Berkshire Hathaway: The Role of Trust in Governance

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1 STANFORD CLOSER LOOK SERIES Topics, Issues, and Controversies in Corporate Governance and Leadership Berkshire Hathaway: The Role of Trust in Governance By David F. Larcker and Brian Tayan May 28, 2010 management and Governance Structure Despite being one of the largest corporations in the world, Berkshire Hathaway receives relatively little public attention for its management and governance structure. 1 For the most part, the company is primarily thought of as the investment vehicle of Warren Buffett and his partner Charlie Munger. Few realize the size and diversity of its asset base which includes insurance (GEICO, General Re, Berkshire Hathaway), regulated gas and electric utilities (MidAmerican), railroads (Burlington Northern), manufactured housing (Clayton Homes), wholesale distribution (McLane), and many specialty finance, manufacturing, service, and retail companies and the manner in which the company is governed. Berkshire Hathaway is built on a model that involves extreme centralization of capital allocation decisions within corporate headquarters and extreme decentralization of operating decisions within individual business units. This is underscored by the distribution of the company s employee base: the corporate office employs 21 individuals, whereas the business units employ over 250,000. It is the lowest ratio of corporate overhead to investor capital among all major corporations (see Exhibit 1). The primary responsibility of headquarters is to allocate capital that the business units generate. For example, if See s Candies generates pre-tax operating cash flow of $70 million during the year, it transfers that amount (less any amount required for capital expenditures) to Omaha for reallocation. Decisions on how to reinvest free cash flow are made entirely by Buffett in some cases in consultation with Munger and are not vetted by any committees or analysts. By contrast, operating decisions are made entirely by the managers who oversee each unit. Whereas Buffett has complete discretion about how to reinvest capital at the corporate level, managers have complete discretion about all operating and capital allocation decisions within their businesses. They are not required to meet with Buffett, submit budgets for approval, or develop long-term operating plans. Instead, they make all decisions themselves, without supervision or corporate control. Munger describes the Berkshire Hathaway system as delegation just short of abdication. 2 The success of this model is predicated on two conditions: purchasing businesses that are unlikely to need significant attention and working with managers who are unlikely to need oversight. The businesses that Berkshire purchases are characterized by stable economics, high levels of free cash flow, and low requirements for incremental capital. 3 They have distinct and durable competitive advantages either in terms of production, distribution, or economic franchise. They are also built on a culture of honesty and integrity. As Munger explains, We try to buy companies so permeated by a good ethos that they don t need a lot of direction and checking from headquarters. 4 They are led by capable and honest management, often the same individuals who founded and still run the company. In most cases, Buffett insists that the seller retain a minority interest, so that they remain de facto owners working in partnership with Berkshire Hathway. Upon the close of an acquisition, managers are given simple instructions. They should treat the business as though they are its sole owner. They should give no consideration to the accounting stanford closer look series 1

2 implications of their decisions but focus entirely on enhancing competitive position and maximizing free cash flow. They should do nothing to tarnish the reputation of their company or Berkshire. Buffett believes that this hands-off approach is critical for a successful long-term working relationship: Our job is not so much to select great managers, because they have this proven record that they come with. Our job is to retain them. We are dependent on them. We can t run their businesses. So our job is to make sure that they have the same enthusiasm, excitement, and passion for their job after the stock certificate changes hands as they had before. 5 Managers are paid modest salaries but stand to receive very significant cash bonuses if performance goals are achieved. Buffett tailors the compensation plan to each business, based on its economics and competitive positioning. Managers are compensated for elements of the business that are directly under their control (such as growth and profitability of insurance contracts). Particular emphasis is placed on the ability to return free cash flow to headquarters. The company does not grant equitybased awards because their value cannot be as closely correlated to performance as can cash bonuses. 6 Still, cash bonuses can reach extreme levels tens of millions for superior performance. By contrast, Buffett and Munger receive modest compensation. Their salaries are set at $100,000. They receive no bonuses, options, or restricted grants. Instead, their economic incentive is driven by direct holdings of company stock which they purchased with their own money in the 1960s. As of year-end 2009, the value of those holdings were $40 billion and $1.3 billion, respectively. Similarly, board members receive negligible fees for their services and are encouraged to purchase substantial sums of company stock with their own money. Equity ownership is intended to align their interests with those of shareholders (see Exhibit 2). Corporate Controls and Oversight The internal controls and oversight mechanisms at Berkshire Hathaway are nominal in comparison to those employed by other corporations. No due diligence is performed before an acquisition is completed. In general, Buffett asks that the seller of a business to suggest a price. If he thinks it is reasonable, he will accept and the deal is closed. Furthermore, purchase decisions are not reviewed in advance by the board. Munger explains, Can you imagine Warren Buffett saying to somebody, Well, I m sorry, I have to go back and check with my directors? I mean, of course he has to go back to check with his directors, but he knows what they re going to say, and everybody knows that what he says is going to govern. 7 Buffett is also primarily responsible for enterprise risk management. Risk oversight is not delegated to a committee or risk management function. According to Buffett, I regard myself as the chief risk officer at Berkshire. 8 The company s primary tool to mitigate enterprise risk is the delegation of responsibility to managers with proven skill and integrity. Munger explains, A lot of people think if you just had more process and more compliance, you could create a better result in the world. Well, Berkshire has had practically no process. We had hardly any internal audit until they forced it on us. We just try to operate in a seamless web of deserved trust and be careful whom we trust. 9 Why This Matters 1. The Berkshire Hathaway model is predicated on responsibility and trust. How do the company s acquisition criteria, operating principles, and incentives work together to reinforce those values? 2. The theory of corporate governance is based on an assumption that self-interested managers will take actions that benefit themselves at the cost of shareholders (the agency problem ), and yet Berkshire Hathaway is built on the opposite assumption. How should companies take agency risk into account when designing their governance systems? 3. The operating principles of Berkshire Hathaway are in stark contrast to the best practices recommended by governance experts. What does this say about the reliability of those best practices? 1 For more on this topic, see also: David F. Larcker and Brian Tayan, stanford closer look series 2

3 The Management of Berkshire Hathaway, GSB Case No. CG-16, Jan. 01, Available at: 2 The DuBridge Distinguished Lecture Series, A Conversation with Charlie Munger, California Institute of Technology, Mar. 11, MidAmerican Energy and Burlington Northern are two notable exceptions to this last criterion. For a discussion of how they fit into the Berkshire model, see the Berkshire Hathaway Annual Report, 2009, Letter to Shareholders. Available at: 4 Wesco Financial, 2008 Annual Meeting, cited in: Outstanding Investor Digest, Vol. XXI, No. 4&5, Aug. 31, Edited lightly for clarity. 5 Berkshire Hathaway, 2008 Annual Meeting, cited in: Outstanding Investor Digest, Vol. XXI, No. 4&5, Aug. 31, In terms of value realized rather than expected value on the grant date. 7 Keynote speech by Charles T. Munger, Stanford University Director s College, held at Stanford Law School, Jun. 26, Hathaway, 2008 Annual Meeting, cited in: Outstanding Investor Digest, loc. cit. 9 Wesco Financial, 2007 Annual Meeting, cited in: Outstanding Investor Digest, Vol. XXI, No. 1&2, Feb. 29, Edited lightly for clarity. David Larcker is the Morgan Stanley Director of the Center for Leadership Development and Research at the Stanford Graduate School of Business and senior faculty member at the Rock Center for Corporate Governance at Stanford University. Brian Tayan is a researcher with Stanford s Center for Leadership Development and Research. They are coauthors of the books A Real Look at Real World Corporate Governance and Corporate Governance Matters. The authors would like to thank Michelle E. Gutman for research assistance in the preparation of these materials. The Stanford Closer Look Series is a collection of short case studies that explore topics, issues, and controversies in corporate governance and leadership. The Closer Look Series is published by the Center for Leadership Development and Research at the Stanford Graduate School of Business and the Rock Center for Corporate Governance at Stanford University. For more information, visit: Copyright 2012 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved. stanford closer look series 3

4 Exhibit 1 Berkshire Hathaway Operating Companies (2009) insurance businesses Company Employees Company Employees Berkshire Hathaway Homestate Cos. 591 General Re Corporation 2,513 Berkshire Hathaway Reinsurance Group 523 Kansas Bankers Surety Company 18 Boat America Corporation 379 Medical Protective Corporation 414 Central States Indemnity Co. 408 National Indemnity Primary Group 393 GEICO 23,549 United States Liability Insurance Group 546 Insurance total 29,334 non-insurance businesses Company Employees Company Employees Acme Building Brands 1,947 Kingston (1) 109 Adalet (1) 191 Kirby (1) 549 Altaquip (1) 329 Larson-Juhl 1,594 Applied Underwriters, Inc. 471 The Marmon Group 15,410 Ben Bridge Jeweler 744 McLane Company 15,441 Benjamin Moore 2,380 MidAmerican Energy Company (2) 3,567 Borsheim s Jewelry 168 MidAmerican Energy Holdings Co. (2) 25 Burlington Northern Santa Fe 35,000 MiTek, Inc. 1,723 The Buffalo News 730 Nebraska Furniture Mart 2,627 Business Wire 498 NetJets 7,226 CalEnergy (2) 360 Northern Natural Gas (2) 878 Campbell Hausfeld (1) 448 Northern and Yorkshire Electric (2) 2,455 Carefree of Colorado (1) 172 Northland 64 Clayton Homes, Inc. 12,133 PacifiCorp (2) 3,158 Cleveland Wood Products (1) 80 Pacific Power (2) 1,164 CORT Business Services 2,248 The Pampered Chef 791 CTB International 1,165 Precision Steel Warehouse 168 Dairy Queen 2,342 Richline Group 2,003 Douglas / Quikut (1) 56 Rocky Mountain Power (2) 2,125 Fechheimer Brothers 677 Russell Corporation 1,744 FlightSafety International 4,140 Other Scott Fetzer Companies (1) 137 Forest River, Inc. 5,355 See s Candies 3,000 France (1) 80 Shaw Industries 25,492 Fruit of the Loom 26,952 Stahl (1) 99 Garan 4,485 Star Furniture 740 H. H. Brown Shoe Group 1,162 TTI, Inc. 2,603 Halex (1) 96 United Consumer Finance Company (1) 197 Helzberg Diamond Shops 2,147 Vanity Fair Brands, Inc. 2,529 HomeServices of America (2) 2,415 Wayne Water Systems (1) 177 Iscar 9,583 Wesco Financial Corp. 13 Johns Manville 6,411 Western Enterprises (1) 254 Jordan s Furniture 812 R.C. Willey Home Furnishings 2,250 Justin Brands 793 World Book (1) 191 Kern River Gas Transmission Co. (2) 162 XTRA 523 Non-insurance total 227,758 Corporate office 21 Total Berkshire Hathaway 257,113 (1) A Scott Fetzer Company (2) A MidAmerican Energy Holdings Company stanford closer look series 4

5 Exhibit 2 Berkshire Hathaway: Compensation and Equity Ownership (2009) summary Compensation Named Executive Officers Year Annual Salary Annual Bonus All Other Compensation Total Compensation Warren E. Buffett, Chairman and CEO 2009 $ 100,000 - $ 75,000 $ 175,000 Charles T. Munger, Vice Chairman , ,000 Marc D. Hamburg, CFO ,500-12, ,750 Note: All other compensation includes the value of director fees received by Buffett for serving on the board of The Washington Post Company in which Berkshire Hathaway has a significant ownership position. Non-Executive Directors 2009 Non-Executive Directors 2009 Howard G. Buffett $ 3,000 Charlotte Guyman $ 7,000 Stephen B. Burke - Donald R. Keough 6,700 Susan L. Decker 3,000 Thomas S. Murphy 7,000 William H. Gates, III 2,700 Ronald L. Olson 3,000 David S. Gottesman 3,000 Walter Scott, Jr. 3,000 equity ownership Director Class A Class B Total Value Economic Interest Warren E. Buffett 350,000 75,013,134 39,667,367, % Howard G. Buffett 1, , ,970, % Stephen B. Burke 5-496,000 - Susan L. Decker - 6, ,000 - William H. Gates, III 4,350 77,313,900 5,534,194, % David S. Gottesman 19,044 2,604,439 2,060,867, % Charlotte Guyman ,959,000 - Donald R. Keough 70-9,943,000 - Charles T. Munger 13,057-1,295,124, % Thomas S. Murphy 1,310 11, ,705, % Ronald L. Olson ,000 29,160,000 - Walter Scott, Jr ,919,000 - Notes: Based on year-end closing prices: BRK.A: $99,190; BRK.B: $66. Shares beneficially owned by William H. Gates, III includes 77,313,900 Class B shares owned by the Bill & Melinda Gates Foundation Trust. Source: Berkshire Hathaway, form DEF 14A, filed with the Securities and Exchange Commission, Mar. 11, stanford closer look series 5