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 basewhich 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 companiesand 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 companys 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 Sees 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 Buffettin some cases in consultation with Mungerand 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 advantageseither 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 dont 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
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Berkshire Hathaway: The Role of Trust in Governance

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 cant 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 levelstens 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

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, Im 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 theyre 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 companys 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

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

1. The Berkshire Hathaway model is predicated on responsibility and trust. How do the companys 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,

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Berkshire Hathaway: The Role of Trust in Governance

The Management of Berkshire Hathaway, GSB Case No. CG-16, Jan. 01, 2009. Available at: https://gsbapps.stanford.edu/cases/. 2 The DuBridge Distinguished Lecture Series, A Conversation with Charlie Munger, California Institute of Technology, Mar. 11, 2008. 3 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: http://www.berkshirehathaway.com/reports.html. 4 Wesco Financial, 2008 Annual Meeting, cited in: Outstanding Investor Digest, Vol. XXI, No. 4&5, Aug. 31, 2008. Edited lightly for clarity. 5 Berkshire Hathaway, 2008 Annual Meeting, cited in: Outstanding Investor Digest, Vol. XXI, No. 4&5, Aug. 31, 2008. 6 In terms of value realized rather than expected value on the grant date. 7 Keynote speech by Charles T. Munger, Stanford University Directors College, held at Stanford Law School, Jun. 26, 2006. 8 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, 2008. 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 Stanfords 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: http://www.gsb.stanford.edu/cldr. Copyright 2012 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved.

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Berkshire Hathaway: The Role of Trust in Governance

Exhibit 1 Berkshire Hathaway Operating Companies (2009) insurance businesses

Company Berkshire Hathaway Homestate Cos. Berkshire Hathaway Reinsurance Group Boat America Corporation Central States Indemnity Co. GEICO Employees 591 523 379 408 23,549 Company General Re Corporation Kansas Bankers Surety Company Medical Protective Corporation National Indemnity Primary Group United States Liability Insurance Group Insurance total Employees 2,513 18 414 393 546 29,334

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

(1) (2)

A Scott Fetzer Company A MidAmerican Energy Holdings Company

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Berkshire Hathaway: The Role of Trust in Governance

Exhibit 2 Berkshire Hathaway: Compensation and Equity Ownership (2009) summary Compensation
Named Executive Officers Warren E. Buffett, Chairman and CEO Charles T. Munger, Vice Chairman Marc D. Hamburg, CFO Year 2009 2009 2009 Annual Salary $ 100,000 100,000 862,500 Annual Bonus All Other Compensation $ 75,000 12,250 Total Compensation $ 175,000 100,000 874,750

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 Howard G. Buffett Stephen B. Burke Susan L. Decker William H. Gates, III David S. Gottesman 2009 $ 3,000 3,000 2,700 3,000 Non-Executive Directors Charlotte Guyman Donald R. Keough Thomas S. Murphy Ronald L. Olson Walter Scott, Jr. 2009 $ 7,000 6,700 7,000 3,000 3,000

equity ownership
Director Warren E. Buffett Howard G. Buffett Stephen B. Burke Susan L. Decker William H. Gates, III David S. Gottesman Charlotte Guyman Donald R. Keough Charles T. Munger Thomas S. Murphy Ronald L. Olson Walter Scott, Jr. Class A 350,000 1,406 5 4,350 19,044 100 70 13,057 1,310 284 100 Class B 75,013,134 841,050 6,250 77,313,900 2,604,439 600 11,600 15,000 Total Value 39,667,367,000 194,970,000 496,000 413,000 5,534,194,000 2,060,867,000 9,959,000 9,943,000 1,295,124,000 130,705,000 29,160,000 9,919,000 Economic Interest 24.3 % 0.1 % 3.4 % 1.3 % 0.8 % 0.1 % -

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, 2010.

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