Friday, July 4, 2014

Buffett & Munger on Compensation - Part II

A follow up to this post. In this CNBC interview, Warren Buffett helps explain why less than optimal compensation systems come to exist in the first place:

"...once a board has delegated to a committee and they've spent hours working on something, and then they report it and there's 20 other items on the agenda and the Chairman calls on the comp committee to give his report and gives it in about 30 seconds, it never gets voted against. And it would be regarded as sort of usurping the power of the committee to all of a sudden say I've got a better idea. I haven't talked to the compensation consultants, I haven't looked at the figures, but I still have a better idea. It doesn't happen."

Becky Quick -- the CNBC interviewer -- brought up the idea that corporate boards might become rather clubby at times. Buffett responded by saying he finds it "always interesting...to read academic discussions of boards." Some have a tendency to overestimate the likelihood that corporate board actions will be primarily about "business maximization" and underestimate the social component.

"...boards are in part business organizations and in part social organizations. People walk into those with their behavior formed by dozens of — usually your people have achieved some standing, perhaps, in the community. So they've learned how to get along with other people. And they don't suddenly change their stripes when they come into a board meeting. So there's a great tendency to behave in a socially acceptable way and not necessarily in a business maximization way. The motives are good; the behavior is formed by decades earlier."

That comment about boards being social organizations -- and the implications for owners -- deserves some attention. In the real world, corporate board behavior isn't, as some might like to imagine, necessarily all about what's best for the business and owners. During the same interview, Andrew Ross Sorkin later asked:

"I hear you saying this is what happens. My question is should it happen this way?"

Buffett's response:

"Well, no, obviously you know everybody would speak freely and all of that sort of thing, and dialogue would be encouraged and the chairman would love to hear reasons why his ideas were no good, but it isn't quite that way."

Buffett later goes on to explains another important dynamic at work:

"There are a number of directors at any company that are making two or three hundred thousand dollars a year, and that money is important to them. And what they really hope is they get invited to go on other boards.

Now if a CEO comes to another CEO and says I hear you've got so-and-so on the board, we need another woman or whatever it may be, oh, she will behave.

If they say she raises hell at every meeting, she's not going to be on the next board. On the other hand, if they say she's constructive, her compensation committee recommendations have been spot on, et cetera, she's got another $300,000 a year job. That's the real world."

These are, at least in some ways, remarkably blunt comments that reveals just how social -- and not surprisingly a bit self-serving -- things end up being on at least some boards. The idea that "business maximization" is what boards are about is an invented version of how humans -- even very capable ones -- are likely to behave in groups. The error of expecting otherwise seems similar to the error of assuming that market participants will mostly act in a cold and rational manner.

There are, of course, some very good boards. That doesn't mean many boards are not susceptible to some of these adverse dynamics.

It's worth noting that, unlike many other companies, non-executive board members at Berkshire Hathaway (BRKado not get paid.

Here's Charlie Munger's take:

"You start paying directors of corporations two or three hundred thousand dollars a year, it creates a daisy chain of reciprocity where they keep raising the CEO and he keeps recommending more pay for the directors..."

He also said the following when asked about the unconventional view that lots of disclosure regarding executive compensation is not necessarily the best thing for shareholders:

"I think envy is one of the major problems of the human condition... And so I think this race to have high compensation because other people do, has been fomented by all this publicity about higher earnings. I think it's quite counterproductive for the nation. There's a natural reaction to all this disclosure because everybody wants to match the highest."

Buffett followed with this:

"It's very natural to think if you're a director of the ABC Corp. and the CEO of the XYZ Corp is getting more, well, our guy is at least as good as theirs. And it goes on and on and on.

So publication of the top salaries has cost the American shareholder money. Maybe disclosure is the great disinfectant, all of that, sunshine is the great disinfectant. Sunshine has cost American shareholders money when it comes to paying their managers."

Munger then quipped that it's "a peculiarity of ours, but we're right".

Basically, publishing the information creates envy that leads to higher pay packages. They think people will generally expect to earn more when they see what others are earning.

In the 2006 letter, Buffett offers some thoughts on Berkshire's board (page 18) and compensation practices (starting at the bottom of page 19).

Also, for some additional thoughts on compensation -- including the misalignment of interests that can occur with stock options -- check out the Compensation section of the 1994 letter.

Adam

Long position in BRKb established at much lower than recent market prices

Related posts:
Buffett & Munger on Compensation - Part I
The Illusion of Consensus
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