Corporate Governance According to Charles T. Munger

The following post comes to us from David Larcker, Professor of Accounting at Stanford University, and Brian Tayan of the Corporate Governance Research Initiative at the Stanford Graduate School of Business.

Berkshire Hathaway Vice Chairman Charlie Munger is well known as the partner of CEO Warren Buffett and also for his advocacy of “multi-disciplinary thinking”—the application of fundamental concepts from across various academic disciplines to solve complex real-world problems. One problem that Munger has addressed over the years is the optimal system of corporate governance. How should an organization be structured to encourage ethical behavior among organizational participants and motivate decision-making in the best interest of shareholders? His solution is unconventional by the standards of governance today and somewhat at odds with regulatory guidelines. However, the insights that Munger provides represent a contrast to current “best practices” and suggest the potential for alternative solutions to improve corporate performance and executive behavior. In our paper, Corporate Governance According to Charles T. Munger, which was recently made publicly available on SSRN, we examine this solution in greater detail.

The need for a governance system is based on the premise that individuals working in a firm are self-interested and therefore willing to take actions to further their own interest at the expense of the organization’s interests. Most large corporations today have adopted governance systems that include extensive incentives and controls. Charlie Munger, however, contends that it is unreasonable to expect such a system to work equally well in all settings. He points out that many successful organizations, including Berkshire Hathaway, operate under a model that relies on fewer rather than more controls. This system can be described as a trust-based system.

The lynchpin of a trust-based system is the choice of chief executive officer. A CEO of high capability and sound integrity does not require extensive monitoring and can be relied on to make correct (rational) decisions in the long-term interest of the organization. From a theoretical perspective, this approach makes sense: one way for a company to reduce agency costs is to hire someone who, because of his or her character, is unlikely to engage in actions that are detrimental to shareholders. Once the right CEO is selected, he or she should be empowered to make decisions without extensive review by the board of directors.

The second main element of a trust-based system is the development and maintenance of a culture that encourages responsible behavior. Several organizational features contribute to a responsible culture. First is accountability. The system should be designed so that the people within an organization who make decisions bear the consequences of those decisions. Second is the adoption of basic controls. The organization should remove easy opportunities for individuals to engage in self-interested behavior. Third is conservative accounting. Conservative accounting creates a margin of safety, providing assurance to investors and management that corporate performance is at least as good as reported. Fourth is modest compensation both for executives and for the board of directors. Fifth is simplicity. Complex systems increase the likelihood that management and directors do not have a firm handle on the activity that takes place in the organization.

The full paper is available for download here.

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