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E-MailThe following post comes to us from Lawrence A. Cunningham, Henry St. George Tucker III Research Professor of Law at George Washington University Law School. This post is based on and adapted from The Essays of Warren Buffett: Lessons for Corporate America (3d ed. 2013) by Professor Cunningham.
In Warren Buffett’s model of corporate governance, managers are stewards of shareholder capital. The best managers think like owners in making business decisions. They have shareholder interests at heart. But even first-rate managers will sometimes have interests that conflict with those of shareholders. How to ease those conflicts and to nurture managerial stewardship have been constant objectives of Buffett’s long career and a prominent theme of his shareholder letters that I began collecting two decades into the stand-alone book, The Essays of Warren Buffett: Lessons for Corporate America, the third edition of which was released in March 2013.
The essays address some of the most important governance problems. The first is the importance of forthrightness and candor in communications by managers to shareholders. Buffett tells it like it is, or at least as he sees it, and laments that he is in the minority. Berkshire’s annual report is not glossy; Buffett prepares its contents using words and numbers people of average intelligence can understand; and all investors get the same information at the same time. Buffett and Berkshire avoid making predictions, a bad managerial habit that too often leads other managers to make up their financial reports.
The next management lesson is to dispense with formulas of managerial structure. Contrary to textbook rules on organizational behavior, mapping an abstract chain of command on to a particular business situation, according to Buffett, does little good. What matters is selecting people who are able, honest, and hard-working. Having first-rate people on the team is more important than designing hierarchies and clarifying who reports to whom about what and at what times.
Special attention must be paid to selecting a chief executive officer (CEO) because of three major differences Buffett identifies between CEOs and other employees. First, standards for measuring a CEO’s performance are inadequate or easy to manipulate, so a CEO’s performance is harder to measure than that of most workers. Second, no one is senior to the CEO, so no senior person’s performance can be measured either. Third, a board of directors cannot serve that senior role since relations between CEOs and boards are conventionally congenial.
Major reforms are often directed toward aligning management and shareholder interests or enhancing board oversight of CEO performance. Stock options for management were touted as one method; greater emphasis on board processes was another. Separating the identities and functions of the Chairman of the Board and the CEO or appointment of standing audit, nominating and compensation committees were also heralded as promising reforms. Perhaps the most pervasive prescription is to populate boards with independent directors. None of these innovations has solved governance problems, however, and some have exacerbated them.
The best solution, Buffett instructs, is to take great care in identifying CEOs who will perform capably regardless of weak structural restraints. Large institutional shareholders must exercise their power to oust CEOs that do not measure up to the demands of corporate stewardship. Outstanding CEOs do not need a lot of coaching from owners, although they can benefit from having a similarly outstanding board. Directors therefore must be chosen for their business savvy, their interest, and their owner-orientation. According to Buffett, one of the greatest problems among boards in corporate America is that members are selected for other reasons, such as adding diversity or prominence to a board—or, famously, independence.
Most reforms are painted with a broad brush, without noting the major differences among types of board situations that Buffett identifies. For example, director power is weakest in the case where there is a controlling shareholder who is also the manager. When disagreements arise between the directors and management, there is little a director can do other than to object and, in serious circumstances, resign. Director power is strongest at the other extreme, where there is a controlling shareholder who does not participate in management. The directors can take matters directly to the controlling shareholder when disagreement arises.
The most common situation, however, is a corporation without a controlling shareholder. This is where management problems are most acute, Buffett says. It would be helpful if directors could supply necessary discipline, but board congeniality usually prevents that. To maximize board effectiveness in this situation, Buffett believes the board should be small in size and composed mostly of outside directors. The strongest weapon a director can wield in these situations remains his or her threat to resign.
All these situations do share a common characteristic: the terrible manager is a lot easier to confront or remove than the mediocre manager. A chief problem in all governance structures, Buffett emphasizes, is that in corporate America evaluation of chief executive officers was never conducted in regular meetings in the absence of that chief executive. Holding regular meetings without the chief executive to review his or her performance can produce marked improvement in corporate governance.
The CEOs at Berkshire’s various operating companies enjoy a unique position in corporate America. They are given a simple set of commands: to run their business as if (1) they are its sole owner, (2) it is the only asset they hold, and (3) they can never sell or merge it for a hundred years. This enables Berkshire CEOs to manage with a long-term horizon ahead of them, something alien to the CEOs of public companies whose short-term oriented shareholders obsess with meeting the latest quarterly earnings estimate. Short-term results matter, of course, but the Berkshire approach avoids any pressure to achieve them at the expense of strengthening long-term competitive advantages.
Sometimes management interests conflict with shareholder interests in subtle or easily disguised ways. Take corporate philanthropy, for example. At most major corporations, management allocates a portion of corporate profit to charitable concerns. The charities are chosen by management, for reasons often unrelated either to corporate interests or shareholder interests. Most state laws permit management to make these decisions, so long as aggregate annual donations are reasonable in amount, usually not greater than 10% of annual net profits.
Berkshire does things differently. It makes no contributions at the parent company level and allows its subsidiaries to follow philanthropic policies they had in effect before Berkshire acquired them. For two decades, moreover, Berkshire used an imaginative program through which its shareholders designated the charities to which Berkshire would donate and in what amounts. Nearly all shareholders participated, donating tens of millions of dollars annually to thousands of different charities. Political controversy over the abortion issue, however, interfered with this program. Political activists organized boycotts of Berkshire’s products to protest particular charitable donations that were made, destroying this feature of Berkshire’s “partnership” approach.
The plan to align management and shareholder interests by awarding executives stock options not only was oversold, but also subtly disguised a deeper division between those interests that the options created. Many corporations pay their managers stock options whose value increases simply by retention of earnings, rather than by superior deployment of capital. As Buffett explains, however, simply by retaining and reinvesting earnings, managers can report annual earnings increases without so much as lifting a finger to improve real returns on capital. Stock options thus often rob shareholders of wealth and allocate the booty to executives. Moreover, once granted, stock options are often irrevocable, unconditional, and benefit managers without regard to individual performance.
It is possible to use stock options to instill a managerial culture that encourages owner-like thinking, Buffett agrees. But the alignment will not be perfect. Shareholders are exposed to the downside risks of sub-optimal capital deployment in a way that an option holder is not. Buffett therefore cautions shareholders who are reading proxy statements about approving option plans to be aware of the asymmetry in this kind of alignment. Many shareholders rationally ignore proxy statements, but the abuse of stock options should be on the front-burner of shareholders, particularly institutional investors that periodically engage in promoting corporate governance improvements.
Buffett emphasizes that performance should be the basis for executive pay decisions. Executive performance should be measured by profitability, after profits are reduced by a charge for the capital employed in the relevant business or earnings retained by it. If stock options are used, they should be related to individual performance, rather than corporate performance, and priced based on business value. Better yet, as at Berkshire, stock options should simply not be part of an executive’s compensation. After all, exceptional managers who earn cash bonuses based on the performance of their own business can simply buy stock if they want to; if they do, they “truly walk in the shoes of owners,” Buffett says. And owners’ interests are paramount on executive pay as with other corporate governance topics Buffett addresses, such as risk management, corporate compliance and financial reporting.
One Comment
It was a response to one I’d sent him, pitching an investment idea. For a kid interested in learning stocks, Buffett was a great role model. His investing style — diligent security analysis, finding competent management, patience — was immediately appealing.
Buffett was kind enough to respond to my letter, thanking me for it and inviting me to his company’s annual meeting. I was hooked. Today, Buffett remains famous for investing The Right Way. He even has a television cartoon in the works, which will groom the next generation of acolytes.
But it turns out much of the story is fiction. A good chunk of his fortune is dependent on taxpayer largess. Were it not for government bailouts, for which Buffett lobbied hard, many of his company’s stock holdings would have been wiped out.
Berkshire Hathaway, in which Buffett owns 27 percent, according to a recent proxy filing, has more than $26 billion invested in eight financial companies that have received bailout money. The TARP at one point had nearly $100 billion invested in these companies and, according to new data released by Thomson Reuters, FDIC backs more than $130 billion of their debt.
To put that in perspective, 75 percent of the debt these companies have issued since late November has come with a federal guarantee
Without FDIC’s debt guarantee program, even impregnable Goldman would have collapsed.
And this excludes the emergency, opaque lending facilities from the Federal Reserve that also helped rescue the big banks. Without all these bailouts, the financial system would have been forced to recapitalize itself.
Banks that couldn’t finance their balance sheets would have sold toxic assets at market prices, and the losses would have wiped out their shareholder’s equity. With $7 billion at stake, Buffett is one of the biggest of these shareholders.
He even traded the bailout, seeking morally hazardous profits in preferred stock and warrants of Goldman and GE because he had “confidence in Congress to do the right thing” — to rescue shareholders in too-big-to-fail financials from the losses that were rightfully theirs to absorb.
Keeping this in mind, I was struck by Buffett’s letter to Berkshire shareholders this year:
“Funders that have access to any sort of government guarantee — banks with FDIC-insured deposits, large entities with commercial paper now backed by the Federal Reserve, and others who are using imaginative methods (or lobbying skills) to come under the government’s umbrella — have money costs that are minimal,” he wrote.
“Conversely, highly-rated companies, such as Berkshire, are experiencing borrowing costs that … are at record levels. Moreover, funds are abundant for the government-guaranteed borrower but often scarce for others, no matter how creditworthy they may be.”
It takes remarkable chutzpah to lobby for bailouts, make trades seeking to profit from them, and then complain that those doing so put you at a disadvantage.
Elsewhere in his letter he laments “atrocious sales practices” in the financial industry, holding up Berkshire subsidiary Clayton Homes as a model of lending rectitude.
Conveniently, he neglects to mention Wells Fargo’s toxic book of home equity loans, American Express’ exploding charge-offs, GE Capital’s awful balance sheet, Bank of America’s disastrous acquisitions of Countrywide and Merrill Lynch, and Goldman Sachs’ reckless trading practices.
And what of Moody’s, the credit-rating agency that enabled lending excesses Buffett criticizes, and in which he’s held a major stake for years? Recently Berkshire cut its stake to 16 percent from 20 percent. Publicly, however, the Oracle of Omaha has been silent.
This is remarkably incongruous for the world’s most famous financial straight-shooter. Few have called him on it, though one notable exception was a good article by Charles Piller in the Sacramento Bee earlier this year.
Buffett didn’t respond to my email seeking a comment.
What saddens me is that Buffett is uniquely positioned to lobby for better public policy, but he’s chosen to spend his considerable political capital protecting his own holdings.
If we learn one lesson from this episode, it’s that banks should carry substantially more capital than may be necessary. You would think Buffett would agree. He has always emphasized investing with a “margin of safety” — so why shouldn’t banks lend with one?
Yet he mocked Tim Geithner’s stress tests, which forced banks to replenish their capital. Why? Is it because his banks are drastically undercapitalized? The more capital they’re forced to raise, the more his stake is diluted.
He points to Wells Fargo’s deposit funding model being more robust than investment banks’, but that’s no excuse for letting tangible equity dwindle to three percent of assets. At that low level, the capital structure would have collapsed were it not for bailouts.
And by the way, the strength of Wells’ funding model is a result of FDIC insurance, among the government subsidies Buffett complains about in this year’s letter.
To me this feels like a betrayal. There’s a reason he’s Warren Buffett and not, say, Carl Icahn.
As Roger Lowenstein wrote in his 1995 biography of Buffett, “Wall Street’s modern financiers got rich by exploiting their control of the public’s money … Buffett shunned this game … In effect, he rediscovered the art of pure capitalism — a cold-blooded sport, but a fair one.”
But there’s nothing fair about Buffett getting a bailout, about exploiting the taxpaying public for his own gain.