2010: Did the financial crisis change how Buffett thinks about a manager's integrity?

AUDIENCE MEMBER: Dear Mr. Buffett, dear Mr. Munger. My name is Richard Rentrop. I’m a shareholder from Germany. Mr. Munger, you just mentioned again the importance of integrity. My question is about changes in integrity of management. One of your three key questions is, does management love what they do, or does management love the money? So how do you see the crisis having changed integrity of management?

CHARLIE MUNGER: I think what led to the crisis involved, to some extent, a lack of integrity in many a management. Fortunately, some of them are now gone. So, integrity’s very important. It’s the safest way to make money, also. There’s an occasional perfect knave who succeeds pretty well with money, but that kind of success reminds me of what Pope Urban said about Cardinal Richelieu.

He said, “If there is a God, Cardinal Richelieu has much to answer for. But if there is no God, he’s done rather well.” (Laughter)

And too many people want to be like Pope Urban’s view of Cardinal Richelieu. Integrity is important, it’s terribly important. And of course, everybody mouths the integrity, even when it’s lacking. So it’s difficult to be sure that professing integrity is the same as having it.

WARREN BUFFETT: The “everyone else is doing it” is the toughest thing.

CHARLIE MUNGER: Yeah.

WARREN BUFFETT: You had this classic example. In about 1993, roughly, the Accounting Standards Board came out and said what was obvious to everybody all along—that stock options were actually an expense, and that expenses, for some reason or another, belonged on the income statement.

Corporate America fought back like you cannot believe. I mean, it was like World War III had broken out, in terms of armies of CEOs marching on Washington. The Accounting Standards Board backed off. Congress—the Senate—voted 88 to 9 to tell them that, you know, what the hell did the Accounting Standards Board know about accounting, and that the Senate would tell them what accounting was all about.

When the Accounting Standards Board backed off, they said, “We’ll now say that you can do it one of two ways. Number one is preferred,” which was to expense. “Number two was acceptable, but not preferred.”

Of the Standard & Poor’s 500 companies, 498 chose number two, the non-preferred way. Two took the preferred method.

I talked to a number of people in that 498 that I would trust to be a trustee of my will, you know, I’d love to have them as a next-door neighbor, they could marry my daughter, but in the end, they said, “I can’t do it if the other guy isn’t doing it.”

It was a variation on, “I’m doing it because the other guy is doing it.” They basically said, “I’ll be penalizing my shareholders if I report less in the way of earnings than I can report. And all the other guys are doing it that way, and I understand your point.”

The situational ethics problem is huge. I gave you earlier that illustration of how rare it is to find, if you carry it out to tenths of a cent, a four in reported earnings, quarterly. That’s not accidental. But if you talk to the people that play games to get that four up to five, they would say, “Everybody else is doing it, your own statistics proved that.”

It is a tough problem to deal with. We try to create as few situations in Berkshire as we can that would induce such behavior. I don’t have the managers submit budgets to me, there is no Berkshire budget, you know. They can use them in their own operations. Some do, and some don’t. Many do, a great many do.

But if they submit them to me, the temptation becomes, if they’re not quite making it and they think I’m looking at them all the time, the temptation becomes to fudge in some way. Very few would do it, but the more that thought the other ones were doing it, the more that would do it. It’s just human behavior. And you want to try and create a structure that minimizes the weaknesses in human behavior.

And I think Berkshire’s about as good a place at that as any, although I’m sure we’re not perfect at it.

CHARLIE MUNGER: Yeah, what’s really interesting on this issue is that so much of the bad behavior does not come from malevolence or overweening greed or anything like that.

It comes from subconscious poor cognition that justifies a lot of behavior that’s really not justifiable if it’s better understood. And that happens to practically everybody.

The cure is very difficult. The best cure is to have a system where the people who are making the decisions bear the consequences.

That’s why the system that Wall Street created, where nobody really owned the mortgages—they just passed them rapidly to somebody else at a profit—meant nobody felt any responsibility that the mortgages be any good.

Systems like that, at a basic level, are irresponsible systems, and it’s deeply immoral to create irresponsible systems like that. But the people who create them don’t realize they’re being immoral, they think those systems are wonderful.

Who do you see apologizing for the behavior you now find so regrettable in our recent mess? There are very few apologies, you’ll note. People think they did fine.