS
Mt
OK
Vt
DC
Ky
nC
Or
Wa
De
La
nD
Pa
WI
FL
Ma
ne
rI
WV
a lower number means more kick;
JWH-018 can be almost ten times as
potent as tHC. research has shown
that the length of this “side chain” has
a lot to do with it. Four to 6 carbon
atoms (represented in the diagram
as corners) is the sweet spot.
Wy
4
5
6 Carbons
62
Kansas was the first state to ban synthetic cannabinoids,
thanks largely to the work of Morris and his four-person team
of chemists. An understated guy in a polo shirt and slacks, with
a gun on his belt, Morris pulls on a pair of blue latex gloves
and focuses the microscope, preparing to demonstrate the differences between traditional marijuana and the new synthetic
versions. He does not buy the “incense” pitch. “It’s pretty clear
that people selling this product have found a legal way to be a
drug dealer,” he says.
The weed is obviously marijuana. It’s green and brownish,
with a stinky-sweet aroma. And it’s hairy, covered in what are
called cystolithic hairs. “Most plants do not have that kind of
hair, unless it’s hops,” says Morris. Under a microscope the hairs
look like tiny bear claws, but that doesn’t matter. On the street,
the physical profile is enough for police to confiscate the material and charge someone with possession.
Next, Morris pours out a sample of the incense. The vegetation is indiscernible and there is no telltale scent. “It just smells
like incense,” he says. And with so many potential ingredients,
he notes, drug sniffing dogs are apt to be ineffective, too.
Then Morris puts the sample under a microscope, revealing
a series of tiny amber beads embedded within crushed leaves.
“You could mow your yard and make a product that could get
you high,” Morris says. “The plant is just the vehicle they put
the crystals on top of.” So if officers in Johnson County confiscate a suspicious packet, they have to test it. Morris must run
each substance through an oven-sized machine called a gas
chromatograph mass spectrometer, in which the sample is superheated. Different chemicals vaporize at different speeds.
When they do, each gives off a unique fragmentation pattern, a
lot like a tiny firework. The time lapsed and the explosion style
provide the drug equivalent of a fingerprint.
All that testing takes time. Most police agencies have evidence
backlogs of at least six months, Morris says, so it’s likely some
abused chemicals haven’t been discovered yet. “You take one out
and another just pops up,” he says, shaking his head.
In late 2009 the sheriff ’s office began getting reports from
high school resource officers about kids buying incense and
smoking it. Rather than confiscate the material or try to close
down the shops selling it, Morris asked undercover officers to
go in and buy more. Like Upchurch when he was first setting
up shop, Morris analyzed the chemicals appearing in popular
32 | Bloomberg Businessweek’s Best of
brands. (Upchurch isn’t a chemist; he’s a former Web designer, but he paid a private chemical lab to help figure out his initial recipes.) In his own lab, Morris identified three probable
ingredients in most blends—JWH-018, JWH-073, and HU-210—
and proposed that Kansas ban them. In March 2010 the state
made all three illegal. Other states followed suit. Louisiana has
even banned the use of the plant damiana, a central American
shrub that smells like chamomile and looks a little like pot. The
current DEA ban covers five cannabinoids as well as any “analogues,” small manipulations of molecular structures that essentially work the same as the original molecule.
Upchurch orders many of his “special additives” from China,
and both he and Morris use the international export directory Alibaba.com to see what’s available. Search “buy JWH” and
you’ll find at least 3,800 Chinese labs standing by for custom
orders. Hubei Prosperity Galaxy Chemical, for example, offers
photos of its operation in Hubei on mainland China, with rows
of workers in white suits. Hubei notes on its website that it can
ship 5,000 kilograms of JWH-019 per month. (The company declined to comment.) One hundred kilograms is enough to make
the equivalent of about 1 million joints of marijuana. Such Web
traffic appears to be completely unregulated. On a recent day,
Morris spotted one site that had mislabeled an ultrastrong hallucinogen as a low-dose cannabinoid.
For incense smokers, product mislabeling and reformulation can be dangerous. “All of these things act on various parts
of your brain called receptor sites,” Morris says, describing the
biochemistry that helps regulate normal states of consciousness. Synthetic cannabinoids target the CB1 and CB2 receptors,
which either cause hallucinations in the first instance or can alleviate nausea and instill calm in the second. “Think of it as a
lock-and-key system,” he says. “The receptor site is the lock and
the drug is the key. As the key goes into the lock, it sort of opens
up the psychoactive properties of the receptor site.”
After testing more than 100 packets from different suppliers, Morris has noticed a disturbing trend: There is no trend.
The type and quantity of mind-altering agents in many blends
can vary not only between brands but also between packets
of the same stuff. He’s found processors using different synthetic cannabinoids anywhere from two to more than 500
times stronger than THC. Some target the CB1, others the CB2.
Many manufacturers are mixing multiple chemicals together
PHOtOGraPH By MICHaeL SCHMeLLInG FOr BLOOMBerG BUSIneSSWeeK
CHart By eVan aPPLeGate
Data: aUnG et aL, PUBCHeM, natIOnaL aLLIanCe FOr MODeL State DrUG LaWS
June 20 — June 26, 2011
Bloomberg Businessweek
to create signature blends, forging new combinations.
Side effects and tragedies have risen along with profits. The
American Association of Poison Control Centers logged just 14
calls about the harmful effects of incense in 2009. That number
jumped to 2,874 in 2010. By the end of May 2011, it had fielded an additional 2,324, on pace to double last year’s numbers.
Hospitals have reported that smoking incense can cause agitation, racing heartbeat, vomiting, intense hallucinations, and
seizures. “Marijuana can make you calm and relaxed, but this
seems to cause anxiety,” says Dr. Anthony J. Scalzo, medical
director of Missouri Poison Control, who spotted the first outbreak of emergency room visits in late 2009. “People think that
if you can buy it legally, it must be safe. But they don’t know
what they are dealing with,” he says.
According to news reports, in Indianola, Iowa, a recent high
school grad smoked some incense that was bought at a Des
Moines mall and told friends “that he felt like he was in hell.”
Ninety minutes later he came home, took a family rifle, and
killed himself. In Omaha a student stormed his high school in
January and shot and killed the assistant principal and himself. Toxicology reports later indicated the presence of synthetic
cannabinoids in his system.
Many cathinones are repackaged as “bath salts”—those tiny,
soluble gel capsules often sold in large bottles at such places as
Bath & Body Works. Instead of being sold by the jar, though, they
are sold at much smaller retailers in small packets with names
such as Sexperience, Ivory Wave, or Vanilla Sky for up to $50 a
pop. Rather than drop one in the bath water, users crush it up
to be snorted, smoked, or swallowed. Bath salt usage has followed a similar spike: There were 302 calls to poison centers
in 2010 and 2,507 by the end of May this year. According to Dr.
Mark Ryan, director of the Louisiana Poison Center, these bath
salts can cause paranoia, extreme anxiety, delusion, combativeness, suicidal thoughts, chest pains, and even “excited delirium,”
kansas Forensic
scienTisT jeremy
morris has
iDenTiFieD Dozens
oF synTheTic
BlenDs
the so-called Superman effect, where a user becomes so excited
and detached from reality that he or she continues to rampage
even after being shot, becoming nearly impossible to restrain.
Additional news reports show that in Louisiana a 21-year-old allegedly snorted a pack of bath salts and suffered three days of
intermittent psychotic episodes before fatally shooting himself.
Other cases of users losing control include a Mississippi man who
used a skinning knife to slash his own face, a Kentucky woman
who abandoned her two-year-old son along the interstate after
hallucinating that he was a demon, and a West Virginia man
who dressed up in a bra and panties and stabbed his neighbor’s
pygmy goat to death.
Initially the DEA pinpointed Spice and K2 (K2, the mountain,
is really high) as the two main brands of incense being abused.
Spice was European; in 2009, U.S. Customs and Border Protection banned its import. K2 was domestic, originally made
by Jonathan Clark Sloan, who runs Bouncing Bear Botanicals,
an exotic plant and natural extracts dealer operating out of a
warehouse in Oskaloosa, Kan.
As two of the more popular brands, the names K2 and
Spice have become synonymous with herbal incense mixed
with cannibinoids. “It’s like when you say Xerox but you mean
copying,” says the DEA’s Collier. “The name has taken on a
life of its own.”
Authorities have come down on Sloan, but not for K2. On
Feb. 4, 2010, the Kansas Bureau of Investigation and sheriff ’s
officers from Jefferson and nearby Johnson counties joined with
U.S. Food and Drug Administration officials to raid the premises of Bouncing Bear. Sloan was charged in state court with 20
counts, including unlawful cultivation and distribution of several controlled substances—stimulants such as mescaline, bufotenine, dimethyltraptamine, and lysergic acid amide, which were
allegedly being harvested from a series of cactus plants, river
toads, tree barks, and Hawaiian baby wood rose seeds, respectively. An FDA spokesperson refused to comment on whether
an investigation is ongoing. Sloan has yet to plead.
Sloan’s preliminary hearing is set for mid-September. No
state or federal charges regarding the manufacturing and distribution of K2 specifically have been filed. “That was certainly
an issue at the time, but not an overriding issue. There were a
lot of overriding drugs involved,” says Jefferson County attorney
Robert Fox, who is in charge of prosecuting the case.
For now, Sloan has ceased making K2, though he remains
committed to the business and the idea of selling a brand as
much as a product. “We licensed the K2 name to another company,” he writes in an e-mail to Bloomberg Businessweek. He’s
also suing two competitors for copyright infringement to protect
his trade name. There may be some sense in Sloan’s approach,
since the crackdown on his operation hasn’t hurt demand for
synthetic drugs and has only raised the profile of the name. The
name K2 could even work for a new, legal blend.
63
To an extent, incense manufacturers are trying to legitimize
their nascent industry. Broider, of the herbal incense trade
group, says Nahita has asked its manufacturing members to
voluntarily publish their contact information and to assign
numbers to their products so any bad batches can be reported
and recalled. He is against formal regulation. “It’s not the taxpayers’ burden to regulate a private market,” he says.
In May the Retail Compliance Assn. went further, petitioning
congressional representatives to consider a federal licens➡
ing system to help track both the number of manufacturers
Businessweek.com | 33
June 20 — June 26, 2011
Bloomberg Businessweek
The Missouri law banning synthetic cannabinoids entirely
will take effect in August. For Pandora Potpourri, that means
going back to the lab. On a Friday in early May, Upchurch and
Harness don black rubber gloves and respirators, then congregate in the rear of the garage to brew up a new batch of test
product. It’s not a cannabinoid but a lab-made enzyme inhibitor
with anti-depressant and anti-anxiety effects, Upchurch says. In
the work zone are two mixers, a large scale, and a cooling rack
stacked with cookie sheets. The top three slots are already filled
with one-kilo trays of a multicolored potpourri spread thin to
help it dry quickly and evenly.
“Those are keys from this morning,” Harness tells Upchurch. Upchurch looks skeptical. “Keys? Are we calling them
‘keys’ now? I think you mean kilograms,” he says. They weigh
out more than 1,000 grams of damiana and mullein, a yellowflowered Mediterranean shrub. Next, Harness opens a large
glass jar filled with white powder, pouring what appears to
be a few tablespoons’ worth into a large plastic measuring jug
34 | Bloomberg Businessweek’s Best of
700
Calls regarding “incense”
(synthetic marijuana)
Calls regarding “bath salts”
(synthetic speed)
600
500
400
12-month totals:
3,024 bath salt calls
4,907 incense calls
300
200
100
0
June 2010
Sept. 2010
Jan. 2011
May 2011
Data: aMerICan aSSOCIatIOn OF POISOn COntrOL CenterS
situated on the scale. To dissolve the powder he adds a bottle
of the grain alcohol Everclear, their latest mixing solvent. Harness stirs the concoction with a paint stick until it looks like a
clumpy vanilla milkshake, then pops open another jug to add
more grain alcohol.
Upchurch isn’t happy. “They all dissolve differently,” he says
to himself. Usually he can dilute 250 grams of cannabinoid per
gallon, meaning it would take about one bottle of booze to
merge with the host plant. Eventually he and Harness turn on
both mixing bowls. Upchurch needs this test to succeed. So far
he’s invested $40,000 buying and researching new chemicals,
but none have worked quite right. For a small-time business,
that’s an expensive learning curve. “If someone is creating a
law on something that we have research on, the next logical
step is we have to create something new, where less is known
about it,” he says.
Law enforcement has affected business in another way,
too. Behind Upchurch there is a shelf lined with large, open
boxes filled with different kinds of vegetation. Because state
laws aren’t the same and can change so quickly, he’s switched
from creating large custom batches for each region to creating premixes of treated ingredients to meet the standards
of various states. “When compounds become outlawed, we
remove them and replace them with suitable alternatives,”
he says. “In general that may still vary from lot to lot based
on destination.”
Even so, business is good—so good that Upchurch just bought
a new bag sealer that can print the company name on each seal
to foil counterfeiters. He has four regional salesmen and is looking to expand, though he says he doesn’t ask too much about
his troop’s sales pitches.
After pouring his mixes onto some cookie sheets and setting them out to dry, he mentions that he’s also going back to
school, this time for an online master’s degree in international
business and marketing.
If Upchurch doesn’t find the next synthetic, someone else will. Micah Riggs, for one, may have been trying.
In late September 2010, police reported having discovered
a lab above Coffee Wonk. According to the probable-cause
statement, there was a recently graduated chemist from the
University of Kansas working there who admitted attempting
to synthesize new strains of JWH. Riggs has been charged with
intent to create a controlled substance or a controlled substance analogue. In May he was arraigned and pled not guilty.
His trial is set for December. Riggs points out that he formed
a company, Wonk Labs LLC, purchased most of his supplies
from a mainstream research supply company, and was already
looking for more formal office space. “We weren’t planning to
make any set compound, we were in the research phase,” he
says. “Things like this scare creative people from ever going
into business.” <BW>
PHOtOGraPH ILLUStratIOn By CreDIttK
64
and distributors operating and the chemicals and dosages they
are using. Unlike Upchurch, RCA states openly that the products are likely to be consumed. “There is no doubt that people
are buying these products and using them off-label. They are
going to do with it what they want to do with it,” RCA director
Francis says. The RCA’s official position is not to sell to anyone
under 21. It also has suggested enacting a special product tax,
much like that applied to cigarettes, to help address potential
health problems related to use of the products. “There’s got to
be a resource for responding to any claims of addiction or ill
consumers,” he says.
Upchurch belongs to both trade groups and has adopted his
own restrictions. The back of each packet bears two more disclaimers: One clearly states that none of the federally banned
substances are in his packets. The other states that the packets
are not for sale to anyone under 19 years old. He also says he
tests his products twice during manufacturing to ensure quality. First, every shipment of raw base chemicals that arrives is
sent off to a DEA-registered testing lab to confirm it matches
what was ordered. Second, each final batch of product is also
sent to a lab to make sure it was blended properly and not contaminated by ingredients from other blends. His ratio of cannabinoids to vegetation needs to remain constant. The target
ratio among mixed cannabinoids must remain consistent, too;
anything with more than a 5 percent variation is thrown out.
“We don’t want it to be a drug. If we put in something that is
extremely potent, it will be abused,” he says.
Attention to production and labeling doesn’t seem to reassure law enforcement. This spring, Morris came up with a
new approach to combating the drugs. Rather than ferret out
problem ingredients one by one, he successfully petitioned the
Kansas legislature to ban the seven chemical classes most associated with cannabinoids. When the law went into effect at the
end of March, it banned hundreds of compounds at once. Eight
other states, including Missouri, have adopted similar measures.
Kansas and four other states have also applied the tactic to bath
salts, banning a wide class of cathinones that include popular stimulants such as mephedrone and methylenedioxypyrovalone. Such approaches could become a template for broader
national action: Congress is considering a class-based synthetic cannabinoid ban. It would also apply to the next generation
of product lines, such as capsule-based synthetic cannabinoid
“plant fertilizers,” supposedly for house plants.
calls To Poison
conTrol cenTers
Meet the Richard
Simmons of expat
golf instructors
page 92
May 30 — June 5, 2011
Bloomberg Businessweek
Shoes&The
The Golf Pro Diaspora&BBQ Tech
If ever there
was an unlikely
fan of 19th
century French
social science ...
page 94
The $140m Bear
85
REAGAN: CYNTHIA JOHNSON/TIME LIFE PICTURES/GETTY IMAGES; KNUT: MICHAEL KAPPELER/AFP PHOTO/GETTY IMAGES
Knut and the perils of the
high-stakes celebrity animal business.
By Peter Savodnik
Businessweek.com | 35
May 30 — June 5, 2011
Bloomberg Businessweek
A
86
s the world’s first celebrity polar
bear, Knut used to spend his days
feasting on raw meat, swimming in
a black-bottom pool, and gazing at
the hundreds—if not thousands—of
visitors who flocked to see him every
day at the Berlin Zoo. During his prime, candymaker
Haribo churned out 1 million raspberry-flavored
Knut gummy bears daily, and Berliner Volksbank
issued tens of thousands of ATM cards featuring his
furry face. There was also the 2007 book, Knut: How
One Little Polar Bear Captivated the World, and the
2008 film, Knut & Friends. Along with Leonardo DiCaprio, he graced the cover of Vanity Fair.
Knut (pronounced Kuh-noot in German) achieved
international fame hitherto unknown in the animal
kingdom on account of his irresistible story. He was
born into captivity in 2006, rejected by his mother,
and raised by a zookeeper. To environmentalists, Knut
was an emblem of the anti-global-warming movement;
to business, he was a cuddly money machine. In its
167-year history, the Berlin Zoo—which is subsidized
by the city and listed on the Berlin Stock Exchange—
has been profitable for only three years, says Heiner
Klös, its animal curator. Those were 2007 to 2009, the
Years of Knut, when yearly attendance rocketed from
2.5 million to 3.5 million visitors, and the zoo made
more than $30 million. In all, Gerald Uhlich, a former
chief executive of the zoo and the architect of Brand
Knut, estimates that the polar bear generated more
than $140 million in global business.
In 2010, however, Knut grew up and became less
cute, and attendance waned. Then in March, he unexpectedly died. Zoo-dwelling polar bears usually live
well into their thirties—Debby of Winnipeg made it to
42—but an autopsy revealed Knut had suffered from
encephalitis, an inflammation of the brain that caused
him to lose consciousness, tumble into the water, and
drown in front of several hundred horrified fans.
Now the fate of Brand Knut—unprecedented in the
history of brands and animals—is up for grabs. Scores
of book publishers, moviemakers, marketers, advertisers, and manufacturers of stuffed animals, lunchboxes, and coffee cups hope to profit before the public’s memory of the cuddly cub is replaced with that
of a large, dead polar bear. There are already plans
for a television documentary in Germany. The chinamaker KPM is issuing $315 commemorative Knuts
that have Zur Erinnerung (“in memoriam”) inscribed
on them. Uhlich is writing a book about the untold
story behind the rise of “der Icebear.” And for good
reason. “A dead Knut brand could still make millions,”
says Birgit Clark, a London-based trademark attorney
who has studied the Knut phenomenon.
What happens to Brand Knut in
the next few months will determine if it stays profitable or,
like Knut, dies too.
However, the greatest
threat to the brand—and
The DVD has been
selling strong even
though Knut was born
in a zoo, not the Arctic
Ich bin ein
Berliner Volksbank
ATM card
The VF cover helped
rehabilitate DiCaprio’s
career. The German
edition was a fan favorite
“A dead Knut
brand could
still make
millions,”
says one
expert.
Many are
already
trying
Will Heidi (left) eclipse Knut?
36 | Bloomberg Businessweek’s Best of
Both Germany and
Azerbaijan put
Knut’s cuddly face on
their postage stamps
Berliners
purchased Knut
votive candles
after his untimely
death
potential Knut profiteers—is actually its owner, the
Berlin Zoo, which is reluctant to profit from a dead
polar bear. Clark says the zoo licenses the Knut trademark only to outfits deemed environmentally sensitive—those that preserve Knut’s image as “an ambassador of climate change,” says Klös. This leaves
Uhlich, the former zoo chief and aspiring Knut biographer, exasperated. “Brand Knut is established,” he
says. “There is still greater potential to use it for further products or services!”
Uhlich, who left the zoo in late 2007 amid a rather
public philosophical dispute over, among other
things, profiting from a baby polar bear, isn’t alone.
Udo Marin, the chief executive officer of the Berlin
Club of Merchants and Industrialists, also believes
the zoo failed to exhaust its moneymaking potential. “Knut presented the unique chance to generate
so much money via marketing that the zoo could have
become independent of state subsidies,” Marin says.
Yet ulterior motives, he says, led the zoo to resist that.
“The traditional zoo director doesn’t like the idea
of being responsible for a positive net result,” Marin
says. “He is the head of an educational unit. Education
is one of the basic jobs of government.” The good thing
about governments, Marin says, is that “generally
they don’t question the wisdom of visiting the umpteenth zoologist congress in Australia or buying
a rare bird which no one is interested in.”
But if the Berlin Zoo doesn’t capitalize on the
THIS PAGE: HEIDI: SEBASTIAN WILLNOW/AP PHOTO; OPPOSITE PAGE: KNUT: MICHAEL GOTTSCHALK/AFP/GETTY
IMAGES; NECKLACE: JAN BAUER/AP PHOTO; COIN: ANITA BUGGE/WIREIMAGE; HILTON: SEAN GALLUP/GETTY IMAGES
Etc. Celebrity Animals
May 30 — June 5, 2011
Bloomberg Businessweek
What do opossums
look like anyway?
(See below, left)
It is unlikely that Heidi
the opossum will
get her own candy
The easiest way
to keep Knut close to
your heart
This work by
American sculptor
Daniel Edwards
is beyond words
Everyone wanted
some Knut magic,
including
Paris Hilton
Knut (2006-11),
the world’s
most branded
polar bear
The Berlin Zoo
made more
than $30 million
during the Years
of Knut
87
memory of Knut soon, the brand may be devalued
for everyone. Bernhard Fischer-Appelt, the managing director of FischerAppelt, a public-relations firm
in Hamburg that represents the Leipzig Zoo, says the
zoo community is eagerly watching events in Berlin.
Fischer-Appelt expects that, in a post-Knut landscape,
museums will hedge their bets and embrace a new
business model, shuffling in one or two celebrity
animals per year—each of which, he says, is worth
“a couple million dollars” in ticket sales and licensing deals. The Leipzig Zoo is already employing this
strategy with Heidi the opossum, the star of an exhibit opening on July 1. Zoo spokeswoman Maria Saegebarth predicts Heidi could be bigger than Knut.
“From our point of view,” she says, “it’s not possible to compare the cases of Heidi and Knut. The attention and interest in Heidi is huge—and no one has
even seen her yet.”
Other celebrity animals are also threatening to
transform the modern zoo into a hotbed of merchandising—including Leo the Pakistani snow leopard at the Bronx Zoo; Miwa the baby monkey and
her friend, Uribo, the boar, in Kyoto; and, until recently, Paul the octopus, who lived in an aquarium
in Oberhausen, Germany. Paul, famous for predicting the 2010 World Cup winner, had a following—and
an agent—when he died in October. His remains were
cremated, and a shrine was erected in his honor.
Yet future celebrity animals may walk a fine line
Leo the
snow
leopard,
Uribo the
boar, and
Heidi the
opossum are
challenging
Knut’s status
that Knut—or, for that matter, Free Willy’s Keiko or Sea
World’s Shamu—never had to worry about. Many zookeepers increasingly believe giving animals names,
background stories, and cuddly personae is exploitative. Yet they also realize that branding them is the
only way to make money off them through ticket
sales, merchandising agreements, and licensing
deals. Indeed, the tale of Knut was partly contrived
by the same camp that supposedly opposes telling
tales about animals. Ian Sterling, a polar bear expert
at the University of Alberta, says it’s more common
for mother polar bears to spurn cubs in captivity than
in the wild—meaning the sob story the Berlin Zoo used
to market Knut was, to a degree, its own creation.
This doesn’t surprise animal rights activists. “It’s
always business with zoos,” says Ingrid Newkirk, the
president of People for the Ethical Treatment of Animals. “Zoo visits are declining because people can
see actual animals in the wild. They can see YouTube
and National Geographic and the Discovery Channel.
Zoos are struggling to make themselves sexy.” Yet Klös
doesn’t see it that way. Knut, he says, remains “the
most popular animal in the world, more popular than
Mickey Mouse.” It’s no surprise, then, that the Berlin
Zoo is going to erect a Knut statue, which is a good
way to lure those who miss him. Still, Klös dismisses
talk of a Knut 2.0. “The finance people say it would be
wonderful to have another Knut,” he says dismissively, before adding: “You can’t do that again.” œ
Businessweek.com | 37
Robin Li banged heads to beat Google
and make his search engine No. 1 in China.
His next target: The rest of the world
Won
Li gets prepped
for his speech at the
annual Baidu World
conference in Beijing
38 | Bloomberg Businessweek’s Best of
China
By Brad Stone and Bruce Einhorn
Photographs By Andrew Rowat
Businessweek.com | 39
Many CEOs
have admirers.
Robin Li–the 41-year-old,
American-educated
chief executive officer of
the Chinese search engine
Baidui–has a fan club.
62
And each year at the Baidu World conference in Beijing, the
members of the Robin Li fan club come out to get close to the
object of their worship.
On a late morning in September, about 30 college-age kids
wait expectantly outside the China World Hotel in downtown
Beijing. When Li emerges from a dark blue sedan, the fan club
mobs him, waving signs and screaming his name while Li poses
for pictures with a tight, uncomfortable smile before darting
into the building to rehearse his keynote address. “Robin Li is
my idol,” says Yan Huifeng, a student from Sichuan University
in Chengdu. Liu Zhiqiang, a student at Beijing’s Renmin University of China, says: “He is handsome and very intelligent
and outstanding.”
Like much about the 10-year-old company, the Robin Li fan
club isn’t quite what it appears to be. The exuberance, club
members say later, was coordinated by Baidu, which Yan says
flew her into town and paid for her hotel. The students all
say they admire Robin Li, but their loyalty to the company he
founded has its limits. “If I want to know about what happens
abroad, I will use Google,” says one of the students. “Baidu’s
information is influenced by the government so much.”
The world knows Baidu as the search engine that kicked
Google’s butt out of China, with an assist from the Communist
Party. The company has a 73 percent share of the world’s largest
Internet market by users, and has the fifth-largest market capitalization ($38.3 billion) among the world’s pure-play Internet
companies, trailing Google, Amazon.com, Tencent (an instant
messaging and gaming company based in Shenzhen), and only
narrowly, eBay. It’s now 57 percent bigger than Yahoo!—and with
significantly brighter prospects. Baidu “has the best business in
the world,” says Gene Munster, an analyst at Piper Jaffray. “It’s
hugely profitable, with massive growth ahead in the population
of Chinese Internet users, and the government backing it up. Essentially it’s a state-sponsored monopoly.”
Baidu’s stock price has more than doubled since January,
when Google first disclosed that Chinese hackers had targeted
its mail servers and announced “a new approach” to China,
with the company saying it would no longer censor search results. The highly public stance ultimately led Google to begin
redirecting all searches to a Google site in Hong Kong. This
allows the company to avoid the strict censorship rules that
Baidu and others in mainland China must follow, while also
40 | Bloomberg Businessweek’s Best of
putting it at a major disadvantage in the huge Chinese market.
“Every once in a while a gift is handed to you. We handed one
to Robin,” says Eric Schmidt, Google’s chief executive officer.
Schmidt argues that the playing field in China has always been
unfairly tilted in Baidu’s favor, though he goes out of his way to
stay eligible for membership in the Robin Li fan club. “Robin is
an example of a clever entrepreneur,” Schmidt says. “He’s navigated the conflicts within China—which are ferocious.”
While Li has earned the grudging respect of Google execs,
Baidu’s tactics are a sharp contrast with the Google founders’
sincere, if not always sincerely observed, slogan: Don’t be evil.
If crawling the Web empirically and without commercial bias
is the moral duty of a search engine, Baidu is, at least in the
eyes of its competitors, not a moral company. For years legions of advertisers have complained on Chinese Web forums
that Baidu secretly penalizes the search rankings of websites
that decrease their spending on Baidu. Archrival Chinese Internet company Alibaba, Jack Ma’s Internet conglomerate that
runs the Taobao e-commerce site and is 40 percent owned by
Yahoo, says Baidu unfairly penalizes the search ranking of companies that accept ads from some Taobao merchants.
Robin Li disputes these allegations, saying the company
never links search results and advertising. “We have a Chinese wall within the company” between the search and ad
teams, he says, without irony. “These are all conspiracy theories. In reality we have no incentive to do that. Paid search
is proven, and we are very confident we will be able to make
“Every once in a while
a gift is handed to you,”
says Eric Schmidt,
chief executive officer
of Google. “We handed
one to Robin.”
November 15 — November 21, 2010
Bloomberg Businessweek
Li poses with members
of the Robin Li fan
club, some of whom
were flown in by Baidu
63
a lot of money by doing the right thing for users and advertisers.” Many Chinese are nonetheless quick to believe the
worst about Baidu: In 2008 the company quickly denied Internet chatter claiming it had taken money from Sanlu Group,
a dairy producer that had sold milk powder tainted with the
toxic chemical melamine, to keep the scandal out of search.
At least six children died and more than 54,000 were hospitalized. Baidu has conceded that it has sometimes been too
lax in policing its advertisers. In late 2008 the company acknowledged it had prominently listed ads from medical companies that weren’t properly licensed, though Greg Penner,
an early investor and Baidu board member who also serves
on the board of Wal-Mart Stores, points out that no one in the
Chinese search industry was vetting these advertisers.
One more denial: Baidu says it is not a kingdom built on
Internet piracy, though music companies say its popular MP3
service allows users to download just about any song ever recorded for free. The recording industry sued in 2005, but Chinese district and appeals courts sided with Baidu, which says
it’s merely giving users the content they want by linking to
popular music websites.
For many people outside China, these issues are minor compared with censorship. Like all Chinese Web companies, and
Google’s Chinese language site until this year, at the behest of
the Chinese government Baidu blocks pornography or references to topics such as Taiwanese independence, the Dalai Lama,
and the 1989 Tiananmen Square massacre. The practice is called
zi lu, or “self-discipline,” and Baidu does it well. Last year the
company accepted one of 20 awards from the Internet Society of
China, given for what the group calls “industry self-regulation.”
Li, the fourth of five children born to factory-worker parents in Yangquan, a city of 1.3 million in northern China, received his bachelor’s degree from the prestigious Peking University in 1991, and got a master’s in computer science from
the State University of New York at Buffalo in 1994. He has
spent years in America, and speaks flawless English. His fidelity to China is nevertheless unquestioned. Li says that Baidu
manipulates search results to obey the law of the land and
that failing to comply would risk its license to operate in China
and let down users and investors. “If the law clearly prohibits certain types of information, be it porn, or anti-government information, then I’m sure there’s a reason for it,” he
says a few days before the Baidu World event, while sitting
in the rooftop rock garden at his company’s new headquarters, a 91,500-square-meter building (complete with a gym,
yoga studio, and nap rooms) in the city’s bustling Shangdi
district. Of censorship broadly, Li says: “I’m an entrepreneur.
I’m not a politician. I should not be in a position to make this
kind of a call.”
Instead, Li is focused on the future: expanding into games,
e-commerce, and online payments, establishing a Hulu-like
video site called Qiyi, and exporting the Baidu brand abroad.
He says engineers are translating the site into a dozen languages. “I hope in ten years, Baidu will become a household name
in 50 percent of the world. Sooner or later you will see a
➡
China-based company that really has a global impact and
Businessweek.com | 41
November 15 — November 21, 2010
Bloomberg Businessweek
I think Baidu has a chance to become one of those companies.
We should be able to compete on a global basis.”
Before Baidu expands, however, it needs to answer an obvious question in an age when even the most transparent of Internet companies are struggling to maintain the faith of their
users. “Why should I trust Baidu?” asks Rebecca MacKinnon, a
senior fellow at the New America Foundation who writes about
the Chinese Internet. “For the same reason nobody trusts the
Xinhua news agency when it tries to expand into global readership, it’s going to be very difficult for any Chinese companies that deal with content to get anyone to trust them outside of China.”
64
This past June, Baidu hired Kaiser Kuo, an Internet pundit
and former guitarist of the ’90s Chinese metal band Tang Dynasty, to fill the new position of director of international communications. Kuo’s role, in part, is to help tell Baidu’s story
to the world. “This is a company that looks a lot better on the
inside than it does on the outside,” he says.
Baidu says it’s not evil, just misunderstood. And because it’s
expanding into fields like e-commerce and video games, and
plans to get into markets outside of China, the company wants
the world to know it better. And to trust it.
Key to the rollout and renovation of the Baidu brand is the
selling of Robin Li. Once a Silicon Valley cubicle jockey earning
around $45,000 a year at Infoseek, a forgotten portal from the
Web’s past, Li is now the second-richest man in China, with a
fortune valued at $7.2 billion according to Forbes magazine.
Li is a poised but uninspiring public speaker and guarded in
conversations with the press. Friends and colleagues say he is
still essentially an engineer, and that his devotion to Baidu defines him. They tell stories of countless nights Li worked straight
through, and of the times he fell asleep in his car after the drive
home because he was too tired to walk to the front door. As for
his faith in Baidu’s future, there’s this: According to public financial records, Li has never sold a single share of Baidu stock.
Recently, Li has begun cultivating an international profile.
In July he attended Allen & Co.’s annual conference in Sun
Valley, Idaho, for the first time and found a natural ally in Facebook founder Mark Zuckerberg. The two have talked several
times, both executives confirm. On Nov. 15, Li will participate
in a Silicon Valley public forum for the first time, at the Web
2.0 Summit in San Francisco.
Li’s biggest boosters are his U.S. investors. A decade ago
they backed an introverted search engineer and never anticipated he would take them on such a lucrative ride. “He had all
the ingredients to be a good entrepreneur,” says Hugo Shong,
a founding partner at IDG Capital Partners, a firm with deep
roots in China that invested $1.5 million in Baidu in 2000—
a stake worth $170 million at Baidu’s IPO in 2005. “We were
worried about his marketing skills. He was so quiet.”
Scott Walchek, an Alamo (Calif.)-based angel investor who
put $1.25 million in Baidu and made hundreds of millions as
a result, said that during the early years of the company he
and other U.S. investors disagreed with Robin Li at almost
every turn. “Nearly everything we said he should do, Robin
disagreed. And he was always right.”
Baidu is proudly Chinese, but its origins are in Silicon Valley.
In 1998, Li’s co-founder, Eric Xu, was a sales rep for a U.S. biotech firm who decided he wanted to make a documentary about
42 | Bloomberg Businessweek’s Best of
Baidu’s new
headquarters
in Beijing’s Shangdi
district, complete
with gym, yoga studio,
and nap rooms
November 15 — November 21, 2010
Bloomberg Businessweek
When Brin and Page
visited Baidu, the
company scheduled the
meeting during a Chinese
holiday when the office
would be empty.
That way the Google
founders couldn’t see
how many engineers
Baidu employed.
American innovation. Enlisting well-known Chinese American
documentary filmmaker Ruby Yang, Xu got interview sessions
with the British-American venture capitalist Michael Moritz and
future Stanford University President John L. Hennessy. When Xu
landed a chat with Jerry Yang, the Taiwanese born co-founder of
Yahoo, he brought two friends to the taping: a fellow sales rep
named Melissa Li, and her husband, Robin.
Xu conducted the interview while Li and Melissa looked
on quietly. “I got inspired,” Xu says more than a decade later.
“I’m sure Robin got inspired, too, seeing an ethnic Chinese
who created such a powerful company.”
At the movie’s debut on Stanford University’s campus in
1999, Xu says Melissa pulled him away from the screening and
declared that she would like her husband to be an Internet
company founder.
Li was already a true believer in search. In 1996 he received
a patent related to what he called link analysis, a way to rank
search listings by the number of incoming links to sites. Stanford doctoral students Larry Page and Sergey Brin would separately come up with the similar PageRank algorithm. Inspired
by Yang and pushed by Melissa, Xu and Li decided to use Li’s
research to build a search engine for the slumbering Chinese
Internet market.
Looking for seed money, they brought their business plan
to Bob King, a stalwart of the Silicon Valley investment community who put early money in Oracle and Intel and had appeared
in Xu’s documentary. Greg Penner, King’s partner at the time,
recalls that Li “wanted to create a major media company. That
was his vision from day one. We weren’t convinced that this
was absolutely going to happen. We felt like if it did happen,
he was the right guy to back.”
With $1.2 million in seed money from King, Penner, and
Walchek, Xu and Li left their wives in America and moved to
a single hotel room near Peking University in Bejing. They
stayed for over a year, working 15-hour-days in a nearby office.
Later that year they scored an additional $10 million from
IDG and ePlanet Ventures, an affiliate of Valley venture capital firm Draper Fisher Jurvetson.
In its early days, Baidu wasn’t modeling itself on Google. Li
and Xu were much more interested in being the next Inktomi,
a U.S. firm that powered search on other Web portals and was
eventually acquired by Yahoo in 2002 for $235 million. Rather
than host an independent site, Baidu licensed its search index
to Sina and Sohu.com, then the dominant portals in China, and
charged them each time a user conducted a search. Busy copying Yahoo’s portal business model, those companies didn’t realize search’s potential, concedes Charles Zhang, chairman and
CEO of Sohu. “That’s how Baidu captured this opportunity
while [we] were not paying attention,” he says.
Those relationships frayed immediately, however, since the
number of search queries—and licensing fees owed to Baidu—
were constantly growing. Two people involved in Baidu’s early
operations recall that Sina delayed a payment while demanding to renegotiate its search deal. Warming to Baidu’s power, Li
temporarily cut Sina off, infuriating the larger portal.
With its partnerships imperiled by its own success, Baidu
began hedging and developed a website of its own. Finian Tan,
then a Hong Kong-based partner at ePlanet, says he was so worried about the company’s prospects that he contacted Jerry
Yang, an ePlanet investor, and offered to sell Baidu to Yahoo for
$40 million. It’s not clear whether Yang remembered Li from
the documentary shoot; he referred the matter to a Yahoo colleague, who did not respond. (Yang declined to comment for
this story.) Baidu had no choice but to devote its energies to its
own website. “We became Baidu.com because we were forced
into it,” Tang says.
By 2004, Baidu was allowing advertisers to pay to appear
at the top of related search results, mimicking a model pioneered by a Pasadena (Calif.) company called Overture. Baidu
was newly profitable and its traffic, along with China’s Internet population, was skyrocketing. That year, Google contributed $5 million to Baidu’s $15 million third round of financing,
aiming to strike up a relationship with the Chinese startup.
Although Google had offered search in Chinese from its servers abroad since 2000, the Baidu investment was meant to
lay the groundwork for a possible acquisition and ward off the
possibility that rivals could buy it, according to former Google
executive James Mi, now a venture capitalist in Beijing.
From the beginning, Baidu and Google didn’t trust each
other. In late 2004, Brin and Page visited Baidu’s offices during
a visit to China. Xu says the Baidu team scheduled the meeting
during a national holiday when the office would be empty, so
the Google executives couldn’t see how many engineers Baidu
employed. Brin and Page declined to eat the Subway sandwiches
Baidu served for lunch. ( James Mi recalls that this was because
the Google founders had recently gotten sick from uncooked
food in India and were being cautious.) When Brin asked whether the Baidu logo was a dog’s paw, Li corrected him brusquely.
(It’s a bear paw.) “We respected Google, but as a company we
were competitive and we wanted to make sure they respected
us,” says Xu, who left the company in late 2004 and founded a
venture capital firm that specializes in biotechnology.
As Baidu filed to go public in July 2005, acquisition and investment offers poured in. The story of those offers has not been
told before. According to several people familiar with the
➡
submissions, Masayoshi Son, founder of SoftBank, the
65
Businessweek.com | 43
November 15 — November 21, 2010
Bloomberg Businessweek
66
Google responded to Baidu’s success by hiring noted computer scientist Kai-Fu Lee from Microsoft and opening a research and development center in Beijing. “At that time I had
concerns. Google had a lot of money,” Li says.
Yet Google never materialized as a threat, for reasons that no
one can agree on. What’s clear is that Google’s China service was
mysteriously unreliable, particularly when the Chinese government was angry with the U.S. Google also documented several
instances when it was the victim of what’s called domain name
system poisoning; users typed in Google.cn and found themselves at Baidu instead.
Some Google executives privately say they think the Chinese government was never going to let Google succeed. MacKinnon, at the New America Foundation, says the opaque Chinese regulatory system makes it difficult to prove there was
Li (fourth from
left) with his crew
in 2000, and jotting
notes in a hotel suite
Baidu rented as
an office in 2002
44 | Bloomberg Businessweek’s Best of
official discrimination. “Did Google face a very poisonous atmosphere in China? Sure,” she says. “Whether this was the
result of top down policy or the fact that Baidu’s government
relations were simply better is impossible to say.”
In November 2009, Kai-Fu Lee announced he was leaving Google to start a Web incubator, throwing the company’s
regional leadership into disarray. Two months later, Google
suffered the attempted hack on its e-mail servers, and after
a debate in which Schmidt tried to persuade Brin and Page
to stay in China—and was overruled by the founders—Google
relocated its search servers to Hong Kong, declared itself
not evil, and departed the field. “We understand from a
commercial standpoint that this isn’t the ideal state of affairs to compete in that market,” says David C. Drummond,
Google’s chief legal officer. “But after a couple of years observing these content laws, we decided they weren’t consistent with our values.”
Google may have lost its battle with the Chinese government, but it was defeated first in the marketplace. Li says his
original impulse when facing off against American competitors was to downplay Baidu’s heritage as a Chinese company,
because “in most consumer’s minds, Chinese products are
low quality.” But in a widely televised ad campaign that referenced a popular Hong Kong film, Google was depicted as a
clueless Caucasian who could only interpret a complex Chinese sentence in a single way. A scholar representing Baidu
handles the sentence correctly; the Google character ends
up spitting blood. “It was the easiest way to tell them Baidu
knows Chinese better,” Li says of the ad.
For years, Baidu really was better able to parse sentences
in Chinese. Baidu also put more sales people on the ground to
talk to advertisers, and demonstrated a better grasp of Chinese
tastes. Baidu’s home page has 11 links, in underlined blue, to
various services such as Baidu Knows, a Q&A service; Baidu
Post-Bar, a popular bulletin board; and Baidu Encyclopedia,
a made-in-China alternative to Wikipedia. Like Google, Baidu
is a verb: To search, users click on a box that says “Baidu It.”
“Robin took the best of everything that was happening in the
U.S. at the time and added Chinese characteristics,” says U.S.
venture capitalist Tim Draper.
Baidu MP3 proved a particular draw for Chinese Internet
users, and no wonder, since it helps users download for free.
BAIDU
Japanese Internet giant, wanted to keep Baidu private and offered to invest $100 million at a $1 billion valuation. Yahoo and
Microsoft made acquisition offers at a little over $1 billion. Google
kept a close eye on the proceedings. Its China-based brain trust
wanted the U.S. search company, valued at $27 billion in its own
2004 IPO, to bid $2 billion for Baidu. Google management in
Mountain View, Calif., ultimately made a $1.6 billion bid.
Baidu’s board of directors was split, with the U.S. partners
of ePlanet’s affiliate, Draper Fisher Jurvetson, aggressively lobbying for the sale to Google. “It was certainly a very stressful
period for me,” Li says. “During the day I would talk to potential investors and tell them why they should buy Baidu stock.
At night, I picked up the phone and called the directors and
explained why they shouldn’t sell the company so early.”
Weighing the possibility that the impassioned Li might
resign and scuttle an acquisition, the board voted unanimously to go public. Asad Jamal, the founding partner of ePlanet
and a Baidu board member, thinks a $2 billion bid would have
cemented an acquisition. “I personally think that was a missed
opportunity for Google,” Jamal says.
Baidu stock hit the Nasdaq on Aug. 5, 2005, and jumped
from $27 to $122 in a day, briefly valuing the company at more
than $4 billion and showering hundreds of millions on Baidu’s
early investors. News of the offering also imprinted Baidu on
the minds of Chinese consumers and advertisers, and made Li
China’s first billionaire Web prodigy.
November 15 — November 21, 2010
Bloomberg Businessweek
In its IPO prospectus, Baidu said its music service accounted
for about 40 percent of its traffic. (It now claims that number is
down to around 5 percent as interest in digital music has waned.)
Baidu says it is trying to reach an accommodation with record
labels and in 2008 hired Catherine Leung, a former executive
at Universal Music Group, to lead the discussions. Still, Li says
piracy is not his problem. “If [users] are looking for certain type
of content that is publicly available, we cannot say, in order to
make sure record companies are happy, let’s completely block
out this type of service. We choose not to do that.” Sohu CEO
Zhang says such an argument “is the official line. They’re not
conducting evil, just spreading it.” Of course, Sohu also links to
free tunes, and Zhang says he won’t clean up his act until Baidu
does. “We will just follow the big fish,” he says.
Google, because of its need to forge strong relations with the
entertainment industry in the U.S., could never facilitate copyright infringement in the same way. Only in 2009 did Google
introduce a free, ad-supported music service in China, in conjunction with music labels. By then it was far too late. Baidu
was the fun option for the masses, while Google was viewed as
the search engine for the coastal intelligentsia, who admired its
brave resistance and then loud rejection of government censorship requirements. Robin Li heard about Google’s threatened
withdrawal from China in his car on the way to the office, via
a congratulatory text message from a friend at a Chinese Web
portal. “I certainly don’t agree with the way they framed the
issue,” he says of Google’s exit, noting that despite the censorship, there are millions of Chinese websites only because there
is a search engine to help people find them. “There are people
who don’t like us. I think for a service with hundreds of millions of daily users, it’s probably normal, especially when you
have a competitor that claims they are anti-government, that
they don’t like censorship.”
A few hours after greeting his fans, Li addressed the
Baidu World conference. He spoke in Chinese to an audience
of developers and Communist Party officials, and announced
that Baidu would start placing games, videos, and maps directly within search results. Li then praised Wan Gang, China’s
Minister of Science and Technology, for articulating the need
for such functionality.
It was a moment that revealed a truth rarely visible to nonChinese. Despite the perception of Baidu as a preferred vendor
of the Communist Party, company executives say they must
constantly curry favor, particularly as the Party asserts greater
control over the media. “One of Baidu’s biggest challenges is
keeping its copybook clean with the government,” says Duncan
Clark, chairman of BDA China, an investment advisory and
consulting firm in Beijing. Kaiser Kuo puts it less delicately:
“We get smacked as hard as anyone.”
The blows, particularly in the last two years, have left several
marks. In November 2008, government-operated China Central
Television aired several in-depth investigations about Baidu
surrounding allegations that the company earned millions on
ads from unlicensed medical providers, and prominently displaying these ads when users typed health-related queries. The
first story ran on Li’s 40th birthday, timing that no one at Baidu
dismissed as coincidental. The following quarter, Baidu boosted its ad spending by 41 percent, with the bulk of the increase
going to CCTV. Few Chinese Internet watchers thought it was a
An Alibaba spokesman
says of Baidu: “These
guys are like hoodlums.”
Baidu’s communications
chief responds by
calling Alibaba
“whiny little bitches.”
coincidence when the negative coverage ceased.
In August the Xinhaua News Agency announced it was developing a competing search engine in conjunction with China
Mobile, one of the country’s state-owned mobile carriers. In
September the People’s Daily, the Communist Party mouthpiece, appointed a former Olympic Ping-Pong player to run
its new search engine, Goso. The idea of government-backed
entities developing something as technologically complex as
a search engine doesn’t concern Baidu much. To observers
familiar with how business is conducted in China, though, the
announcements were a strong message aimed at Baidu: Don’t
get too comfortable. “The experience with Google made it
very clear to the government that sometimes a commercial
company will not play by the rules,” says Mark Natkin, managing director of Marbridge Consulting in Beijing.
With Baidu assured of nothing from the government, and
Google fading from view, Baidu is now fighting Alibaba and
Tencent in a three-way skirmish to be China’s preeminent Internet company. Alibaba has blocked Baidu’s search engine
from cataloging products from its marketplace and is developing its own shopping-oriented search engine. Tencent has been
cherry-picking engineers from Google and Baidu and vowing to
improve its Soso.com search engine. “It’s real war,” says Tom
Melcher, a U.S. entrepreneur who has lived in China for eight
years. “It makes Ellison vs. Gates look tame.” Proving the point,
John Spelich, an Alibaba spokesman, said of Baidu in August:
“These guys are like hoodlums.” Kaiser Kuo responds by calling Alibaba execs “whiny little bitches.”
During rehearsal the night before his Baidu World speech,
Li is asked whether he’s satisfied that Baidu has struck the right
balance between loyalty to the Chinese government and service for its users. “At the end of the day,” says Li, “if users don’t
find what they want, they won’t use you. If they find what they
want, they come back again.”
Of course, if you believe Baidu has always had a unique
home-field advantage over rivals like Google, that proposition
has never been seriously tested. With other Chinese Internet
firms rushing to build search engines, and with Li’s ambitions
to move overseas where Western rivals are entrenched, Baidu
is about to face more serious competition than ever before. The
world’s Internet users will finally get to decide for themselves
whether they can really trust Baidu. <BW>
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Businessweek.com | 45
Companies&Industries
Luxury
From
Mao
Jackets
▶ A Chinese
military
uniform maker
takes on European fashion houses
To Silk Suits
▶ “China has the ability to create its
own” luxury brand
26
26
Chinese entrepreneurs have long sought
to tap local demand for European luxury
goods by distributing them for other
companies—or developing private-label
brands made in China and then marketed as European or American. A third
option is just buying them, as the Hong
Kong-based billionaire brothers Victor
and William Fung did with European
fashion houses Cerrutti 1881 in 2010 and
▶ A Chinese military uniform maker
Delvaux in 2011.
takes on European fashion houses
Then there’s China Garments,
a state-owned apparel maker whose
▶ “China has the ability to create its
products range from Mao suits to miliown” luxury brand
tary uniforms to riot gear. The comChinese
entrepreneurs
long
pany recently
unveiledhave
plans
forsought
the
to
tap local
demand
forluxury
European
luxury
launch
of China’s
first
men’s
apgoods
by distributing
for other
parel brand
aimed at them
domestic
concompanies—or
developing
private-label
sumers yet designed
and produced
in
brands
made
in China
and then
marItaly, the
stomping
grounds
of globally
keted
as European
American.
A third
recognized
brandsor
such
as Gucci,
Eroption
is justZegna,
buyingand
them,
as the Hong
menegildo
Salvatore
FerKong-based
billionaire
brothers
ragamo. The
brand’s name
willVictor
marry
and
Fung did
European
two William
words, Sorgere
inwith
Italian,
meanfashion
houses
Cerrutti
1881
in 2010charand
ing “to rise,”
and
Sheji in
Chinese
Delvaux
in 2011. “nation.” The label’s
acters, meaning
Thenwill
there’s
China Garments,
clothes
be produced
by the same
a state-owned apparel maker whose
products range from Mao suits to military uniforms to riot gear. The company recently unveiled plans for the
launch of China’s first luxury men’s apparel brand aimed at domestic consumers yet designed and produced in
Italy, the stomping grounds of globally
recognized brands such as Gucci, Ermenegildo Zegna, and Salvatore Ferragamo. The brand’s name will marry
two words, Sorgere in Italian, meaning “to rise,” and Sheji in Chinese characters, meaning “nation.” The label’s
clothes will be produced by the same
46 | Bloomberg Businessweek’s Best of
Loblaw, the Canadian grocer,
during the Canadian Food
Summit in Toronto on Feb. 7.
His words drew fire from
some farmers. A Loblaw
spokesman said Weston
referred to inspection
standards, not fresh
food in general.
Quoted
family that controls the big Hong Kongbased wholesaler and distributor Li
&
Fung, said
on are
Jan.great
26 it...is
in day
talks
“Farmers
markets
One
they’re
kill somestake
people,
to
buy going
an 80topercent
inthough.”
French
——Galenhouse
Weston,Sonia
Executive
Chairman
of
fashion
Rykiel.
“It takes
Loblaw,
Canadian
grocer, brand,” says
time
tothe
become
a luxury
during the Canadian Food
Cherry Blossoms’ Lim. “Local brands
Summit in Toronto on Feb. 7.
are
ratherdrew
recent
and cannot claim
His words
fire from
asome
heritage,
aA
history
farmers.
Loblaw and beyond, a
myth.
Beyond
quality, this may be
spokesman
said Weston
referred
to inspection
the
major
gap to bridge with Western
standards,
not fresh
luxury
brands.”
food
in
general.
The Sorgere deal came about after
Raffaele Caruso CEO Umberto Angeloni spoke on the merits of making highfamily
that controls
the
big Hong Kongend apparel
in Italy at
a conference
in
based
distributor
Li
Beijingwholesaler
in October.and
“Rather
than having
&
Fung,
said brand
on Jan.made
26 it in
is in
talksit
a fake
Italian
China,
to
buy an
80 percent
stake
inChinese
French
would
be wiser
to have
a real
fashion
house
takes
brand made
inSonia
Italy,” Rykiel.
Angeloni“It
said
in
time
to become
luxurylater,
brand,”
says
his speech.
Two amonths
Zhan,
Cherry
Blossoms’
Lim. presented
“Local brands
Fiordelli,
and Angeloni
a
are
rather
recent and
cannot
claimcolsample
of Sorgere’s
first
menswear
alection
heritage,
a history and
beyond,
a
to government
officials
in Beimyth.
Beyond
quality,
may be
jing. The
full range
will this
be shown
at a
the
major
gapintothe
bridge
withcapital
Western
fashion
show
Chinese
on
luxury
Mar. 29brands.”
and available in the brand’s own
Thestores
Sorgere
camethis
about
after
retail
firstdeal
in China
summer
Raffaele
CEO Umberto
Angeloand thenCaruso
internationally,
including
in
ni
spoke
theMilan.
merits——Andrew
of making Roberts
highNew
Yorkonand
end
in Wong
Italy at a conference in
and apparel
Stephanie
Beijing in October. “Rather than having
The bottom line China Garments, a maker of sailor
asuits
fake
Italian
brand
madea luxury
in China,
and
riot gear,
is launching
line of it
madewould
be wiser
to have
a realless
Chinese
in-Italy menswear
costing
20 percent
than rivals’.
brand made in Italy,” Angeloni said in
his speech. Two months later, Zhan,
Fiordelli, and Angeloni presented a
sample of Sorgere’s first menswear collection to government officials in Beijing. The full range will be shown at a
fashion show in the Chinese capital on
Mar. 29 and available in the brand’s own
retail stores first in China this summer
and then internationally, including in
New York and Milan. ——Andrew Roberts
and Stephanie Wong
The bottom line China Garments, a maker of sailor
suits and riot gear, is launching a luxury line of madein-Italy menswear costing 20 percent less than rivals’.
ILLUSTRATION BY WALTER GREEN; WESTON: FRANK GUNN/THEILLUSTRATION
CANADIAN PRESS/FRANK
GUNN; TWEETED:
EVERETT
COLLECTION(1);
GETTY
IMAGES(1) GUNN; TWEETED: EVERETT COLLECTION(1); GETTY IMAGES(1)
BY WALTER GREEN;
WESTON: FRANK
GUNN/THE
CANADIAN
PRESS/FRANK
February 13 — February 19, 2012
Bloomberg Businessweek
tive Officer Zhan Yingjie. “China has the
ability to create its own” luxury brand.
Francesco Fiordelli, an Italian designer who has worked at Hugo Boss
and Gucci, has been hired as Sorgere’s
fashion director, while Soragna (Italy)based Raffaele Caruso is making its
made-to-measure and ready-to-wear collections. “We need to educate consumers,” says Zhan, adding that Sorgere’s
Italy-based
company
manufactures
top two lines,
dubbedthat
Black
and Blue,
suits
and slacks
forin
Christian
Dior
and
will carry
a “Made
Italy” tag.
“China
Lanvin.
wantmanufacturing
to turn round center
the old
isn’t just“We
a global
thinking
we can
onlycenter.
do processand Italythat
a global
design
These
ing,”
says China
Chiefsays.
Executwo roles
can beGarments
mixed,” Zhan
tiveSorgere
Officer Zhan
Yingjie. to
“China
has the
may struggle
persuade
ability
toshoppers
create itstoown”
luxury
Chinese
switch
their brand.
alleFrancesco
Fiordelli, an
Italian
degiance
from established
Italian
menssigner
who has
worked
at HugoZegna,
Boss
wear brands
like
Ermenegildo
and
Gucci,
hired
as Sorgere’s
whose
suitshas
arebeen
wildly
popular
among
fashion
Soragna
(Italy)-to
affluentdirector,
Chinese.while
Sorgere
is expected
based
making
chargeRaffaele
about 20Caruso
percentisless
thanits
top
made-to-measure
and ready-to-wear
international brands.
Zegna chargescollections.
“We need
to educate consumabout $2,400
for double-breasted
wool
ers,”
sayssuits.
Zhan,“Made
addinginthat
Sorgere’s
and silk
China
products
top
lines, dubbed
and Blue,
are two
presumed
to be ofBlack
low quality
by
will
a “Made
in Italy”except
tag. “China
the carry
Chinese
themselves,”
where
isn’t
just
a global
manufacturing
center
China
has
unrivaled
expertise such
as
and
Italyorasilk,
global
design
center.
These
in jade
says
Laurence
Lim
Dally,
two
roles can
be mixed,”
ZhanBlossoms
says.
managing
director
of Cherry
Sorgere
may struggle
toKong.
persuade
Market
Research
in Hong
ImChinese
shoppers
to switch
theirprestige
alleported luxury
goods
“get their
giance
from
established Italian
mensfrom the
craftsmanship
Chinese
still do
wear
brands
Ermenegildo Zegna,
not have,”
helike
says.
whose
suits are wildly
popular
Nonetheless,
as investors
getamong
a
affluent
Chinese. Sorgere
is expected
better understanding
of what
appealsto
to
charge
about
20 percent
less than
top
emerging
market
consumers,
“creating
international
brands.
Zegna
something from
a blank
sheetcharges
of paper
about
for double-breasted
wool
is less $2,400
to be feared
than perhaps it was
and
silk suits.
“Made
in China
products
before,”
says Hugh
Devlin,
a consultant
are
be ofgoods
low quality
byat
whopresumed
heads theto
luxury
practice
the
themselves,”
except
where
law Chinese
firm Withers
Worldwide
in London.
China
unrivaled
expertise
as
Nothas
everyone
agrees:
Fungsuch
Capiin
jade
silk, says Laurence
Lim
Dally,
tal,
theor
investment
arm of the
Fung
managing director of Cherry Blossoms
Market Research in Hong Kong. Imported luxury goods “get their prestige
from the craftsmanship Chinese still do
not have,” he says.
Nonetheless, as investors get a
better understanding of what appeals to
emerging market consumers, “creating
something from a blank sheet of paper
is less to be feared than perhaps it was
before,” says Hugh Devlin, a consultant
who heads the luxury goods practice at
law firm Withers Worldwide in London.
Not everyone agrees: Fung Capital, the investment arm of the Fung
March 19 — March 25, 2012
Bloomberg Businessweek
Markets&Finance
Wagyu cattle
Japanese banks and
at least
institutions have put
that
$281 million into funds
ponds
fish
and
s
farm
in
st
inve
Japan
The Scent of Fast
Money—and Tuna
▶ Funds hope to cash in on the global
popularity of Japanese cuisine
▶ “Food is the one area that has big
FROM TOP: TIMOTHY HEARSUM/THE IMAGE BANK/GETTY IMAGES; CHARLES PERTWEE/BLOOMBERG;
JAMES WHITLOW DELANO/REDUX; DIMITRIOS KAMBOURIS/WIREIMAGE/GETTY IMAGES
investment potential”
The world’s appetite for Japanese tuna,
Wagyu beef, and other delicacies prized
in restaurants as far away as New York
and London is behind an unusual investment trend in Japan. Institutional
investors and regional banks, chasing returns they hope will be as high as
7 percent, have poured at least 23 billion
yen ($281 million) into about a dozen
funds that invest in Japanese farms and
fish ponds.
Four of these food industry funds are
managed by former Citigroup banker
Daisuke Mori, who has pooled 10 billion
yen from regional banks and institutional
investors to put into projects including
tuna farming, most of them on the southern island of Kyushu, far from the radiation contamination caused by last year’s
earthquake and tsunami. “Food is the
one area that has a big investment potential,” says Mori, 44, president of Dogan
Investments in Fukuoka City. “Locally
farmed tuna, pork, and beef on Kyushu
island should get a stronger connection
with the big market outside of Japan.”
Ryohei Hayashi, a senior Dogan manager, says the latest of its funds, which are
Katsuura’s fis
h
market
closed to individual investors, is targeting a 7 percent return this year.
Global demand for Japanese food
products has led at least 25 regional
banks to increase lending to farmers who
want to export abroad. Mori, who ran
Citigroup’s Fukuoka branch during his
six-year tenure at the bank, has invested
Burimy
48 million yen in fish processor Burimy,
which breeds hundreds of thousands of
bluefin tuna and yellowtail in pens about
half a mile offshore. The company plans
to sell 2,000 farmed tuna this year and
to more than double sales next year, says
Takahiro Hama, a company director. Burimy is talking with Tokyobased Nomura Holdings about an
initial public offering to fund export
growth in the Middle East and Europe,
says Hama.
The tuna farm exports about 40 percent of its fish, mostly to stores and restaurestau
rants in California and New York, includinclud
ing Morimoto, a Manhattan restaurant
owned by Masaharu Morimoto, star of the
TV show Iron Chef.. (Tuna pizza served on
a crispy tortilla with olives is a specialty.)
Japan’s exports of tuna and yellowtail
climbed 16.9 percent and 18.1 percent, respectively, in 2011 from the previous year,
to 7.36 billion yen and 7.76 billion yen, according to Japan’s Ministry of Agriculture,
Forestry, and Fisheries.
Japan’s regional banks, faced with
anemic lending rates of 1.04 percent, also
are seeking to capitalize on the popularity
of Japanese delicacies. Kagoshima Bank,
based in Kyushu, has increased loans to
farmers willing to concentrate on specialty foods for export rather than rice or
sugarcane for domestic consumption. Agricultural lending by the bank rose 3 percent from the previous year as of Sept. 30.
Average loans outstanding in Japan declined for a second consecutive year.
Among farmers benefiting from the
lending increase are those raising Wagyu
beef and Kagoshima black swine, says
Masanaka Mei, head of trade promotion
at the bank, who has accompanied the
lender’s president, Motohiro Kamimura,
on trips to Asia and Europe along with
customers to scout out markets. Wagyu
cattle, including those from Kobe in western Japan, are a Japanese breed known
for the tenderness and marbled texture
of its meat. Black swine, trademarked as
Kagoshima Kurobuta, are a rare breed of
pig whose meat has high fat content and
is prized for its texture and flavor.
Nomura has set up a sweet mini-tomato farm joint venture with wholesaling
company Wago and has tapped former
stockbroker Shigekazu Wakabayashi to
oversee the operation. Instead of hitting
the road to visit brokerage clients, Wakabayashi these days rises at 7 a.m. and
dons a T-shirt, jeans, and boots. “It’s a big
change in my life, turning into a farmer
from a securities salesman,” he says.
——Shigeru Sato and Shingo Kawamoto
57
The bottom line Investors are hoping for 7 percent
returns from local farms and fish ponds benefiting
from the global appetite for Japanese food.
Iron Chef star
Morimoto puts
farmed tuna
on his pizza
Businessweek.com | 47
Contents ­ The education of an e-textbook startup 37 ­ Why your Internet connection seems slow 37 ­ The Isaac Asimovs of Intel 38
­ Innovator: Ajay Godhwani’s app gives voice to the speechless 40 ○ Edited by Barrett W. Sheridan
Technology
Coming This Christmas,
A Robot That Cares
Toys “R” Us bets My Keepon, originally a $30,000 robot for autism research, will be a holiday hit
PHOTOGRAPHS BY TIMOTHY ARCHIBALD FOR BLOOMBERG BUSINESSWEEK
“When
“When you see it rocking out, you just can’t help but love it”
As robots go, My Keepon appears underwhelming. It stands about 10 inches
high and looks like two tennis balls
fused together. It has no arms, no antennae, and no laser beams. What it
does have is a wicked sense of rhythm.
Fire up the stereo and My Keepon starts
grinding away, spinning its torso and
thumping its head to the beat.
My Keepon also has the backing of
one of the world’s largest toy stores,
Toys “R” Us, which has the exclusive
U.S. rights to sell the
A microphone
robot, originally a therain My Keepon’s
peutic tool for autistic
nose picks up
children. The retailer will
music, including
begin lining the shelves
tunes whistled
with My Keepons in late
or hummed
October, priming it to
be the big holiday hit. By Christmas,
if the bet pays off, My Keepon’s career
arc will look a lot like Dr. Phil’s: from
therapist to globally recognizable celebrity. “When you see it rocking out, you
just can’t help but love it,” says Richard
Barry, a vice-president at Toys “R” Us.
Keepon’s story begins about seven
years ago with Hideki Kozima, a Japanese expert in artificial intelligence and
robotics at the School of Project Design
at Miyagi University. Kozima theorized
that an emotive robot could help autistic
children, who can be overwhelmed in
face-to-face interactions, by reducing
the complexities of communication to
a few simple gestures. A child pats the
robot on the head. It responds with
a playful bob. The child talks to the
robot. It turns to face him and nods.
To test his idea, Kozima created Keepon, a fuzzy, mouthless
robot packed with $30,000 worth
of machinery, sensors, and computer chips. (The name is a portmanteau of the Japanese word for yellow,
kiiroi, and the onomatopoeia
→
pon for bounce.) In clinical use,
48 | Bloomberg Businessweek’s Best of
The research
version includes
cameras behind
the eyes that
track movement
35
My Keepon’s
computer takes
a song’s rhythm
and tempo,
adds a touch
of randomness,
and makes the
bot dance
My Keepon’s
fuzzy form
twists, bows,
and bobs as it
dances. It can
also sneeze
August 15 — August 28, 2011
Bloomberg Businessweek
Technology
a researcher in an observation room
controls Keepon wirelessly, dictating
its interactions with children. While
testing the gizmo in day-care centers,
Kozima found that autistic children
made more eye contact with the robot
than they did with people. Behaviors
they rarely expressed toward humans,
like touching and nurturing, became
more commonplace. Since then dozens
of research centers and universities
have bought the pricey bot for therapeutic work. “Using a robot can be a
real ice breaker for children and clinicians,” says Anjana N. Bhat, a researcher at the University of Connecticut’s
Neag School of Education, who is conducting clinical trials with robots and
autistic children.
The research caught the attention
of Dr. Marek Michalowski, a PolishAmerican robotics expert with a background in computer science and
psychology. Michalowski is fascinated by the complexity of the gestures
humans use to communicate, and
wondered if a robot like Keepon could
reproduce them. “You could have a
future robot that nods at the appropriate tempo when you order it to make a
sandwich,” he says. Michalowski went to
Japan to work at Kozima’s lab in 2006,
and began teaching Keepon that most
universal of gestures: dancing. He wrote
software so that Keepon would bob its
head along to fast tracks and swoon
during slow dance numbers.
In early 2007, Michalowski put together a video of Keepon dancing to
I Turn My Camera On by the indie rock
band Spoon. The little yellow blob
gave its all for the production, rocking
back and forth, turning, squishing, and
Roboticist Marek
Michalowski
My Keepon has two modes: touch
and dance. In touch mode, the robot
responds to pats with a range of gestures, such as turning, wiggling, or
“Defendants have uncovered smoking-gun
evidence that the purported contract at the
sneezing. Part of the fun comes from
heart of this case is a fabrication.”
uncovering My Keepon’s reactions.
——Facebook, in an Aug. 4 court filing
Hit it on the head six times, for inclaiming a lawsuit brought by Paul Ceglia is
stance, and it will pop up and down
based on fraud. The Buffalo (N.Y.) resident
six times while emitting a variety of R2says he owns half the social network.
D2-like beeps and boops. There’s a bit
of mystery to dance mode, too. A microphone in My Keepon’s nose listens
to a song—or even a rhythm hummed
or whistled—and runs the tempo and
amplitude through an algorithm that
introduces some randomization. Fire
up a country hit and watch My Keepon
stretching. The video turned into an Insashay to the beat. Play the same song
ternet sensation, with over 2.6 million
again, and My Keepon will do a difplays on YouTube. Among the viewers
ferent dance, while still matching the
were toy makers interested in creating
rhythm and tempo.
a consumer version. Last year, MichaIt’s that focus on the unexpected
lowski and Kozima decided to team up
that Michalowski says will separate My
with WOW! Stuff, a British gadget and
Keepon from other toys that “lose their
toy maker, which agreed to dedicate
novelty once someone has gone through
a portion of sales to autism research.
their range of responses.” My Keepon
Richard North, WOW! Stuff ’s floppy
can remember sequences of touches
haired managing director, explains that
and notices when it’s been ignored. It
the company scours the world for good
will tweak its behavior based on this hisideas and then has its own team of engitory, wiggling in different ways and letneers refine the products. In this case,
ting out an occasional cry for attention.
refining Keepon meant writing new softThe toy’s backers pitch My Keepon as
ware to govern the bots’ interactions
a blank slate that could appeal to kids
with people, and replacing a lot of the
and adults. “You might see Keepon
handmade machinery with off-the-shelf
as pensive or sad, maybe whatever you
parts. For example, WOW! Stuff ’s verare feeling,” Michalowski says. North,
sion, renamed My Keepon, uses touch
of course, is readying a line of accessoand sound sensors to detect a nearby
ries, like Western outfits, to let people
human instead of cameras behind the
customize the bot to their liking.
eyes. “There were severe cost conToys “R” Us has plans to put histraints, but we had to figure out ways
tech marketing displays in its stores
to add variation and personality and
and launch a television ad campaign.
avoid being a gimmick,” says North.
Though the final price isn’t set yet, My
Keepon will sell for less than $50. “It
will have a huge presence,” says Barry.
Michalowski’s big hope is that the
proceeds from My Keepon will help
cover the costs of new therapeuWOW! Stuff’s
tic units, so additional autism
Richard North
research can be conducted.
He and North also plan to offer robot
robotics hobbyists the tools to program My
Keepon themselves, giving it moves un
undreamt of by its creators. “We expect
kids and adults to personalize not just
on the outside but on the inside too,”
says North. ——Ashlee Vance
Quoted
The bottom line Toys “R” Us plans a big marketing
push this fall for My Keepon, which will sell for less
than $50—outfits and accessories not included.
Businessweek.com | 49
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rescue. Letting hunters pay to kill endangered
oversial, but it might just save a species. We
s well beyond the boardroom, because market
e from the most unexpected places.
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