Berkshire’s Radical Strategy: Trust

OMAHA â€" “By the standards of the rest of the world we overtrust. So far it has worked very well for us. Some would see it as weakness.”

That was Charlie Munger, vice chairman of Berkshire Hathaway and Warren Buffett’s best friend, speaking during the weekend at the company’s annual meeting, known as “Woodstock for Capitalists.”

Mr. Munger, 90, was ruminating on the state of corporate governance, offering a counternarrative to the distrustful culture of most businesses: Instead of filling your ranks with lawyers and compliance people, he argued, hire people that you actually trust and let them do their job.

Here’s a little-known fact: Berkshire Hathaway, the fifth-largest company in the United States with some $162.5 billion in revenue and 300,000 employees worldwide, has no general counsel that oversees the holding company’s dozens of units. There is no human resources department, either.

If that sounds like a corporate utopia, that’s probably because it is. To some people in this day and age â€" given the daily onslaught of headlines about scandal and fraud in corporate America â€" that also may sound almost like corporate negligence.

Mr. Munger’s thought experiment about trust is being studied at the Rock Center for Corporate Governance at Stanford University. A professor wrote a paper last month about his contention, examining its suitability to corporate structures.

As Pollyannaish as Mr. Munger may sound, his view has a profound counterintuitive truth to it: Behavioral scientists and psychologists have long contended that “trust” is, to some degree, one of the most powerful forces within organizations.

Mr. Munger and Mr. Buffett argue that with the right basic controls, finding trustworthy managers and giving them an enormous amount of leeway creates more value than if they are forced to constantly look over their shoulders at human resources departments and lawyers monitoring their every move.

It may seem irresponsibly idyllic, but Mr. Buffett, 83, has always followed a sometimes unusual â€" if not counterintuitive â€" approach. “We are very disciplined in some ways, and by ordinary business standards we’re sloppy in other ways,” he conceded.

And Mr. Munger and Mr. Buffett say they readily accept the risk of such a permeable system. “We will have a problem of some sort at some time,” Mr. Buffett said to his faithful audience. He added, “300,00 people are not all going to behave properly all the time.”

Mr. Munger also acknowledged that he knew that when there was a problem, shareholders and other critics would wag their fingers and question why there were not more controls.

But he added that he believed that trust in his managers, without the safety net of lawyers and compliance officers, outweighed whatever risk they might help mitigate. More to the point, the increasing reliance on peering over the shoulder does not appear to have stemmed bad behavior, judging by the steady stream of scandals.

“A lot of people think if you just had more process and more compliance â€" checks and double- checks and so forth â€" 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,” Mr. Munger said at Westco Financial’s annual meeting in 2007, distilling his vision.

A widely circulated study by two professors at the University of Zurich supports Mr. Munger’s thesis: “Conventional wisdom suggests more monitoring and sanctioning of management. We argue that these efforts will create a governance structure for crooks,” wrote the professors, Margit Osterloh and Bruno S. Frey. “Instead of solving the problem, they make it worse. Selfish extrinsic motivation is reinforced.”

Of course, Berkshire is a special breed of company, almost a throwback to a bygone era. Its board and shareholders have given Mr. Buffett an enormous reservoir of trust. (Critics might say too much trust.) That trust is imbued in its culture. Many of the controls and processes that most companies have adopted simply don’t exist at Berkshire. (It is worth noting that many of Berkshire’s portfolio companies have their own general counsels and human resources departments.)

And so when Mr. Buffett was asked over the weekend how he felt about an accounting error at Bank of America that overstated its capital and forced it to suspend a stock buyback and a dividend increase, it wasn’t a surprise to hear him say, “That error that they made doesn’t bother me.” Many analysts and investors said the mistake raised questions about controls at the company, in which Mr. Buffett is a large investor. He said, “You do the best you can.”

Why was Mr. Buffett so blasé about the error? Well, he trusts the bank’s management. Others part ways with him on this.

So is Berkshire’s approach scalable? Yes and no.

“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,” David F. Larcker, a professor of accounting at Stanford, and Brian Tayan, a researcher at the university, wrote. “The risk is that the board makes an incorrect assessment of an executive’s ability and integrity and selects the wrong C.E.O.”

That puts a lot of emphasis on selecting the right people â€" and mistakes do get made.

But Mr. Munger doesn’t suggest that businesses trust people blindly. Some basic controls are needed.

In a lecture he gave at Stanford in the late 1990s, he said: “A very significant fraction of the people in the world will steal if (a) it’s very easy to do and (b) there’s practically no chance of being caught. And once they start stealing, the consistency principle â€" which is a big part of human psychology â€" will combine with operant conditioning to make stealing habitual.”

Not all industries may be equal when it comes to trust either. The financial industry, for example, has a long reputation for complexity and bad behavior. “You’re never going to have perfect behavior in a miasma of easy money,” Mr. Munger told the crowd over the weekend.

Berkshire has not been problem-free. Two years ago, Mr. Buffett fired one of his top managers, David Sokol, over trading in the stock of Lubrizol ahead of Berkshire buying the company. (The Securities and Exchange Commission investigated Mr. Sokol but closed the case without bringing charges.) Mr. Buffett was also stung when one of his portfolio companies, General Re, a reinsurance company, was accused of participating in sham transactions with American International Group. The company settled with the government for $92.2 million.

Mr. Munger, in a previous annual meeting, contended that the best way to hold managers accountable is to make them eat their own cooking. Mr. Munger pointed to the late Columbia University philosophy professor, Charles Frankel, who believed “that systems are responsible in proportion to the degree in which the people making the decisions are living with the results of those decisions.” Mr. Munger cited the Romans, “where, if you build a bridge, you stood under the arch when the scaffolding was removed.”

Almost six years after the financial crisis, there is still little supply of trust to go around. But by Mr. Munger’s thinking, maybe there should be.

Andrew Ross Sorkin is the editor at large of DealBook. Twitter: @andrewrsorkin