Still think the playing field is level?

From Bloomberg


Buffett Misses Chance to Show Moral Courage

What were they thinking? How could Warren Buffett excuse David Sokol’s trading in Lubrizol Corp. (LZ) stock while Sokol was pitching the company to Berkshire Hathaway Inc. (BRK/A) as an acquisition candidate?

Buffett and Sokol both say that nothing “unlawful” was going on (Sokol even went so far as to tell CNBC he did nothing inappropriate). Their explanation is that, because a deal with Lubrizol hadn’t actually been struck and wasn’t likely when Sokol bought his shares, it was all right for Sokol to profit from his knowledge of a possible deal.

On Wall Street, we call this kind of trading front-running, and everybody knows that it is wrong. People get fired for doing it. Sokol said that he is leaving Berkshire to pursue other business interests, and the timing is linked to Berkshire’s April 30 annual shareholder meeting, which is attended by tens of thousands of people. That’s probably true, in a sense. Buffett must want this mess cleared up and out of the way before he has to take questions from shareholders.

Buffett gave out a few facts in his press release yesterday, but the Schedule 14A filed with the Securities and Exchange Commission by Lubrizol fills in the damning pieces. After deciding to pursue Lubrizol as an acquisition candidate for Berkshire in the fall of 2010, Sokol tried to buy 50,000 shares on Dec. 13, the day he presented Berkshire’s possible interest to Citigroup Inc. and asked it to set up a meeting with Lubrizol’s management. He was able to acquire only 2,300 shares, and sold them a week later.

Sokol’s Purchase

On Jan. 5, the day before Lubrizol’s management held a special meeting to discuss a possible sale to Berkshire, Sokol began to buy stock again. The following day, Lubrizol hired Evercore Partners Inc. (EVR) as its banker to respond to the potential interest of Berkshire. By Jan. 7, Sokol had purchased 96,400 out of a targeted 100,000 Lubrizol shares.

It strains credulity to claim these dates were coincidental and that Sokol had only a 5 percent belief (as he has stated) that Berkshire would buy Lubrizol. Sokol covered his bases by casually mentioning to Buffett that he owned stock when he pitched the acquisition in December. He gave no details and apparently kept quiet for almost three months, until after the Berkshire board had sealed the deal on March 13.

When Berkshire announced it was buying Lubrizol, the stock soared and Sokol pocketed a $3 million profit. It’s a large sum, but Sokol is a very rich man already, and it looks like he fell into the classic trap of the rich and powerful, who so often blow their reputation over trivia.

Misleading by Omission

With hindsight, Lubrizol’s SEC filing may be misleading by omission -- inadvertently so. Nowhere is Sokol’s financial interest mentioned in the catalog of events leading up to the deal. The relevant section of the filing says, in short, that neither Berkshire nor any of its subsidiaries (other than its externally managed pension funds) directly or indirectly owned a material amount of Lubrizol stock within the past three years.

Sokol may not technically fit into the definitions of this section, but it highlights the importance of disclosing positions in acquired stock by interested parties who could profit from the deal and that are material. In this light, you have to wonder what Lubrizol management thinks today about its dealings with Sokol.

Not surprisingly, according to the Financial Times, the SEC is now beginning an investigation. Presumably, it will look into whether there are similar patterns of trading in advance of other acquisition pitches by Sokol to Berkshire, whether consummated or not. One specific transaction that has piqued the curiosity of onlookers for months is Sokol’s purchases of shares of Middleburg Financial Corp. (MBRG) since 2010. And even if the SEC concludes that Sokol did nothing illegal, the known facts suggest that what Sokol did was wrong.

Lottery Tickets

In substance, when Sokol pitched the deal to Buffett, he was holding stock in Lubrizol that had the equivalent of free lottery tickets attached. These 96,400 lottery tickets gave Sokol unfair odds -- odds far better than in the kind of lottery the general public gets to play.

It would be inexcusable for the chief executive officer of Berkshire Hathaway to front-run a potential acquisition this way. Why then, couldn’t the CEO of Berkshire admit it is inexcusable for one of his own senior managers to do so? Instead of condemning Sokol, Buffett gave him a pat on the back on the way out the door. Since when is it enough to merely uphold the letter of the law, especially at Berkshire? Whatever happened to Buffett’s famous saying, “Lose money and I will forgive you, but lose even a shred of reputation and I will be ruthless”?

It’s too bad that Buffett missed an opportunity to show moral courage, stand up for principle, reinforce to his employees what he expects from them, and, not least of all, to live up to his own public reputation.

Editor’s note: Alice Schroeder has been subpoenaed by Berkshire subsidiary NetJets seeking confidential information related to her news sources for other publications. The matter is being heard in Connecticut state court.