Predictably, the news that former Berkshire-Hathaway executive David Sokol bought stock of Lubrizol before recommending that to Berkshire boss Warren Buffett that Berkshire acquire Lubrizol has prompted a shareholder derivative suit:
Mr. Sokol was widely considered Mr. Buffett’s heir apparent until he resigned abruptly last month after it emerged that he had personally bought $10 million worth of stock in Lubrizol shortly before bringing Lubrizol to Mr. Buffett’s attention. In March, Berskhire announced that it had agreed to purchase Lubrizol for $9 billion — causing its shares to surge and increasing the value of Mr. Sokol’s holding by $3 million.
The shareholder derivative complaint, filed in the Delaware Court of Chancery by the Berkshire shareholder, Mason Kirby, asks the court to disgorge Mr. Sokol’s trading profits in Lubrizol and to award damages because of the damage done to Berkshire’s goodwill. ...
The lawsuit said that Mr. Sokol’s actions violated his duties to Berkshire and impaired the company’s reputation by spawning an S.E.C. inquiry. Moody’s Investors Service and Standard & Poor’s, the two largest credit ratings agencies, also flagged concerns over the incident’s impact on the company, the complaint says.
It's an interesting case. Let's start with the proposition that there is a state law cause of action for insider trading. In Pfeiffer v. Toll, 989 A.2d 683 (Del.Ch. 2010), Vice Chancellor Laster explained that the law in this area rests on the old chestnut Brophy v. Cities Service Co., 70 A.2d 5 (Del.Ch. 1949):
In Brophy, Chancellor Harrington [allowed] a derivative claim brought against the executive secretary of one of the directors of Cities Service Company. 70 A.2d at 7-8. The secretary allegedly knew that Cities Service planned to make open-market purchases that would likely boost its stock price. The secretary purchased shares for his personal account in advance of the corporate repurchase and later sold the shares for a profit after the market price rose. Id. at 7. Chancellor Harrington recognized that “in the absence of special circumstances, corporate officers and directors may purchase and sell its capital stock at will, and without any liability to the corporation.” Id. at 8. He nevertheless held that because the secretary acquired knowledge about the corporation's plans in the course of his employment, i.e. it was confidential corporate information, “the application of general principles would seem to require the conclusion that he cannot use that information for his own personal gain.” Id. In broad language, Chancellor Harrington rejected the argument that the corporation suffered no harm as a result of the secretary's activities. He explained: “In equity, when the breach of a confidential relation by an employee is relied on and an accounting for any resulting profits is sought, loss to the corporation need not be charged in the complaint.” Id. He continued: “Public policy will not permit an employee occupying a position of trust and confidence towards his employer to abuse that relation to his own profit, regardless of whether his employer suffers a loss.” Id.
Brophy is not squarely on point, however, because it involved a case in which the insider traded in the stock of his own corporation.
Here, however, Sokol traded in the stock of a different corporation. Sokol was not a fiduciary of Lubrizol. He owed Lubrizol and its shareholders no duty. The question therefore is whether Sokol's trades breached his fiduciary duties to Berkshire.
In other words, does a Brophy claim sound in cases resembling those covered by the federal misappropriation theory of insider trading as well as in those covered by the classic disclose or abstain theory?
I am unaware of any Delaware precedent holding that a state law cause of action for breach of fiduciary duty lies when the facts fit within the misappropriation framework. It would not be surprising if such a cause of action existed, however. In effect, when an executive misappropriates information and uses it to make a profit by trading in the stock of a potential takeover target the executive has usurped a corporate opportunity.
As I explain in my book, Corporation Law (Concept and Insight Series), a corporate opportunity claim entails a two step inquiry: (1) Was the challenged transaction a corporate opportunity? (2) Did the corporation reject the opportunity, so that the officer may take advantage of it? (Technically, under Delaware law, formal presentment of the opportunity to the board is not required, but it is surely the prudent course of action.)
As to the former issue, it is true that “Delaware courts have recognized a policy that allows officers and directors of corporations to buy and sell shares of that corporation at will so long as they act in good faith. A corporation generally has no interest in its outstanding stock or in dealing in its shares among its stockholders.” Beam ex rel. Martha Stewart Living Omnimedia, Inc. v. Stewart, 833 A.2d 961, 973-74 (Del.Ch.2003), aff'd, 845 A.2d 1040 (Del.2004) (internal citations and quotations omitted). In this case, however, the executive traded in the stock of a different company and one in which his employer might well have an interest in acquiring.
So we would apply the multi-factor test developed in Delaware law: (1) Is the corporation financially able to take the opportunity? (2) Is the opportunity in the corporation’s line of business? (3) Does the corporation have an interest or expectancy in the opportunity? (4) Does an officer or director create a conflict between his self-interest and that of the corporation by taking the opportunity for himself?
Applying that test to the known facts, I would conclude: (1) Yes. (2) Berkshire's a multi-line conglomerate. Most anything is in its line of business. (3) and (4) find positive answers because, as Henry Blodget observed:
"Wait--an investment banker suggested to Sokol in Sokol's capacity as a Berkshire executive that Berkshire should buy Lubrizol--and, before taking the idea to Warren Buffett, Sokol rushed out and bought the stock? How is that kosher? How could Sokol possibly think that making that trade--and risking the appearance of impropriety--will be okay?"
When an investment banker brings you an idea in your capacity as an executive, I think that gives your employer an expectancy in it. In turn, buying stock in the target, which you presumably would later sell to Berkshire (or on the market) at a handsome project creates a clear conflict of interest. Not only are you making a side profit on the deal, which agents are not supposed to do, but you also have an incentive to make sure Berkshire buys Lubrizol.
As to the second prong, recall that Buffett allegedly knew about Sokol's trades when the latter proposed the deal to Buffett. A corporate opportunity claim cannot lie where the corporation has properly rejected the opportunity. Buffett's decision, however, cannot constitute such a rejection. As the Delaware Supreme Court explained in Telxon Corp. v. Meyerson, 802 A.2d 257 (Del.Supr. 2002):
While presentation of a purported corporate opportunity to a board of directors, and the board's refusal thereof, creates a safe harbor for an interested director, that safe harbor does not extend to an opportunity presented only to the corporation's CEO. See Broz v. Cellular Info. Sys., Inc., 673 A.2d 148, 157 (Del.1996). Rejection of a corporate opportunity by the CEO is not a valid substitute for consideration by the full board of directors.
Buffett's subsequent decision to go forward with the deal and the Berkshire board's approval of that decision likewise do not help Sokol. The former is another CEO action, while there is no evidence to date that the board specifically approved Sokol's trades (which should have been done ex ante).
Our friend Francis Pileggi reportedly has opined that:
This suit was inevitable. In my view, Sokol will have a very hard time convincing a court of equity that his actions were consistent with his fiduciary duties based on what has been reported.
If there is a corporate opportunity claim on these facts, it affects the remedy. In Pfeiffer, VC Laster explained that:
Harm to the corporation is generally not measured by insider trading gains or reciprocal losses. ... Disgorgement of insider trading profits (or recovery of reciprocal trading losses) is also not the appropriate measure of damages because insiders who trade on an impersonal market typically are not engaging in the type of self-dealing transaction to which a disgorgement remedy historically applies. ... [T]rading in the market [for the employer's stock] typically does not involve the usurpation of a corporate opportunity, where disgorgement has been the preferred remedy.
In a misappropriation-type case like this one, however, disgorgement would be a proper remedy.