Dealpolitik: Does Buffett’s Defense of Sokol Make Sense?

David Sokol started buying shares of Lubrizol the day after he asked Citigroup to arrange a meeting with the CEO of Lubrizol to talk about a transaction with Berkshire Hathaway. A robust debate has developed on both the propriety and legality of those trades.

For those of you who have come embroiled in this ongoing debate, I have a quiz for you (your comments are most welcome, of course.) All of these are hypothetical situations. They are not based on any facts and are for the purpose of making my point. They address Sokol’s fundamental defense as articulated on CNBC and in Warren Buffett’s press release:  That Sokol was not in possession of material non-public information about Lubrizol when he bought shares.

1.       Betty, a secretary in Sokol’s office, stumbles on a note Sokol left on the fax machine. The note is addressed to Citigroup from Sokol and says:  “Although, I haven’t talked to him, based on what you have shown me I think Warren might react favorably to Berkshire buying Lubrizol. Can you set up a meeting for me with the Lubrizol CEO?” A Citi banker scribbles on the bottom “Yes, we will call tomorrow and get right back to you.” Betty buys $5000 of Lubrizol stock later that day.

Is there any doubt Betty would and should be fired for that?  Did she violate the law?

2.      Sokol calls Tom, a lawyer who advises Berkshire. He asks Tom to take a quick look at Lubrizol’s SEC filings to see if there are any “showstoppers” to a deal.

Sokol says “By the way Tom, I think Lubrizol looks like a good investment whether or not Berkshire makes a deal. So far all I have done is ask Lubrizol for a meeting. I haven’t mentioned this to Warren and he makes all the decisions. So if you want to invest yourself, it is fine to go ahead.  In fact, I bought some shares this morning.” Tom buys $100,000 of stock.

Have Sokol or Tom violated the law?

3.      Sokol’s friend Ben is an executive of XYZ Corp. Like Berkshire, XYZ is acquisitive, but Ben doesn’t have the final say on deals. Only Ben’s boss makes acquisition decisions. But Ben sometimes identifies good targets.  Sokol and Ben have an informal arrangement. When one sees what might be a good investment or an acquisition target, each tells the other so he can each buy stock. It is understood that once they propose a deal to their boss, they will not further discuss the target.
If Sokol called Ben and told him he was trying to get a meeting with Lubrizol and Ben bought shares, would either Sokol or Ben have violated the law?

4.      The banker at Citi who met with Sokol calls his trading desk. He tells the traders “Sokol seems to like the look of Lubrizol and has asked us to try to set up a meeting. I don’t know where this is going. Warren hasn’t even seen the deal. Nothing may happen here but I thought you might be interested.”
The Citi trading desk over the course of the next two weeks puts together a portfolio of Lubrizol shares and options representing approximately 3% of the outstanding shares of Lubrizol.

Did Citi violate the law?

Sokol’s and Buffett’s argument is that since Sokol has no authority to commit Berkshire to an acquisition transaction, Sokol’s interest in Lubrizol is not “material” in the eyes of the law.  If that piece of information is not material, then there is likely no violation of law in any of these four examples, although each represent poor judgment and likely violate corporate policy.

So, was Sokol’s lack of final deal-approval authority sufficient to make it immaterial? To answer that question you might want to look at how Lubrizol executives reacted to the phone call they received requesting a meeting with Sokol.
First here is what they did not do: They did not ask “But has Mr. Sokol talked to Mr. Buffett? Does he have the authority to talk to us on behalf of Berkshire?”

Instead, Lubrizol quickly called a special meeting of its board of directors where it had “extensive and thorough discussions about Berkshire’s possible interest.” Then the board hired a lawyer and a financial adviser. Four days later, the board met again to discuss a comparison of an acquisition by Berkshire with other alternatives. The board then instructed the Lubrizol CEO to meet with Sokol.

It is instructive that no one involved with Lubrizol ever seems to have questioned whether Sokol had authority to speak for Berkshire. He may not have had authority to sign the acquisition agreement, but that does not mean his interest in an acquisition by Berkshire is insignificant.

Good lawyers for Sokol will have good defenses for him. But to me, these facts look bad. We all make mistakes and maybe in the scheme of things, this isn’t high on the list of egregious conduct by corporate officers.

After Watergate we often heard, “It isn’t the offense it is the cover-up.”  There has been no cover up here. But the lesson of Sokol may turn out to be “it isn’t the offense, it is the stonewalling.”

Berkshire and Sokol should admit that a serious error was made here.  If they did that, perhaps all could be forgiven. But senior officers trying to defend front-running a potential deal will ultimately just make things worse.

(Note: the author owns shares of Berkshire Hathaway.)

***

Ronald Barusch spent more than 30 years as an M&A practitioner at Skadden, Arps, Slate, Meagher & Flom LLP before retiring last year. He is no longer affiliated with the firm and the views expressed here are his own.

***