Berkshire Hathaway 2009 Annual Meeting Audience Question # 42

How to develop a fair and intelligent compensation package for a manager of a subsidiary that requires a lot of capital

Warren Buffett:

Area 9, please.

Audience Member:

I’m Vishali from the Philippines. My question is about compensation in a capital-intensive subsidiary.

Now, I am going to take the liberty to assume that the large number of bank failures were caused, in large part, by incentive bias.

If a board of directors makes a mistake with compensation, then the board introduces incentive bias towards earnings manipulation.

So bearing in mind rule number one, which is, “don’t lose money,” and bearing in mind that it’s OK to have losses in the short term if the moat is widened, then how do you develop a fair and intelligent compensation package for a manager of a subsidiary that requires a lot of capital?

Warren Buffett:

Well, you obviously… it’s a very, very good question. It’s one that Charlie and I have both thought about. And we’ve been around so many crazy compensation systems that we’ve spent a lot of time thinking about it and talking about it.

In a capital-intensive business, you have to have something that… you have to have a factor in the compensation arrangement that includes a capital cost element.

We have dozens and dozens of subsidiaries. And we have different arrangements for different businesses.

Because… as you point out…an arrangement for a business that needs no capital, like a See’s Candy or a Business Wire or something of that sort, has to be materially different than something that requires a lot of capital.

We think we’ve got rational compensation systems. We agree with you that incentives are very important.

I would say that I think your question implied, a little bit, that the board sets these things. The truth of the matter is, at least over 40 years of experience and 19 boards that I’ve been on and observing behavior a lot of other places… basically, the board has had relatively little effect on it.

The CEO has managed, in most cases… in a great many cases… to be an important determinant of his own… or her own, usually his… own compensation arrangement. They, you know, they… the human relations… first of all, they pick the comp committee, you know.

So I have been on one comp committee out of 19 boards. I mean, people are not looking for Dobermans. They’re looking for Cocker Spaniels. And then… and they’re looking for Cocker Spaniels that are waving… wagging their table… tails, very friendly.

You know, you… CEOs spend a lot of time thinking about who’s on their comp committee. The audit committee is less important.

But the comp committee, they think about plenty.

And the comp committee meets every few months. And a human relations vice president comes in, who is responsible, directly, to the CEO and probably recommends a compensation consultant. And believe me, they don’t go around looking for the ones that are going to upset the apple cart.

So it’s been a system that the CEO has dominated.

And in my experience, boards have done very little in the way of really thinking through, as an owner or as owners’ representatives, what the hell is the proper way to pay these people and how to incent them, not only to do the right thing, but also to incentivize them not to do the wrong thing.

Charlie and I are fairly familiar with a company here in town, the Peter Kiewit Organization. And Pete Kiewit, I don’t know, 50 years ago or more, you know, figured out a very, very logical way to pay people in this business.

And it wasn’t rocket science. And I’ll guarantee he didn’t consult with any compensation consultant on the subject. He just figured it out.

And you would be able to figure out one. I can figure out one. But you have to understand that not every CEO wants a rational compensation system, you know? Who wants rationality, when irrationality pays off more?

So it’s a real problem getting people at the board level… I think the… I don’t think there should be a comp committee. I think the board as a whole actually should thrash this sort of thing out.

So that you don’t get some report from the comp committee, and that’s treated as holy writ, because they’ve debated for a couple of hours the day before, supposedly, and then come in and give some recommendation, everybody rubber stamps it.

I think it ought to be a subject of general discussion. I think it’s very important how you compensate the CEO.

I’ve said, in our annual reports, choosing the right CEO, making sure they don’t overreach, and exercising independent judgement on major acquisitions or divestitures, if the board does that right, you can forget about all this other check the list… checklist stuff.

And if they don’t get that right, the other doesn’t make much difference.

So I would say that it can be done. It’s very difficult to have a system where somebody… where the board, thinking as owners or representing owners, care as much about it as the guy on the other side who’s getting compensated.

I do think it’s gotten better in recent years. But it started from a very low base.

Charlie?

Charlie Munger:

Yeah, there are some counterintuitive conclusions in the field that are quite interesting.

I would argue that a liberally paid board of directors in a big American public corporation is… the liberal pay is counterproductive to good management of the company.

There’s a sort of a reciprocation. You know, “You keep raising me, and I keep raising you.” And it gets very club-like. And I think, by and large, the corporations of America would be managed better if the directors weren’t paid at all.

Warren Buffett:

We’re working toward that.

Well, it is interesting. Because the SEC would define independent directors, you know, as… they would question, you know, my independence, if we would own billions and billions of dollars’ worth of some security, but we would sell them some ice cream at Dairy Queen or something of the sort.

And the… to get real owners’ representatives is very… and knowledgeable, because they’ve got to know business. They have to really have some business savvy.

And the truth is, if you get somebody that’s getting $200,000 a year, $250,000 a year, for being director of a company, and they don’t have that much income outside or net worth, and they would just love to get one more directorship for another $200,000, they are very unlikely to sit there and argue with the CEO and say that the system is rigged in favor of incentive compensation or something of the sort.

There is more baloney in the compensation arrangements…

And now, you have these 100-page proxy statements. If you take 100 pages to explain how you’re paying the people of the place, something is wrong. I mean, you don’t need 100… we don’t have 100-page, you know, understandings or anything of the sort.

But it’s gotten to be more and more of a game as it’s gone along.

And I would say that, as Charlie… that when compensation is a very important part of a director’s wellbeing, you do not have an independent director.

And the funny thing is, the way it’s… the system has been arranged, those are the very people that tend to be regarded as the independent directors, in most cases.

Charlie Munger:

It’s way worse than practically anybody recognizes. Elihu Root, who was the ultimate good Cabinet officer in the United States, used to have a saying that no man was fit to hold public office who wasn’t perfectly willing to leave it at any time.

And of course, the minute he left public office, he went right back to being the leading lawyer of the world. So he didn’t have much to lose by…

But the man who has a lot to lose from his office is going to be very loath to be an independent director.

So the way we do it, at Berkshire Hathaway, is one-tenth of 1 percent of America. And the way everybody else does it is silly.

Warren Buffett:

I love being up here with him.

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