Berkshire Hathaway Vice Chairman Charlie Munger is well known as the partner of CEO Warren Buffett and also for his advocacy of “multi-disciplinary thinking”—the application of fundamental concepts from across various academic disciplines to solve complex real-world problems. One problem that Munger has addressed over the years is the optimal system of corporate governance. How should an organization be structured to encourage ethical behavior among organizational participants and motivate decision-making in the best interest of shareholders? His solution is unconventional by the standards of governance today and somewhat at odds with regulatory guidelines. However, the insights that Munger provides represent a contrast to current “best practices” and suggest the potential for alternative solutions to improve corporate performance and executive behavior.

Charlie Munger

Trust-Based Governance

The need for a governance system is based on the premise that individuals working in a firm are selfinterested and therefore willing to take actions to further their own interest at the expense of the organization’s interests. To discourage this tendency, companies implement a series of carrots (incentives) and sticks (controls). The incentives might be monetary, such as performance-based compensation that aligns the financial interest of executives with shareholders. Or they might be or cultural, such as organizational norms that encourage certain behaviors. The controls include policies and procedures to limit malfeasance and oversight mechanisms to review executive decisions. Most large corporations today have adopted governance systems that include extensive incentives and controls, including an independent board of directors to monitor management, an internal audit department, compliance and risk management, and elaborate executive compensation contracts. Charlie Munger, however, contends that it is unreasonable to expect such a system to work equally well in all settings:

“One solution fits all” is not the way to go. All these cultures are different. The right culture for the Mayo Clinic is different from the right culture at a Hollywood movie studio. You can’t run all these places with a cookie-cutter solution.1

He points out that many successful organizations, including Berkshire Hathaway, operate under a model that relies on fewer rather than more controls:

A lot of people think if you just had more process and more compliance—checks and doublechecks and so forth—you could create a better result in the world. Well, Berkshire has had practically no process. We had hardly any internal auditing until they forced it on us. We just try to operate in a seamless web of deserved trust and be careful whom we trust.2

To Munger, “The right culture, the highest and best culture, is a seamless web of deserved trust.”3 A trust-based system allows individuals to operate without extensive control procedures and therefore avoid the time and cost of having their own actions monitored and having to monitor the actions of others. As such, a trust-based system can be more efficient than a compliance-based system, but only if self-interested behavior among employees and executives is low. Munger explains: “Good character is very efficient. If you can trust people, your system can be way simpler. There’s enormous efficiency in good character and dis-efficiency in bad character.”4

Via: acquia.gsb.stanford.edu, by David F. Larcker and Brian Tayan, Stanford Graduate School of Business