the curious case of David Sokol and Berkshire Hathaway

The case of David Sokol, late of Berkshire Hathaway, has been widely reported over recent days.  The facts, as I understand them, are as follows:

Sokol’s behavior…

1.  One of Warren Buffett’s chief lieutenants and touted as a potential successor to the Sage of Omaha, Mr. Sokol had the task of finding a suitable target for the merger and acquisition “elephant gun” Mr. Buffett proclaimed last year he had primed to fire.  There may have been others looking as well, but Mr. Sokol certainly was one.

2.  Mr. Sokol decided to recommend Lubrizol to Mr. Buffett as a company that Berkshire should purchase.

3.  Prior to approaching his boss, Mr. Sokol bought $9+ million in Lubrizol stock for himself.

4.  In his presentation to Mr. Buffett, Mr. Sokol mentioned his own holding, but only in passing.  He apparently did so in a way that it didn’t highlight the relevant points of how recent or how large his purchase had been.

5.  Buffett decided to buy Lubrizol.  Sokol sold his stock for a $3 million personal profit.

6.  After this became know, Sokol resigned from Berkshire.  Buffett maintains that Sokol did nothing wrong and that the resignation has nothing to do with his Lubrizol stock purchase.

7.  The SEC is now investigating Sokol, with the focus of the inquiry on whether there are other instances of the same buy-for-yourself-then-recommend behavior.

…isn’t the issue on Wall Street.  Buffett’s is.

People buy Berkshire Hathaway stock because they regard Warren Buffett as a master investor and a person of absolute integrity.  His public appearances draw immense media attention for the same reasons.  Other investors parse each sentence he pens or utters for sophisticated investment insights.  Why, then, would such a hero defend a subordinate who appears to have taken advantage of Mr. Buffett’s trust and used his corporate position for personal gain?   …especially when this conduct appears to fly in the face of the fair-play rules every investment company must follow.

why do this?

No one outside Berkshire Hathaway knows for sure.  I have two observations:

1.  Imagine what Mr. Sokol’s defense against charges of failing in his fiduciary duty to Berkshire Hathaway shareholders might be.  If it were me, I’d argue along three lines:

a) First, I would say that Sokol is an industrialist working for a conglomerate, not a portfolio manager working for a regulated securities company.  Therefore, he’s not subject to the severe controls on the latter’s activities.

b)  I’d then say that Berkshire doesn’t have adequate compliance procedures that establish and monitor standards of conduct.  As as result of this corporate failure, he was ignorant of proper procedures.

c) Then I’d try to argue that his behavior was common practice at Berkshire.

In fact, it appears Sokol is already asserting that what he did is just the same as Charlie Munger (Buffett’s long-time associate and vice-chairman of Berkshire) holding shares of Chinese battery company BYD prior to Berkshire taking a large stake.

In the press, there has been no discussion of Berkshire compliance procedures.  Yes, Buffett wrote a letter on the subject all newly hired executives are required to state that they have read–but nothing else.  No one I’m aware of has written that Berkshire implemented the kind of strict controls over, and intense scrutiny of, personal trading that is mandatory for investment companies.  Nor is there talk of periodic compliance training that is also required for professional investors.  My guess is that, while these procedures may exist in the company’s insurance subsidiaries, there’s no company-wide effort.

Also, if it is correct that the thrust of an SEC investigation of Sokol is on a pattern of behavior rather than this one incident, this suggests that points a) and b) above have merit.

To sum up, at least in the very narrow sense of “can he be convicted?”, Mr. Sokol may actually have done nothing wrong.  Unethical, maybe, but illegal, no.  So there’s little Mr. Buffett can do other than to ask for Mr. Sokol’s resignation.

Ironically, if Berkshire were a regulated investment company, it may well be that Mr. Buffett’s supervisory failure to publicize and enforce the rules would be the main actionable offense.

2.  There could be a second reason for Berkshire wanting to put this incident behind it as quickly as possible.

The shock and outrage in the investment community over the Sokol affair illustrates Wall Street’s belief about what Berkshire is:  the investment company run by one of the greatest American investors of the twentieth century.

To defend itself, Berkshire would likely have to emphasize that Berkshire is a financial services/industrial conglomerate (Geico is its best-known brand), not a regulated investment firm.

What’s so bad about that?  The stock doesn’t trade at the discount to asset value that’s characteristic of multi-industry companies, insurance firms in particular.  Berkshire trades at a substantial, though slowly shrinking, premium to book.   Defense of Berkshire’s behavior regarding Sokol might well end up being an attack on that premium as well, and accelerate its decline.

 

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