How does a company that's had a sterling reputation since the California Gold Rush in the 1850s sully its image after more than a century and a half of prudent and profitable operations?

The answer in the case of Wells Fargo (NYSE:WFC), says Warren Buffett, is a combination of hubris and procrastination.

Chairman and CEO of Berkshire Hathaway.

Warren Buffett, Chairman and CEO of Berkshire Hathaway. Image source: The Motley Fool.

"At Wells Fargo, there were three very significant mistakes, but there was one that dwarfs all the others," said Buffett at Berkshire Hathaway's (NYSE:BRK-A) (NYSE:BRK-B) annual shareholder meeting. "At some point if there's a major problem, the CEO gets wind of it, and the CEO has to act. They didn't act when they learned about it."

Buffett is talking about Wells Fargo's fake-account scandal, in which thousands of its employees opened millions of fake accounts in customers' names. The scandal came to light last September, when the Consumer Financial Protection Bureau announced that it had fined the nation's third biggest bank by assets $100 million.

"Wells Fargo employees secretly opened unauthorized accounts to hit sales targets and receive bonuses," said CFPB Director Richard Cordray at the time. "Because of the severity of these violations, Wells Fargo is paying the largest penalty the CFPB has ever imposed. Today's action should serve notice to the entire industry that financial incentive programs, if not monitored carefully, carry serious risks that can have serious legal consequences."

Wells Fargo's executives knew of the illicit sales practices for years yet allowed them to go on. A report issued by its board of directors in April found that the sales abuses date back to at least 2002. I've opined that they probably go back to 1998. Either way, beginning in 2011, Wells Fargo began firing 1,000 employees a year for opening up accounts for customers without their knowledge or approval.

Yet despite ultimately terminating around 5% of its branch-based employees, Wells Fargo's executives refused to address the root of the problem: the bank's overly aggressive sales quotas. Employees were forced to work nights and weekends, not infrequently without pay, to increase their cross-sales. And when that didn't work, they cut to the chase and opened accounts for customers without their approval to do so.

Since the current lineage of leaders took over following Wells Fargo's 1998 merger with Norwest, they've put cross-selling at the center of the bank's culture. They refer to its branches as "stores," they proudly announced the bank's cross-sell ratio on its quarterly conference calls, and they aspire to sell every customer at least eight of its financial products -- checking and savings accounts, mortgages, car loans, and so on.

"Clearly at Wells Fargo there was an incentive system built around cross-selling a number of services per customer," Buffett told Berkshire Hathaway shareholders on Saturday. "There's nothing wrong with incentive systems, but you have to be very careful about what you incentivize."

A Wells Fargo branch sign.

Image source: The Motley Fool.

Wells Fargo's now-former chairman and CEO, John Stumpf, fumbled his first public comments on the scandal, laying the blame on low-level employees in a CNBC interview with Jim Cramer. Then, Stumpf, in Congressional testimony, came across as unprepared and unrepentant. "They totally underestimated the impact" of the issue, Buffett said of the bank's response.

To make matters worse, after the sales scandal came to light, the media was awash with stories of whistleblowers inside the bank who had been bringing the issue to executives' attention for years, sometimes emailing Stumpf directly. But instead of rewarding these employees, or at the very least protecting them against adverse employment actions, Wells Fargo engaged in a systematic effort to retaliate against them, generally firing whistleblowers in such a way that they had no chance of ever again getting a job in the financial-services industry.

Buffett is the first to admit that no company is perfect. And when you employ hundreds of thousands of people, as both Wells Fargo and Berkshire Hathaway do, it's inevitable that inappropriate behavior will take place. "You're going to have problems. We have around 367,000 employees," said the 86-year-old billionaire. "People are doing something wrong as we talk about it today – there's no doubt about it."

To Buffett's point, however, while a company's executives can't police everything its employees do, once they are made aware of inappropriate behavior, there's a duty to stop it. That didn't happen at Wells Fargo.

John Maxfield owns shares of Wells Fargo. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.