Berkshire Hathaway 2017 Annual Meeting Audience Question # 1

How Berkshire ensures its many managers will behave in the right way

Carol Loomis:

Now, my first question. It’s about Wells Fargo, which is Berkshire’s largest equity holding… 28 billion at the end of the year. And this question comes from a shareholder who did not wish to be identified.

“In the wake of the sales practices scandal that last year engulfed Wells Fargo, the company’s independent directors commissioned an investigation and hired a large law firm to assist in carrying it out.”

“The findings of the investigation, which were harsh, have been released in what is called the Wells Fargo Sales Practices Reports.” You can find it on the internet.”

“It concludes that a major part of the company’s problem was that, and I quote, ‘Wells Fargo’s decentralized corporate structure gave too much autonomy to the community banks’ senior leadership,′ end of quote.”

“Mr. Buffett, how do you satisfy yourself that Berkshire isn’t subject to the same risk, with its highly decentralized structure and the very substantial autonomy given to senior leadership of the operating companies?”

Warren Buffett:

Yeah, it’s true that we at Berkshire probably operate on as… we certainly operate on a more decentralized plan than any company of remotely our size.

And we count very heavily on principles of behavior rather than loads of rules.

It’s one reason at every annual meeting you see that Salomon description. And it’s why I write very few communiqués to our managers, but I send them one once every two years and it basically says that we’ve got all the money we need. We’d like to have more, but we’re… it’s not a necessity.

But we don’t have one ounce of reputation more than we need, and that our reputation at Berkshire is in their hands.

And Charlie and I believe that if you establish the right sort of culture, and that culture, to some extent, self-selects who you obtain as directors and as managers, that you will get better results that way in terms of behavior than if you have a thousand-page guidebook.

You’re going to have problems regardless. We have 367,000, I believe, employees. Now, if you have a town with 367,000 households, which is about what the Omaha metropolitan area is, people are doing something wrong as we talk here today. There’s no question about it.

And the real question is whether the managers at… are in a better… are worrying and thinking about finding and correcting any bad behavior, and whether, if they fail in that, whether the message gets to Omaha, and whether we do something about it.

At Wells Fargo, you know, there were three very significant mistakes, but there was one that dwarfs all of the others.

You’re going to have incentive systems at any business… almost any business. There’s nothing wrong with incentive systems, but you’ve got to be very careful what you incentivize. And you can’t incentivize bad behavior. And if so, you better have a system for recognizing it.

Clearly, at Wells Fargo, there was an incentive system built around the idea of cross-selling and number of services per customer. And the company, in every quarterly investor presentation, highlighted how many services per customer. So, it was the focus of the organization… a major focus.

And undoubtedly, people got paid and graded and promoted based on that number… at least partly based on that number.

Well, it turned out that that was incentivizing the wrong kind of behavior.

We’ve made similar mistakes. I mean any company’s going to make some mistakes in designing a system.

But it’s a mistake. And you’re going to find out about it at some point. And I’ll get to how we find out about it.

But the biggest mistake was that… and I don’t know… obviously don’t know all the facts as to how the information got passed up the line at Wells Fargo.

But at some point, if there’s a major problem, the CEO will get wind of it. And that is… at that moment, that’s the key to everything, because the CEO has to act.

That Salomon situation that you saw happened because of… on April, I think, 28th, the CEO of Salomon, the president of Salomon, the general counsel of Salomon, sat in a room and they had described to them, by a fellow named John Meriwether, some bad practice, terrible practice, that was being conducted by a fellow named Paul Mozer, who worked for them.

And Paul Mozer was flimflamming the United States Treasury, which is a very dumb thing to do.

And he was doing it partly out of spite, because he didn’t like the Treasury and they didn’t like him. So he put in phony bids for U.S. Treasurys and all of that.

So on April 28th, roughly, the CEO and all these people knew that they had something that had gone very wrong, and they had to report it to the Federal Reserve Board in New York… the Federal Reserve Bank of New York.

And the CEO, John Gutfreund, said he would do it, and then he didn’t do it. And he undoubtedly put it off just because it was an unpleasant thing to do.

And then on May 15th, another Treasury auction was held, and Paul Mozer put in a bunch of phony bids again.

And at this point, it’s all over, because the top management had known ahead of time, and now a guy that was a pyromaniac had gone out and lit another fire. And he lit it after they’d been warned that he was a pyromaniac, essentially.

And it all went downhill from there. It had to stop when the CEO learns about it.

And then they made a third mistake, actually, but again, it pales in comparison to the second mistake.

They made a third mistake when they totally underestimated the impact of what they had done once it became uncovered, because they… there was a penalty of 185 million. And in the banking business, people get fined billions and billions of dollars for mortgage practices and all kinds of things.

The total fines against the big banks, I don’t know whether the total’s 30 or 40 or a billion or whatever the number may be.

So, they measured the seriousness of the problem by the dimensions of the fine. And they thought $185 million fine signaled a less offensive practice than something involved 2 billion, and they were totally wrong on that.

But the main problem was they didn’t act when they learned about it. It was bad enough having a bad system, but they didn’t act.

At Berkshire, we have… the main source of information for me about anything that’s being done wrong at a subsidiary is the hotline. Now, we got 4,000 or so hotline reports… or that come… we get communications on the hotline… perhaps 4,000 times a year.

And most of them are frivolous. You know, the guy next to me has bad breath or something like that. I mean it’s… … but there are a few serious ones, and the head of our internal audit, Becki Amick, looks at all those. People… a lot of them come in anonymous, probably most of them.

And some of them, she refers back to the companies, probably most of them. And… but anything that looks serious, you know, I will hear about, and that has led to action… well, put it, more than once.

And we’ve spent real money investigating some of those. We put special investigators, sometimes, on them. And, like I say, it has uncovered certain practices that we would not at all condone at the parent company.

I think it’s a good system. I don’t think it’s perfect. I don’t know what… I’m sure they’ve got an internal audit at Wells Fargo, and I’m sure they’ve got a hotline.

And I don’t know the facts, but I would just have to bet that a lot of communications came in on that, and I don’t know what their system was for getting them to the right person. And I don’t know who did what at any given time.

But that was… it was a huge, huge, huge error if they were getting… and I’m sure they were
…getting some communications and they ignored them, or they just sent them back down to somebody down below.

Charlie? You’ve followed it. What are your thoughts on it?

Charlie Munger:

Well, put me down as skeptical when some law firm thinks they know how to fix something like this.

If you’re in a business where you have a whole a lot of people under incentives very likely to cause a lot of misbehavior, of course you need a big compliance department.

Every big wirehouse stock brokerage firm has a huge compliance department. And if we had one, we would have a big compliance department too, wouldn’t we, Warren?

Warren Buffett:

Absolutely.

Charlie Munger:

Absolutely, but doesn’t mean that everybody should try and solve their problems with more and more compliance.

I think we’ve had less trouble over the years by being more careful in whom we pick to have power and having a culture of trust. I think we have less trouble, not more.

Warren Buffett:

But we will have trouble from time to time.

Charlie Munger:

Yes, of course. We’ll be blindsided someday.

Warren Buffett:

Charlie says an ounce of prevention… he said when Ben Franklin, who he worships, said, “An ounce of prevention is worth a pound of cure,” he understated it. An ounce of prevention is worth more than a pound of cure.

And I would say a pound of cure, promptly applied, is worth a ton of cure that’s delayed. It… problems don’t go away.

John Gutfreund said that problem, originally, was… he called it a traffic ticket. He told the troops there at Salomon it was a traffic ticket. You know, and it almost brought down a business.

Some other CEO, that they described the problem that he’d encountered as a foot fault. You know, and it resulted in incredible damage to the institution.

And so you’ve got to act promptly. And frankly, I don’t know any better system than hotlines and anonymous letters to me. I get anonymous letters. And I’ve gotten three or four of them probably in the last six or seven years that have resulted in major changes.

And very, very occasionally they’re signed. Almost always they’re anonymous, but it wouldn’t make any difference, because there were… will be no retribution against anybody, obviously, if they call our attention to something that’s going wrong.

But I will tell you, as we sit here, somebody is doing… quite a few people… are probably doing something wrong at Berkshire, and usually, it’s very limited. I mean maybe stealing small amounts of money or something like that.

But when it gets to some sales practice like was taking place at Wells Fargo, you can see the kind of damage it would do.

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