“Corporate
Governance
In judging
whether Corporate America is serious about reforming
itself, CEO pay remains the acid test. To date, the
results aren’t encouraging. A few CEOs, such as Jeff
Immelt of General Electric, have led the way in initiating
programs that are fair to managers and shareholders
alike. Generally, however, his example has been more
admired than followed.
It’s understandable
how pay got out of hand. When management hires employees,
or when companies bargain with a vendor, the intensity
of interest is equal on both sides of the table. One
party’ s gain is the other party’s loss, and the money
involved has real meaning to both. The result is an
honest-to-God negotiation.
But when
CEOs (or their representatives) have met with compensation
committees, too often one side – the CE O’s – has cared
far more than the other about what bargain is struck.
A CE O, for example, will always regard the difference
between receiving options for 100,000 shares or for
500,000 as monumental. To a comp committee, however,
the difference may seem unimportant – particularly if,
as has been the case at most companies, neither grant
will have any effect on reported earnings. Under these
conditions, the negotiation often has a “play-money”
quality.
Overreaching
by CEOs greatly accelerated in the 1990s as compensation
packages gained by the most avaricious– a title for
which there was vigorous competition – were promptly
replicated elsewhere.
The couriers
for this epidemic of greed were usually consultants
and human relations departments, which had no trouble
perceiving who buttered their bread. As one compensation
consultant commented: “There are two classes of clients
you don’ t want to offend – actual and potential.” In
proposals for reforming this malfunctioning system,
the cry has been for “independent” directors. But the
question of what truly motivates independence has largely
been neglected. In last year’s report, I took a look
at how “independent” directors – as defined by statute
– had performed in the mutual fund field. The Investment
Company Act of 1940 mandated such directors, and that
means we’ve had an extended test of what statutory standards
produce. In our examination last year, we looked at
the record of fund directors in respect to the two key
tasks board members should perform – whether at a mutual
fund business or any other. These two all-important
functions are, first, to obtain (or retain) an able
and honest manager and then to compensate that manager
fairly.
Our survey
was not encouraging. Year after year, at literally thousands
of funds, directors had routinely rehired the incumbent
management company, however pathetic its performance
had been. Just as routinely, the directors had mindlessly
approved fees that in many cases far exceeded those
that could have been negotiated. Then, when a management
company was sold – invariably at a huge price relative
to tangible assets – the directors experienced a “counter-revelation”
and immediately signed on with the new manager and accepted
its fee schedule. In effect, the directors decided that
whoever would pay the most for the old management company
was the party that should manage the shareholders’ money
in the future.
Despite the
lapdog behavior of independent fund directors, we did
not conclude that they are bad people. They’re not.
But sadly, “boardroom atmosphere” almost invariably
sedates their fiduciary genes.
On May 22,
2003, not long after Berkshire’ s report appeared, the
Chairman of the Investment Company Institute addressed
its membership about “The State of our Industry.” Responding
to those who have “weighed in about our perceived failings,”
he mused, “It makes me wonder what life would be like
if we’d actually done something wrong.”
Be careful
what you wish for.
Within
a few months, the world began to learn that many fund-management
companies had followed policies that hurt the owners
of the funds they managed, while simultaneously boosting
the fees of the managers. Prior to their transgressions,
it should be noted, these management companies were
earning profit margins and returns on tangible equity
that were the envy of Corporate America. Yet to swell
profits further, they trampled on the interests of fund
shareholders in an appalling manner.
So what are the directors of these looted funds doing?
As I write this, I have seen none that have terminated
the contract of the offending management company (though
naturally that entity has often fired some of its employees).
Can you imagine directors who had been personally defrauded
taking such a boys-will-be-boys attitude?
To
top it all off, at least one miscreant management company
has put itself up for sale, undoubtedly hoping to receive
a huge sum for “delivering” the mutual funds it has
managed to the highest bidder among other managers.
This is a travesty. Why in the world don’t the directors
of those funds simply select whomever they think is
best among the bidding organizations and sign up with
that party directly? The winner would consequently be
spared a huge “payoff” to the former manager who, having
flouted the principles of stewardship, deserves not
a dime. Not having to bear that acquisition cost, the
winner could surely manage the funds in question for
a far lower ongoing fee than would otherwise have been
the case. Any truly independent director should insist
on this approach to obtaining a new manager.
The reality is that neither the decades-old rules regulating
investment company directors nor the new rules bearing
down on Corporate America foster the election of truly
independent directors. In both instances, an individual
who is receiving 100% of his income from director fees
– and who may wish to enhance his income through election
to other boards – is deemed independent. That is nonsense.
The same rules say that Berkshire director and lawyer
Ron Olson, who receives from us perhaps 3% of his very
large income, does not qualify as independent because
that 3% comes from legal fees Berkshire pays his firm
rather than from fees he earns as a Berkshire director.
Rest assured, 3% from any source would not torpedo Ron’s
independence. But getting 20%, 30% or 50% of their income
from director fees might well temper the independence
of many individuals, particularly if their overall income
is not large. Indeed, I think it’s clear that at mutual
funds, it has.
Let me make a small suggestion to “independent” mutual
fund directors. Why not simply affirm in each annual
report that “(1) We have looked at other management
companies and believe the one we have retained for the
upcoming year is among the better operations in the
field; and (2) we have negotiated a fee with our managers
comparable to what other clients with equivalent funds
would negotiate.”
It
does not seem unreasonable for shareholders to expect
fund directors – who are often receiving fees that exceed
$100,000 annually – to declare themselves on these points.
Certainly these directors would satisfy themselves on
both matters were they handing over a large chunk of
their own money to the manager. If directors are unwilling
to make these two declarations, shareholders should
heed the maxim “If you don’ t know whose side someone
is on, he’ s probably not on yours.”
Finally,
a disclaimer. A great many funds have been run well
and conscientiously despite the opportunities for malfeasance
that exist. The shareholders of these funds have benefited,
and their managers have earned their pay. Indeed, if
I were a director of certain funds, including some that
charge above-average fees, I would enthusiastically
make the two declarations I have suggested. Additionally,
those index funds that are very low-cost (such as Vanguard’s)
are investor-friendly by definition and are the best
selection for most of those who wish to own equities.
I am on my
soapbox now only because the blatant wrongdoing that
has occurred has betrayed the trust of so many millions
of shareholders. Hundreds of industry insiders had to
know what was going on, yet none publicly said a word.
It took Eliot Spitzer, and the whistleblowers who aided
him, to initiate a housecleaning. W e urge fund directors
to continue the job. Like directors throughout Corporate
America, these fiduciaries must now decide whether their
job is to work for owners or for managers.
Berkshire
Governance
True independence
– meaning the willingness to challenge a forceful CEO
when something is wrong or foolish – is an enormously
valuable trait in a director. It is also rare. The place
to look for it is among high-grade people whose interests
are in line with those of rank-and-file shareholders
– and are in line in a very big way.
We’ve
made that search at Berkshire. We now have eleven directors
and each of them, combined with members of their families,
owns more than $4 million of Berkshire stock. Moreover,
all have held major stakes in Berkshire for many years.
In the case of six of the eleven, family ownership amounts
to at least hundreds of millions and dates back at least
three decades. All eleven directors purchased their
holdings in the market just as you did; we’ve never
passed out options or restricted shares. Charlie and
I love such honest-to-God ownership. After all, who
ever washes a rental car?
In addition,
director fees at Berkshire are nominal (as my son, Howard,
periodically reminds me). Thus, the upside from Berkshire
for all eleven is proportionately the same as the upside
for any Berkshire shareholder. And it always will be.
The
downside for Berkshire directors is actually worse than
yours because we carry no directors and officers liability
insurance. Therefore, if something really catastrophic
happens on our directors’ watch, they are exposed to
losses that will far exceed yours.
The
bottom line for our directors: You win, they win big;
you lose, they lose big. Our approach might be called
owner-capitalism. W e know of no better way to engender
true independence. (This structure does not guarantee
perfect behavior, however: I’ve sat on boards of companies
in which Berkshire had huge stakes and remained silent
as questionable proposals were rubber-stamped.) In addition
to being independent, directors should have business
savvy, a shareholder orientation and a genuine interest
in the company. The rarest of these qualities is business
savvy – and if it is lacking, the other two are of little
help. Many people who are smart, articulate and admired
have no real understanding of business. That’s no sin;
they may shine elsewhere. But they don’ t belong on
corporate boards. Similarly, I would be useless on a
medical or scientific board (though I would likely be
welcomed by a chairman who wanted to run things his
way). My name would dress up the list of directors,
but I wouldn’t know enough to critically evaluate proposals.
Moreover, to cloak my ignorance, I would keep my mouth
shut (if you can imagine that). In effect, I could be
replaced, without loss, by a potted plant.
Last
year, as we moved to change our board, I asked for self-nominations
from shareholders who believed they had the requisite
qualities to be a Berkshire director. Despite the lack
of either liability insurance or meaningful compensation,
we received more than twenty applications. Most were
good, coming from owner-oriented individuals having
family holdings of Berkshire worth well over $ 1 million.
After considering them, Charlie and I – with the concurrence
of our incumbent directors – asked four shareholders
who did not nominate themselves to join the board: David
Gottesman, Charlotte Guyman, Don Keough and Tom Murphy.
These four people are all friends of mine, and I know
their strengths well. They bring an extraordinary amount
of business talent to Berkshire’s board.
The primary
job of our directors is to select my successor, either
upon my death or disability, or when I begin to lose
my marbles. (David Ogilvy had it right when he said:
“Develop your eccentricities when young. That way, when
you get older, people won’t think you are going gaga.”
Charlie’s family and mine feel that we overreacted to
David’s advice.)
At our directors’
meetings we cover the usual run of housekeeping matters.
But the real discussion – both with me in the room and
absent – centers on the strengths and weaknesses of
the four internal candidates to replace me.
Our board
knows that the ultimate scorecard on its performance
will be determined by the record of my successor. He
or she will need to maintain Berkshire’s culture, allocate
capital and keep a group of America’s best managers
happy in their jobs. This is not the toughest task in
the world – the train is already moving at a good clip
down the track – and I’m totally comfortable about it
being done well by any of the four candidates we have
identified. I have more than 99% of my net worth in
Berkshire and will be happy to have my wife or foundation
(depending on the order in which she and I die) continue
this concentration.”
