You will recall that we have been following the story about former Berkshire-Hathaway executive David Sokol's trading in the shares of potential Berkshire takeover target Lubrizol. Most recently, for example, I argued that Sokol likely violated his fiduciary duty not to usurp corporate opportunities and that the Berkshire board likely could not be held liable for failure to monitor Sokol.
There's been a stunning development. Berkshire's audit committee has released a report (downloadable from here), which makes damning findings about Sokol:
- His purchases of Lubrizol shares while serving as a representative of Berkshire Hathaway in connection with a possible business combination with Lubrizol violated company policies, including Berkshire Hathaway’s Code of Business Conduct and Ethics and its Insider Trading Policies and Procedures.
- His misleadingly incomplete disclosures to Berkshire Hathaway senior management concerning those purchases violated the duty of candor he owed the Company.
- These events should serve as an opportunity to reinforce to all officers, directors and employees of Berkshire Hathaway and its subsidiaries the importance of adhering to those policies and avoiding conduct that comes close to, or strays over, the line of propriety. To that end, we authorize Warren Buffett to release this report.
Nor is the audit committee finished. It reports that the committee will continue to:
- Work with Company management and legal counsel to identify and implement lessons learned from these events, including possible enhancements to its procedures.
- Cooperation with any government investigations relating to this matter, and monitoring any developments that may emerge from them
- Consideration by the Board, or the Audit Committee, or such other committee as the Board may think appropriate, of possible legal action against Mr. Sokol to recover any damage the Company has sustained, or his trading profits, or both, and of whether the Company is obligated to advance Mr. Sokol’s legal fees associated with proceedings in which he is named.
If my analysis was correct, and Sokol did usurp a corporate opportunity--or breached the duty of candor discussed by the audit committee--the shareholder derivative suit filed against Sokol still would have faced very seriously obstacles. In particular, in order for a shareholder to proceed, the shareholder must convince the court that it would have been futile for the shareholder to make demand on the board of directors before filing suit. A demand is simply a request that the board sue. Procedural rules governing derivative suits require that plaintiff either make demand or show to the court that demand should be excused because it would have been futile. In the usual case, plaintiff goes the latter route. Basically that means that before the plaintiff can sue the plainitff must convince the court that the board of directors can't be trusted to make a good faith, independent judgment about whether to sue the defendant or not. This audit committee report just made the Kirby plainitff's job on that score immensely harder. Critically, however, there is no such obstacle to the company bringing suit. So a Berkshire suit against Sokol puts him in serious jeopardy.
The advancement issue is huge too. In the usual case, a company will advance funds to a director or officer defendant so they can pay their legal bills. It looks like Berkshire may try to refuse to do so. Look for Sokol to sue Berkshire to force them to pay.
What's really interesting is that the audit committee largely exonerates Buffett. With respect to the first meeting at which Sokol pitched the Lubrizol deal, the audit committee states that:
It did not cross Mr. Buffett’s mind at that time that Mr. Sokol might have bought Lubrizol shares after seeking through investment bankers to initiate discussions with Lubrizol concerning a possible Berkshire Hathaway acquisition of Lubrizol. Because Mr. Sokol’s comment about owning the shares was in response to Mr. Buffett’s question how Mr. Sokol had come to know the company, it implied that Mr. Sokol had been following Lubrizol as an owner of its shares, and in that way came to think of Lubrizol as a possible Berkshire Hathaway acquisition.
Notice how Buffett is being insulated by throwing Sokol under the bus. The latter is being sacrificed, perhaps deservedly, to protect the former's reputation.
We see this again in the way the audit committee describes the alleged breach of fiduciary duty on Sokol's part:
Under Delaware law, corporate representatives owe their company a duty of loyalty. The duty of loyalty includes a duty of candor, which requires them to disclose to the corporation all material facts concerning corporate decisions, especially decisions from which they might derive a personal benefit. Mr. Sokol’s actions did not satisfy the duty of full disclosure inherent in the Berkshire Hathaway policies and mandated by state law. His remark to Mr. Buffett in January, revealing only that he owned some Lubrizol stock, did not tell Mr. Buffett what he needed to know. In the context of Mr. Buffett’s question how Mr. Sokol came to know Lubrizol, its effect was to mislead: it implied that Mr. Sokol owned the stock before he began considering Lubrizol as an acquisition candidate, when the truth was the reverse. A candid disclosure would have revealed the timing and size of the purchases, and the communications with Citi concerning obtaining a meeting to mutually explore interest in a potential acquisition that had preceded them. Knowledge of those facts would likely have prompted further questions by Mr. Buffett and could have allowed Berkshire Hathaway to evaluate measures that could have been taken to alleviate the problem before negotiations proceeded with Lubrizol.
A Buffett skeptic might ask whether Buffett should have pushed Sokol harder for details rather than allowing himself to be misled. Given Berkshire's supposedly stringent policy against insider trading, it would seem logical to have insisted on knowing the dates Sokol traded at the first meeting.
My initial reaction to the report was that it could be seen as an implied reprimand to Buffett. On closer inspection, however, I see the report as tossing Sokol to the wolves so as to ensure that Saint Warren's halo remains untarnished.
Others, however, apparently do see at least an implied reprimand to Buffett:
“The gloves are off,” said Michael Yoshikami, chief investment strategist at Berkshire shareholder YCMNet Advisors. Buffett’s “response was benevolent, and now the audit committee is coming back and saying, ‘You might be benevolent but, as a protector of the values of the firm, we don’t think benevolence is appropriate.’”