Exceptional Compensation, But Only for Exceptional Performance

Eighteen years ago, Buffett wrote the following to Salomon, Inc, shareholders after Salomon's 1990-1991 illegal bond trading scandal:

"Most of you have read articles about the high levels of compensation
at Salomon Brothers. Some of you have also read
discussions of incentive compensation that I have written in
the Berkshire Hathaway annual report. In those, I have said
that I believe a rational incentive compensation plan to be an
excellent way to reward managers, and I have also embraced
the concept of truly extraordinary pay for extraordinary managerial
performance. I continue to subscribe to those views.
But the problem at Salomon Brothers has been a compensation
plan that was irrational in certain crucial respects.

One irrationality has been compensation levels that overall
have been too high in relation to overall results. For example, last
year the securities unit earned about 10% on equity capital — far
under the average earned by American business — yet 106 individuals
who worked for the unit earned $ 1 million or more. Many
of these people performed exceedingly well and clearly deserved
their pay. But the overall result made no sense: Though 1990
operating profits before compensation were flat versus 1989, pay
jumped by more than $ 120 million. And that, of course, meant
earnings for shareholders fell by the same amount.

In Salomon Brothers’ business, which combines leverage with
earnings volatility, it is particularly necessary and appropriate that
the financial equation applying personally to managers be comparable
to that applying to the ordinary shareholder. We wish to see
the unit ’ s managers become wealthy through ownership, not by
simply free - riding on the ownership of others, I think in fact that
ownership can in time bring our best managers substantial wealth,
perhaps in amounts well beyond what they now think possible.

To avoid dilution, the trustee of the EPP purchases stock for
the plan in the market and at some point in the future, the company
may itself elect to make stock repurchases to reduce the
shares outstanding. Within a relatively few years Salomon Inc. ’ s.
key employees could own 25% or more of the business, purchased
with their own compensation. The better job each employee does
for the company, the more stock he or she will own.

Our pay - for - performance philosophy will undoubtedly
cause some managers to leave. But very importantly, this same
philosophy may induce the top performers to stay, since these
people may identify themselves as .350 hitters about to be paid
appropriately instead of seeing their just rewards partially assigned
to lesser performers. Indeed, I am pleased to report that certain
of our very best managers have already asked that the EPP be
modified to allow them to substantially increase the proportion
of their earnings that can be invested through the plan.
Were an abnormal number of people to leave the firm, the
results would not necessarily be bad. Other men and women
who share our thinking and values would then be given added
responsibilities and opportunities. In the end we must have
people to match our principles, not the reverse.

Our goal is going to be that stated many decades ago by
J.P. Morgan, who wished to see his bank transact “ first - class
business — in a first - class way. ” We will judge ourselves in fact not
only by the business we do, but also by the business we decline
to do. As is the case at all large organizations, there will be mistakes
at Salomon and even failures, but to the best of our ability
we will acknowledge our errors quickly and correct them with
equal promptness…"
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Warren Buffett, Third Quarter, 1991 Letter to Salomon Inc. Shareholders