Warren Buffett’s 10 Commandments for Company Directors
July 27, 2017 • STRATEGY & MANAGEMENT, SPECIAL FEATURES, Mergers & Acquisitions, Corporate Governance, Editor's choice, Leadership and Organisation
By Lawrence Cunningham
At a symposium I hosted two decades ago featuring Warren Buffett and his annual shareholder letters, the legendary investor joked that his service on 17 public company boards revealed a “dominant masochistic gene”. Warren has since served on several more boards, interacting with some 300 members during his illustrious half-century career. For directors seeking guidance, there are few more experienced mentors.
Warren has devoted parts of his letters to describing what the best directors do, collated in the corporate governance chapter of The Essays of Warren Buffett: Lessons for Corporate America, my authorised thematic arrangement of his writings. Offering a directors’ boot camp, a condensed version of these points follows. Living by Warren’s “ten commandments”, as I call them, has made him excel in the boardroom. They guide me as a director and, if you follow them, your service should be rewarding and effective.
1. Select an Outstanding CEO.The board’s most important job is recruiting, overseeing, and when necessary, replacing, the chief executive officer (CEO), Warren stresses. All other tasks are secondary to that one because, if the board secures an outstanding CEO, it will face few of the problems directors are otherwise called upon to address.
Among outstanding CEOs in Warren’s time are Thomas Murphy, who led Capital Cities Communications before and after it acquired ABC in 1985, and Robert Iger, a Murphy protegee who has been running The Walt Disney Company since 2005. Both are astute, ethical stewards, adept at allocating shareholder capital for both organic and acquisitive growth.
Other stalwarts span from Katharine Graham, who skillfully ran The Washington Post Co., through to Jeff Bezos, current owner of that company’s legacy newspaper and the founder and CEO of Amazon. Such outstanding CEOs all meet Warren’s practical bottom line test: they are people any director would like, trust, and admire, and be happy to have their child marry.
2. Set CEO Performance Standards. All CEOs must be measured according to a set of performance standards, Warren notes. A board’s outside directors must formulate these and regularly evaluate the CEO in light of them – without the CEO being present. Standards should be tailored to the particular business and corporate culture, but stress fundamental baselines such as returns on shareholder capital and steady progress in market value per share.
Performance should not be based solely on quarterly earnings and emphatically not in terms of whether the manager achieves guidance targets. In fact, Warren argues that companies are usually better off not providing analysts with earnings guidance. Directors might remind CEOs that such guidance is not required and may not serve shareholder interests.
3. Adopt an Owner Orientation.All directors should act as if there is a single absentee owner and do everything reasonably possible to advance that owner’s long-term interest, Warren advises. They need to think independently to tighten the wiggle room that “long-term” gives to CEOs – while corporate leaders should think in terms of years, not quarters, they must not rationalise sustained subpar performance by perpetual pleas to shareholder patience. To that end, it is desirable for directors to buy and hold sizeable personal stakes in companies they serve, so that they truly walk in the shoes of owners.
Warren embodies this commandment. He is a shareholder advocate par excellence, whose board service has almost always involved companies where Berkshire owns a significant stake. Prominent examples: Cap Cities/ABC (1986-96); The Coca-Cola Company (1989-2006); Gillette & Co. (1989-2003); The Kraft Heinz Company (2013-present); Salomon Inc (1987-97); US Airways Group (1993-95); and The Washington Post Co. (1974-86 & 1996-2011).
Warren’s board tenure is also long-term. In all but one of the foregoing instances where his board service ended, it did so only because the company ceased to exist: Cap Cities/ABC merged into Disney; Gillette into Procter & Gamble; Salomon into Travelers; and US Airways into America West; while The Post’s assets were divided up for sale.
The exception was Coca-Cola. In 2005, despite Berkshire long owning a substantial stake in the company – worth $8 billion then and $18 billion now – CalPERs as well as Institutional Shareholder Services (ISS) challenged Warren’s independence as a director. They cited business relationships between various Berkshire subsidiaries and Coca-Cola, including Dairy Queen Corporation, a customer. Warren objected, stressing how Berkshire’s large and lengthy stock ownership dwarfed the modest and routine business transactions of its subsidiaries.
In the ensuing board election, 16 percent of Coca-Cola’s shares were cast as withhold votes on Warren, so he was reelected, but nevertheless opted to stand down. While I disagreed with those doubting Warren’s independence, he responded to the shareholder ballot and set an example: any director receiving a non-trivial level of withhold votes should withdraw from the board.
4. Replace Managers Promptly When Needed. If the CEO’s performance persistently falls short of the standards set by the outside directors, then the board must replace the CEO. The same goes for all other senior managers they oversee, just as an intelligent owner would if present. In addition, the directors must be the stewards of owner capital to contain any managerial overreach that dips into shareholders’ pockets. Pick-pocketing may range from imperious acquisition sprees to managerial enrichment through interested transactions or even myopia amidst internal scandal and related crisis.
In addressing these problems, the director’s actions must be fair, swift, and decisive; in crisis response, the Berkshire mantra is “get it right, get it out, and get it over”. The classic case concerned Salomon’s 1991 bond trading imbroglio, four years after Berkshire acquired a block of preferred stock and Warren joined its board.
Amid knowledge of illegality, CEO John Gutfreund allowed problems to fester, refraining from firing the guilty and failing to inform the board or regulators. On becoming aware of the dire events, the board promptly requested Gutfreund’s resignation – and appointed a reluctant Warren Buffett to lead the investment bank out of its dark days and reshape its culture.
5. Speak Up to Colleagues. Directors who perceive a managerial or governance problem should alert other directors to the issue. If enough are persuaded, concerted action can be readily coordinated to resolve the problem. Aside from basics like whether the CEO is meeting performance standards or to curtail managerial excess, take the perennial topic of whether the roles of chairman and CEO should be separate or combined.
As stated in principles Warren endorsed last year with a dozen other boardroom denizens (called “common sense principles”), outside directors are best positioned to evaluate this question and then present it to the full board. Those with strong views, either way, need to make their case to fellow outside directors, based on general research and the company’s specific circumstances and culture. As I wrote in a 2015 Wall Street Journal opinion piece:
Research on the effects of splitting the chief and chairman roles shows that results can depend on where the split takes place. It tends to improve performance at struggling companies—but it impairs prosperous firms. Yet exact effects vary depending on the circumstances, such as whether the switch happened with the appointment of a new CEO or with the demotion of an incumbent.
Those with strong views, either way, need to make their case to fellow outside directors, based on general research and the company’s specific circumstances and culture.
The movement to split the two roles is part of corporate America’s tendency to enact specific procedures to address perceived problems, like expanding board size, adding independent directors, adopting a new code of ethics, updating firm compliance programs, and appointing a monitor to oversee it all. While such steps can improve an organisation’s health, the informal norms that define a corporate culture are more powerful.
Warren believes that the argument should then go further, for companies opting to combine the roles. Those boards should appoint a strong lead independent director who is vested with considerable, and clear, authority and responsibility. Requirements for such a person are capacity to listen to colleagues’ concerns, take their case to other outside directors to build consensus, and constructively challenge management.
6. Reach Out to Shareholders. When a director remains in the minority, and the problem is sufficiently grave, reaching out to absentee owners is warranted, Warren believes. Colleagues may resist or complain, which imposes a useful restraint against going public for trivial or non-rational causes. But consistent with confidentiality and other fiduciary duties, informing shareholders is sometimes appropriate, Warren says.
In 1996, when Warren served on the board of Gillette – of which Berkshire owned 11 percent – Gillette agreed to acquire KKR’s share of Duracell International for $7.82 billion in stock. For its related services in the transaction, KKR’s bill was double that of Gillette’s advisors (though in line with market pricing), and Warren strongly protested the fee. While outvoted by the rest of the board, Warren made a public record of his disagreement for fellow shareholders to see.
As stated in the “common sense principles” endorsed last year, companies should make their officers and directors available to their largest long-term investors. These representatives should discuss issues put to shareholder votes that affect enduring value. In fact, companies should seek reciprocal access, getting their managers and directors out to receive the shareholder perspective.
7. Adjust the Atmosphere.Even high-quality directors can fail because of what Warren calls “boardroom atmosphere”. Populated by the well-mannered, boards see broaching certain topics as akin to belching at dinner – from questioning the wisdom of an acquisition to CEO succession. Adjust the social atmosphere of the room, Warren urges. How to do so depends on the corporate culture and personalities involved. Aside from formal meetings, boards can convene for meals, training sessions and retreats, all offering the chance for diplomatic engagement.
Here too shareholders can play a role. A few large institutions, acting together, can effectively reform a given company’s corporate governance simply by withholding their votes for directors who were tolerating odious behaviour, Warren observes. In some cases, he laments, “this kind of concerted action is the only way that corporate stewardship can be meaningfully improved”.
Any director receiving a significant level of withhold votes should instantly resign. By the same token, any director unable to persuade enough fellow directors or shareholders that vital change is needed ultimately has one vital lever: threaten to resign.
8. Compensation Committees: Negotiate.Warren admonishes boards as to compensation committees: “Directors should not serve on compensation committees unless they are themselves capable of negotiating on behalf of owners.” In other words, this task should not be delegated to consultants, though it too often is.
At this year’s annual meeting of Berkshire shareholders, he warned: “If the board hires a compensation consultant after I’m gone, I will come back.” He quips that CEOs who otherwise welcome him on a board do not want him on the compensation committee.
In the negotiations, the directors must make one point non-negotiable: all forms of compensation, especially equity based, must be treated as an expense for accounting purposes. No CEO can have his cake and eat it too.
Companies boasting such directors gain an advantage; if those directors then follow Warren’s ten commandments, the shareholders are doubly blessed.
9. Audit Committees: Pry. The audit committee occupies a central role in today’s financial reporting ecosystem, yet directors cannot conduct the audit and sometimes feel overwhelmed. Warren’s advice is to focus on what is possible, which is simply getting the auditors to candidly divulge what they know.
Warren prescribes getting answers to these four issues: (a) if the auditor were solely responsible for the financials, would the audit have been done differently; (b) if the auditor were an investor, would the audit have produced all relevant information to understand the company’s performance; (c) if the auditor were the CEO, would internal audit procedure differ; and (d) is the auditor aware of any actions involving shifting revenues or expenses between periods.
10. Choose Well. Finally, what qualities should be sought in directors when boards undertake their own succession planning? The answer: people capable of honouring these commandments, meaning those who are skilled managerial recruiters and overseers given the company’s particular business and culture, owner-oriented, engaged, articulate, communicative, and astute. Basic habits, such as diligence, preparation, and attendance, are also essential.
Warren adds these qualifications that make for high-quality directors: business savvy, a strong interest in the specific company, and an owner-orientation. Companies boasting such directors gain an advantage; if those directors then follow Warren’s ten commandments, the shareholders are doubly blessed.
Featured Image: Warren Buffett © AP Images
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About the Author
Lawrence A. Cunningham, a Professor of Corporate Governance at George Washington University, is a Director of Constellation Software, a Past Director of Ashford Prime, and an Adviser to numerous other Boards of Directors. A prolific author, recent books include “Quality Investing” and “Berkshire Beyond Buffett”. This article is copyright by Prof. Cunningham.
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