Mailbag question from a reader: “Tim, is there any downside to Berkshire’s policy of not covering the Directors with liability insurance against losses. This is something Warren Buffett occasionally brags about. What’s the downside? [rest of conversation redacted] -William.”
Warren Buffett is right to brag about the lack of insurance coverage Berkshire agents have regarding their stewardship of the firm. It is the most surefire way to avoid approving of things that you do not understand, and it invites caution towards those deals that appear lucrative at first glance but have some type of remote catastrophic risk attached (this is why Berkshire avoided an acquisition of Lehman Brothers for pennies on the dollar while Bank of America opened arms for Countrywide Financial).
But that’s not what you asked. The way I see it, there are two potential downsides to not carrying personal liability insurance for directors. The first theoretical downside is that it could lower the quality of people who will be interested in taking on the Director position. This is more than offset by the halo offset of being associated with Warren Buffett specifically, a Fortune 500 company in general, and a company that has over $50 billion in cash on hand to survive adverse circumstances.
But the real risk is that, even after being prudent regarding risk management, an event exposing the Directors to liability could arise which could put the Directors in a conflict of interest with the firm itself. This falls under the broad category of “principal/agent” dilemmas in which the people entrusted to carry out the interests of the corporation have different interests from the corporation itself.
It happened at Texaco during its dispute with Pennzoil during the Getty Oil debacle of the 1980s. I argue that it would have been in the best interest of Texaco to settle with Pennzoil rather than take the suit to court and risk a judgment that could spiral the oil giant towards bankruptcy, but the the Directors of Texaco at the same did not have liability insurance coverage against tortious interference which was alleged when Texaco intervened after Pennzoil entered into agreement with Getty Oil.
When the Texas trial court ruled in Pennzoil’s favor, there were immediately fourteen lawsuits filed against the directors and officers of Texaco that sought personal liability for tortiously interfering and violating the duty of care when trying to acquire Getty Oil. Because they did not have personal liability coverage, Texaco saw the case through to the end. A settlement did not come until Texaco had entered bankruptcy, and part of the settlement terms that the bankruptcy court constructed involved an exculpation against personal liability for the Texaco directors and officers.
It is difficult to tell what motivates a team, as external conduct is the only thing we can analyze. But we do this chain: (1) Texaco directors and officers did not have liability coverage for the matter that prompted the 14 lawsuits; (2) Texaco did not reach a settlement regarding Getty Oil until receiving immunity against those 14 other suits; and (3) the initial settlement offers from Pennzoil that were a fraction of the cost compared to the multi-billion dollar litigation did not have liability waiver provisions because Pennzoil does not have the authority to grant personal liability immunity between Texaco directors and officers and their then-existing shareholders.
On the whole, a lack of personal liability insurance deters excessive risk-taking and encourages an escalation of financial commitments from shareholders (namely, buying more shares since Berkshire does not pay any dividends to reinvest). The standard of care applied to each Berkshire acquisition, or new product development at existing subsidiaries, is going to carry extreme scrutiny because the Berkshire Directors and Officers can face personal financial responsibility if something like Countrywide Financial were to happen under its watch. It is also possible that the directors could be too cautious and ignore lucrative deals with remote risks, thus lowering the ceiling of returns.
But the lack of personal liability coverage provides protection prospectively in the evaluation of business decisions and even provides protection regarding ongoing operations. But the risk emerges when lawsuits relating to past management start to show up. It creates a principal/agent conflict of interest problem because the directors and officers because the subsequent conduct that minimizes personal liability may become different from actions that should be taken in the best interest of the corporation. The odds of this are minimal, but that is a scenario in which the incentives for Berkshire’s agents without personal liability insurance could be at odds with the best interests of shareholders.
Originally posted 2016-01-04 10:20:07.