Solving the Independent Director Problem Raised by Warren Buffett

Writing on the subject of corporate governance in his letter this year to the shareholders of Berkshire Hathaway, Warren Buffett noted that, "overall the deck is stacked in favor of a deal that's coveted by the CEO and his/her obliging staff. It would be an interesting exercise for a company to hire two expert acquisition advisors, one pro and one con, to deliver his or her views on a proposed deal to the board — with the winning advisor to receive, say, ten times a token sum paid to the loser. [But] don't hold your breath waiting for this reform: The current system, whatever its shortcomings for shareholders, works magnificently for CEOs and the many advisors and other professionals who feast on deals."

Elsewhere in his letter, Buffett notes the potential conflict of interest facing "independent" directors who are paid a substantial amount for their board service, but are also expected to play a crucial role in challenging the CEO and management team when necessary.

While Neil and I have a great deal of empathy with Buffett's views on this, in our roles over the years as corporate officers, board directors, and consultants we have repeatedly seen that many of these situations are more complex than they may appear at first.

For example, virtually all of the independent directors we know are well aware that their fiduciary duty of care requires them to occasionally challenge management's thinking — and we have seen plenty of them carry out this duty over the years. We've also sometimes seen boards hire outside advisors who are independent of management.

But most of these situations were awkward for all the parties involved. Why? Because they were exceptions to the boards' normal collegial and often uncritical processes. And therein lies both the problem and the solution.

In our work with clients on strategic risk governance and management, we start with a review of important aspects of our nature as human beings and how we function in groups.

As individuals, we tend to be overoptimistic and overconfident, and to pay more attention (and give greater weight) to new information that supports our current view. It is also the case that when uncertainty increases, we naturally tend to conform more closely to our group or leader's view, and to unconsciously shift more towards learning from and copying the beliefs and behavior of other members of our group. Another aspect of operating in groups is that it triggers our instinctive competition for status. One example of this is that while operating individually (where nobody will see the results of our decisions) we tend to be risk averse, once we are in a group and others will see those outcomes, our mindset often switches from avoiding losses to maximizing gains. This often leads to an increase in collective (over) confidence, and an increased likelihood of rejecting dissenting advice from outsiders.

In our distant evolutionary past, all these behaviors were adaptive and enabled us to survive. In the far more complex situations we often face today, many of them no longer are.

So what is a board to do? Research has shown that simply making people aware of their biases has little impact on an individual or group's ability to overcome them. Given this, the solution we recommend is to establish regular processes — not one-off interventions — that are designed to counteract our evolutionary shortcomings.

Here's an example. Strategic plans and major transaction proposals should always be subjected to a "pre-mortem" risk review. Since human beings are far more detailed when asked to explain the past than they are when asked to predict the future, board members are told to assume it is three to five years in the future and the strategy or deal (or even the company) has failed. We then ask each of them to anonymously write down their answers to three questions: (1) Why did this happen? (2) What warning indicators were missed? And (3), what could have been done differently to avoid failure?

We type up the answers (e.g., while the board is having lunch), and then hand them out for individuals to read. Next, we discuss each failure scenario, without identifying who wrote it. These discussions are always rich and productive. In the context of Buffett's concerns, the key point is that by making pre-mortems and other techniques we use a normal part of the board's process, potential conflicts between independent directors and management are defused before they can occur.

In sum, the best way to respond to the concerns that Warren Buffett raised in this year's Berkshire Hathaway shareholder letter isn't by trying to change human nature. Rather, it is by changing board processes and structures (i.e., the use of outside advisors) to offset our natural instincts and the weaknesses that frequently get organizations into trouble.

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