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Lessons from Warren Buffett - XLIX

Aug 6, 2008

Last week, we learnt how independent directors at a lot of investment partnerships have put up disastrous performance through Buffett's 2002 letter to shareholders. Let us further go down the same letter and see what other investment wisdom he has on offer. Of practicing and preaching
Ok, we have heard a lot about the failings of independent directors and their apathy towards shareholders. However, preaching is one thing and practicing and offering a solution is completely another. Since Warren Buffett himself runs a company, it will be fascinating to understand the guidelines he has set forth for choosing independent directors on his company's board as well as the compensation he pays them. He has the following views to offer on the kind of 'independent' directors he would like to have on his company's board:

Buffett says, "We will select directors who have huge and true ownership interests (that is, stock that they or their family have purchased, not been given by Berkshire or received via options), expecting those interests to influence their actions to a degree that dwarfs other considerations such as prestige and board fees."

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Interesting, isn't it? If a person derives most of his livelihood from a firm and if he is made a director of the firm, he is quite likely to take decisions that result in maximum value creation. While this approach may not be completely foolproof, it is indeed lot better than approaches at other firms where such a criteria is not set forth while looking for independent directors.

Furthermore, on the compensation issue, Buffett has the following to say:

"At Berkshire, wanting our fees to be meaningless to our directors, we pay them only a pittance. Additionally, not wanting to insulate our directors from any corporate disaster we might have, we don't provide them with officers' and directors' liability insurance (an unorthodoxy that, not so incidentally, has saved our shareholders many millions of dollars over the years). Basically, we want the behavior of our directors to be driven by the effect their decisions will have on their family's net worth, not by their compensation. That's the equation for Charlie and me as managers, and we think it's the right one for Berkshire directors as well."

Buffett's superb understanding of human psychology is on full display here. If a person is not behaving rationally, force him to behave rationally by smothering his options. First, choose those people that have a large and true ownership in a firm so that they really think of what is good and what is bad for the firm in the long run. Secondly, pay them a pittance so that like other shareholders, they too derive greater portion of their income from the firm's profits and not take a higher proportion of its expense. This is also likely to pressurise them further to take decisions that are in the shareholders' interest. Indeed, some great lessons on how an independent director should be chosen and to ensure that he continues to think for the shareholders and not against them.

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