Warren Buffett's Rules For Corporate Governance

Warren Buffett focuses on buying companies "any idiot could run, because sooner or later one will." What company has the type of structure in place to survive and possibly thrive during such a period? A company with strong corporate governance. 

If we are searching for a company with strong corporate governance we must agree on what problems lead to weak corporate governance. In The Essays of Warren Buffett, editor Lawrence A. Cunningham lays out Buffett's main frustrations as: 

1. Communication - managers' inability to "tell it like it is" and tell it in simple language.
2. Chain of Command - collaboration of able, hard-working and honest workers is all that is necessary for projects, chain of command impedes the process.

CEO's reliability - finding a CEO of high integrity is of the utmost importance. This is because a) standards for measuring a CEO's performance are inadequate and easily manipulated. b) No one is senior to the CEO and therefore cannot have their performance measured. c) The board of directors has similar interests as the CEO and cannot provide an unbiased assessment, hence they cannot serve a senior to the CEO. 

Now that we have identified the problems leading to weak corporate governance, we need a plan for prevention.  Again, before we can have a plan that works, we need to look at what won't work according to Buffett.  

1. Stock Options for management -  Many companies provide their management with rewards of stock options for increasing earnings rather than superior deployment of capital. However, by simply reinvesting earnings managers can report annual earnings increases and can receive rewards for doing nothing to improve real returns. Stock options lead to executives manipulating the system for their benefit at the expense of the shareholders. If stock options must be given, they should be awarded based on the return of capital investments after taking out interest for the use of that capital. 
2. Separating the identities and functions of the Chairman of the Board and the CEO - Separation does not lead to better oversight as the interests of the two are still aligned. This simply creates conflict of chain of command. 
3. Standing Audit, Nominating and Compensation committees - Decisions are too arbitrary if not based on performance of real capital returns.
4. Independent directors - Selecting directors for diversity and independence does not compare to directors who have the owner-orientation. 
   
   

Having examined the failed concepts of corporate governance, Buffett builds his ideal list of the structure in place for companies he looks to acquire. 

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1. CEOs who are reliable and perform well with weak constraints - CEO's who take an owner-orientation , see themselves as the sole-proprietor of the business, view their business as the only asset they hold, are "all-in" on the company and do not need direction from the owners, but can take advice from a well put together board. Buffet prefers his CEOs to imagine they cannot sell or merge their company for 100 years to take a long term view.
2. Board of Directors who have business savvy, keen interest and owner-orientation - By being well educated and "all-in" such as the CEO, the directors can best provide support and advice to the CEO. The best case scenario is a well put together board and an owner who does not manage the company. This allows the directors to take matters to the owner when issues arise with the manager. The opposite of this is when the owner is the manager, therefore the directors have little influence and can only threaten to quit to get their way. Management issues are most prevalent though in companies without a major shareholder (most companies), where directors struggle to provide discipline to managers and once again can only threaten to quit.  To remedy this, Buffett suggests having a small board of outside directors and to evaluate the C-level executives without the executives in the room. Holding regular meetings without the chief executive to review his/her performance is the leads to a large improvement in corporate governance.
3. CEO performance pay - Stock options should not be allowed. CEOs should be paid based on the profitability of capital investments after taking out the interest for using the capital. The award should be a cash bonus which can be used to purchase common stock of the company. This builds owner-orientation by allowing the CEO to "truly walk in the shoes of the owner".  

By having a CEO who sees the company as his or her own and focuses on the long term horizon , as well as directors who are business savvy and have high interest in the company, Buffett believes corporate governance issues will be minimized.