Investor’s test for corporate governance

Corporate governance is now the most talked about subject for corporate India. Let us see how successful investors define good governance. I turn to Charlie Munger’s thoughts on this subject reported in Stanford Closer Look Series. He suggests that good governance comes from more trust and less controls, conservative accounting and modest compensation.

Most large corporations today have adopted governance systems that include extensive incentives and controls, including an independent board of directors to monitor management, an internal audit department, compliance and risk management, and elaborate executive compensation contracts. Charlie Munger, however, contends that it is unreasonable to expect such a system to work equally well in all settings.

He points out that many successful organizations operate under a model that relies on fewer rather than more controls: A lot of people think if you just had more process and more compliance—checks and double-checks and so forth—you could create a better result in the world. Best companies just try to operate in a seamless web of deserved trust and be careful whom they trust. Munger says that 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.

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. Munger thinks that ninety-nine percent of the troubles that threaten our civilization come from too optimistic accounting. And yet these 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.

Munger also proposes that CEOs receive modest compensation after they have achieved a reasonable level of wealth. He argues that people should take way less than they’re worth when they are favored by life. He would argue that when you rise high enough in American business, you’ve got a moral duty to be underpaid—not to get all that you can, but to actually be underpaid. There’s a lot to be said for the people who have the power getting into a position where they make their money with the shareholders and not off them.

Munger points out examples from American business where founders took no salary from companies they founded. Carnegie was always very proud that the bulk of his fortune had been earned while he took no salary from Carnegie Steel. John D. Rockefeller the First took practically nothing in salary. Over the years, Cornelius Vanderbilt prided himself on living on his dividends and taking no salary. It was a common culture in a different era.