Two investors I admire, Bill Ackman (Trades, Portfolio) and Whitney Tilson (Trades, Portfolio), have recommended that to learn about investing, investors should read Berkshire Hathaway Inc.'s (BRK.A, Financial) (BRK.B, Financial) annual letters to shareholders. This series focuses on the main points Warren Buffett (Trades, Portfolio) makes in these letters and my analysis of the lessons learned from them. In this discussion, I cover the 2002 letter.
Corporate governance
Buffett, in his 2002 shareholder letter, discussed corporate governance and emphasized the need for effective stewardship and the responsible behavior of directors. He criticized the practice of manipulating financial figures and rewarding executives with exorbitant pay for subpar performance. The guru asserts that corporate boards should have prevented such misconduct. This commentary follows the Enron and WorldCom scandals, which led to the introduction of the Sarbanes–Oxley Act, signed into law by President George W. Bush on July 30, 2002.
According to Buffett, directors should act as if they represent a single absentee owner and work in the long-term interest of shareholders. This requires them to remove underperforming managers, regardless of personal likability. However, overreaching by managers has become increasingly common, and directors have failed to take appropriate action.
Buffett suggested that the failure of intelligent and well-intentioned directors can be attributed to the "boardroom atmosphere." He noted that social dynamics make it challenging to question CEOs, especially in the presence of their staff and advisors. To address this issue, he recommended that outside directors regularly meet without the CEO.
While there is a demand for independent directors, Buffett emphasizes the importance of three essential qualities: independence of thought and speech, business savvy and a shareholder-oriented mindset. He reflects on his own interactions with directors and concludes the majority lacked at least one of these qualities, resulting in minimal or even negative contributions to shareholder well-being.
Buffett also criticized the performance of directors in investment companies, including mutual funds, who have failed to negotiate reasonable management fees. He suggested reading John Bogle's book, "Common Sense on Mutual Funds," to gain insight into this issue.
To address the problem of mediocre CEOs and excessive compensation, Buffett said he believes that action by large institutional owners is necessary. He highlighted the concentration of stock ownership among institutions and suggested that a small number of influential institutions could effectively reform corporate governance by withholding votes for directors who tolerate objectionable behavior.
Buffett considers CEO compensation as the acid test for reform. He criticized compensation committees for often blindly following recommendations from consultants, who may not prioritize the interests of shareholders. Directors serving on compensation committees should be capable of negotiating on behalf of owners and should transparently explain their thinking on pay and performance measurements.
The Oracle of Omaha argued that CEOs have sometimes been rewarded greatly while shareholders suffer financial losses. He called for an end to such practices and warned against using the bloated pay of recent years as a benchmark for future compensation. Compensation committees should go back to the drawing board to ensure fair and reasonable pay structures.
The audit committee
In the section on the role of the audit committee, the legendary investor highlighted the limitations of such committees and the need for auditors to take responsibility for uncovering potential earnings deceptions. He expressed concern about managers who manipulate financial numbers using legal but misleading techniques, with auditors often aware of these practices but choosing to remain silent. Buffett said he believes the primary task of the audit committee is to ensure that auditors disclose what they know.
To break the cozy relationship between auditors and management, Buffett suggested that committees should make auditors more concerned about misleading committee members than about offending management. He proposed holding auditors accountable by imposing significant monetary penalties if they fail to disclose what they know or suspect.
To achieve this objective, Buffett recommended that audit committees ask four specific questions of auditors and record and report their responses to shareholders:
If the auditor were solely responsible for preparation of the company’s financial statements, would they have in any way been prepared differently from the manner selected by management? This question should cover both material and nonmaterial differences. If the auditor would have done something differently, both management’s argument and the auditor’s response should be disclosed. The audit committee should then evaluate the facts.
If the auditor were an investor, would he have received – in plain English – the information essential to his understanding the company’s financial performance during the reporting period?
Is the company following the same internal audit procedure that would be followed if the auditor himself were CEO? If not, what are the differences and why?
Is the auditor aware of any actions – either accounting or operational – that have had the purpose and effect of moving revenues or expenses from one reporting period to another?
The questions aim to evaluate the integrity of the company's financial reporting process and the auditors' awareness of any misleading actions. The committee should carefully assess the facts and engage in a thorough evaluation.
Buffett emphasized the importance of providing auditors with sufficient time to conduct a rigorous examination. He warned against haste, which can compromise accuracy, especially when auditors and the committee interact close to an upcoming earnings release. When auditors know the committee will actively endorse management's actions rather than simply accepting them, they will be more likely to resist potential misdoings early in the process, preventing questionable figures from becoming embedded in the company's books.
In summary, Buffett emphasized the need for audit committees to challenge auditors and hold them accountable for uncovering potential earnings deceptions. By asking specific questions and ensuring auditors endorse management's actions, audit committees can create an environment of transparency and discourage misleading practices.
