C&B Notes

Munger on Governance: Spirit vs. Law

Stanford researchers provided a ‘Closer Look’ summary of some of Charlie Munger’s thoughts on corporate governance.  Unsurprisingly, some of these ideas are contrarian and focus more on getting the spirit of governance right rather than focusing on rules and regulations.  Early last year, we shared a note about how a strong and clear culture is by far the most important ingredient for effective risk management and compliance.

…To Munger, “The right culture, the highest and best culture, is a seamless web of deserved trust.” 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.”

…Munger cites former Columbia University philosophy professor Charles Frankel who believed that “truly responsible, reliable systems must be designed so that people who make the decisions bear the consequences.”…  Frankel “said that systems are responsible in proportion to the degree in which the people making the decisions are living with the results of those decisions…  So a system like the Romans had where, if you build a bridge, you stood under the arch when the scaffolding was removed — or if you’re in the parachute corps, you pack your own parachute — those systems tend to work very well.”  Conversely, “a CEO who’s there for five years while the company looks good, after which he’s gone on a pension, is not operating in a responsibility system like that of the Roman engineers.”

…The organization should remove easy opportunities to engage in self-interested behavior: “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 — which is a big part of human psychology — will combine with operant conditioning to make stealing habitual.  So if you run a business where it’s easy to steal because of your methods, you’re working a great moral injury on the people who work for you….  It’s very, very important to create human systems that are hard to cheat.”  Munger calls systems that are easy to cheat “perverse.”  “A system is perverse when good people go bad because of the way the system is structured.  If you run a big chain of stores and you make it easy to steal by your own sloppiness, you will cause a lot of good people to go bad.  You will have created an irresponsible system.”

…Conservative accounting creates a margin of safety in financial reporting, providing assurance to investors and management that corporate performance is at least as good as reported.  According to Munger, “The liabilities are always 100 percent good.  It’s the assets you have to worry about.”  Aggressive accounting also encourages aggressive practices such as overstating revenue and underestimating loan-loss provisions, allowances for uncollectible accounts, reserve estimates, and other accounts to inflate net income.  “Ninety-nine percent of the troubles that threaten our civilization come from too optimistic accounting.  And yet these damn accountants with their desire for mathematical purity want to devote exactly as much attention to accounting that is too pessimistic as they do to accounting that is too optimistic — which is crazy.  Ninety-nine percent of the problems come from being too optimistic.  Therefore, we should have a system where the accounting is way more conservative.”

…Finally, Munger advises that corporate systems maintain simplicity: “One of the greatest ways to avoid trouble is to keep it simple.  When you make it vastly complicated — and only a few high priests in each department can pretend to understand it — what you’re going to find all too often is that those high priests don’t really understand it at all….  The system often goes out of control.”…

The last idea that I want to give to you as you go out in a profession that frequently puts a lot of procedures and a lot of precautions and a lot of mumbo jumbo into what it does: this is not the highest form which civilization can reach.  The highest form that civilization can reach is a seamless web of deserved trust — not much procedure, just totally reliable people correctly trusting one another.  That’s the way an operating room works at the Mayo Clinic.  If a bunch of lawyers were to introduce a lot of process, the patients would all die.  So never forget when you are a lawyer that you may be rewarded for selling this stuff but you don’t have to buy it.  In your own life what you want is a seamless web of deserved trust.  And if your proposed marriage contract has forty-seven pages, I suggest you not enter.