Buffett's sage words on CEO pay, independent directors

26 March 2004

The acid test of whether corporate America is serious about reforming itself is CEO pay, says the multibillionaire investment guru Warren Buffett.

In this year's letter to shareholders in the company he controls, Berkshire Hathaway, the man known affectionately as the 'Sage of Omaha' says: "To date the results are not encouraging. A few CEOs, such as Jeff Immelt of General Electric, have led the way in initiating programs that are fair to managers and shareholders alike. Generally, however, his example has been more admired than followed".

Buffett's letter makes good reading for those boards that are struggling with the CEO pay conundrum as one of the most difficult in corporate governance.

He dismisses the defence offered by some CEO's that they are just the innocent beneficiaries of market forces beyond their control, exposing this as a 'self-serving lie'.

"It's understandable how pay got out of hand. When management hires employees, or when companies bargain with a vendor, the intensity of interest is equal on both sides of the table", says Buffett.

"One party's gain is another party's loss, and the money involved has real meaning to both. The result is an honest-to-God negotiation

"But when CEOs (or their representatives) have met with compensation committees, too often one side - the CEOs -has cared far more about what bargain is struck. A CEO, for example, will always regard the difference between receiving options for 100,000 shares or for 500,000 as monumental.

"To a compensation committee, however, the difference may seem unimportant - particularly if, as has been the case at most companies, neither grant will have any effect on reported earnings. Under these conditions, the negotiations often have a 'play-money' quality".

Buffett noted that overreaching by CEOs greatly accelerated in the 1990s. "The couriers for this epidemic of greed were usually consultants and human relations departments, which had no trouble perceiving who buttered their bread."

Proposals for reforming this malfunctioning system have focused on getting more 'independent' directors, but Buffett says what truly motivates independence has largely been neglected.

Buffetts' study of the performance of independent directors of American mutual funds is not encouraging. "Year after year, at literally thousands of funds (independent) directors had routinely rehired the incumbent management company, however pathetic its performance had been. Just as routinely the directors had mindlessly approved fees that in many cases far exceeded those that could have been negotiated", he says.

Buffett urges that in addition of being independent, directors should have business savvy, a shareholder orientation, and a genuine interest in the company.

"Many people who are smart, articulate and admired have no real understanding of business. That's no sin; they may shine elsewhere. But they don't belong on corporate boards".