Governance by Trust: Philosophy or Fluke?

> Posted by Joshua Goldstein, Principal Director for Economic Citizenship & Disability Inclusion, CFI

The extent of the reciprocal relationship of trust between an employer and employee may be hard to measure, but it may be more indispensable to good governance than a variety of risk management tools. In fact, there are organizations that forego some traditional risk management mechanisms, instead emphasizing the power of trust. One example, according to Andrew Ross Sorkin, writing in DealBook, is Berkshire Hathaway, the American multinational conglomerate that’s currently the fifth-largest company in the United States.

The normative route to good governance encompasses a host of practices including risk management functions, internal auditing, and board committees. A MIX project examining the practices of over 150 MFIs across 57 countries found a positive correlation among institutional governance indicators, suggesting that good governance practices don’t exist in isolation. Putting such watch-dog measures into place, however costly, is increasingly standard practice at institutions both public and private around the world. Without these, who knows what some employees might be tempted to do. It is the price of doing business. Or at least that is the common school of thought.

According to Charles Munger, Vice Chairman of the Berkshire Hathaway Corporation, an emphasis on rigorous oversight can prove counter-productive and lead to just the kind of employee poor performance and misconduct meant to be kept in check. Berkshire, for example, has neither a general counsel nor a human resources department. Trust, not rigorous oversight, turns out to be the coin of the Berkshire Hathaway realm. Yes, good old fashioned trust in Munger’s employees to do the right thing and the earned trust of his employees in him to treat them with the respect and dignity they deserve.

Of course Munger is not naïve about the skepticism his warm and fuzzy approach to workplace management attracts. As he said at Berkshire’s 2014 annual shareholders meeting, “By the standards of the rest of the world, we over trust. So far it has worked very well for us. Some would see it as weakness.”

Indeed, Sorkin writes, the conventional wisdom would be that Berkshire is guilty of corporate malfeasance or at least extreme negligence. Munger has always known that shareholders will take him to the woodshed for any failure, but he believed that trust in his managers outweighed whatever risk mitigated by compliance officers and corporate lawyers. “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 at other firms,” Sorkin adds.

Is this Berkshire Hathaway management-by-trust philosophy worth emulating by other firms or is it a bizarre but wonderful outlier. Would copying it be folly? Does it depend on some intangibles that cannot be fully comprehended or measured and therefore can never be safely reproduced by others?

Well, you can bet the behavioral economists have known for a long time that a trust-based system is more efficient than a compliance-based system. However, this is only true if self-interested behavior among executives and employees is low, says Stanford’s David F. Larcker and Brian Tayan. My guess is that the “self-interested behavior” that defeats a more trust-based system is surely the rule in most workplaces, judging by the emphasis on short-term results and employee turnover that seem to characterize many offices. Also important to point out is the increased pressure on hiring that is inherent in this model. There is great risk, for example, in a company’s board making an incorrect assessment and hiring an executive who does not have the necessary skills or integrity.

Munger’s explicit proposition is that the very existence of a set of internal audit procedures, “checks and double-checks,” result from a company default position of mistrust in its workers and provokes the very self-interested behavior that leads to the poor performance and even dishonesty that it is supposed to curtail.

Is this not true at home within the family as well? Enforcing a child by authoritarian oversight to obey a rule is only effective as long as the parent is in sight or ear shot. Whereas when the child shares in decision-making, is given choices, and understands why rules exist, he can learn to own his behavior and be trusted to do the right things. He is less likely to stray to the dark side when the parent looks away.

Of course paying homage to “trust” in corporate-speak is not enough to create mutual trust, which for most people has to be earned. For example, Don Ogilvie at the Deloitte Center for Banking Solutions writes, “Trust may be intangible, but it is not unmanageable. However, sound management needs to be based on an understanding of what drives trust, the costs and benefits of investing in trust, and the actions institutions can take to build trust.” He goes on to say that the report in which this excerpt is found is designed to provide a foundation for these management efforts in order to harness the “truly strategic asset” that is trust.

Does this way of thinking about “trust” create trust in you? Not in me. The foundation of trust is good behavior, not clever pronouncements. And such manipulative language puts me in mind on the ancient mistrust dictum caveat emptor – buyer beware, which has a well-deserved place of honor in most of our “real worlds”, where trust is often in short supply.

But business as usual at Berkshire Hathaway seems truly based on earned trust, not the lip service paid to trust at many companies – where, in reality, invasive oversight and controls rule. Their nurturing environment appears to support employee excellence, intelligent risk taking, and moral rectitude, and is based on the virtue of reciprocity and shared values. Their results do the talking for them.

As to why Munger and Warren Buffet are different from their corporate peers, I can only speculate, but it seems likely that these Omaha boys had basic trust in the world from childhood – and that this infuses their workplace as adults (see a discussion of childhood trust by Erik Erikson, renowned developmental psychologist, in Childhood and Society).

So how replicable is Berkshire’s trusting work environment? From what I have seen of self-serving behavior in the workplace, I am quite skeptical, but it’s certainly something to consider as we put in place and evaluate the governance mechanisms and controls of our organizations.

For now, the forecast for job growth in risk management is healthy.

Image credit: Spot Us

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