When my friend and co-author Bill Klein returned from a well-deserved vacation, he brought me not a present but a comment on my earlier posts on the Sokol affair. You'll recall, of course, that:
In a statement on Wednesday announcing the departure, Mr. Buffett said that Mr. Sokol had bought thousands of shares in the company, Lubrizol, a maker of lubricants, two months before Berkshire announced a $9 billion deal for the company. Shares of Lubrizol have risen 27 percent since the deal was announced two weeks ago.
We later learned that:
Investors were shocked to learn this week that David Sokol, a trusted lieutenant to Berkshire Hathaway Chairman Warren Buffett, had bought nearly $10 million worth of stock in Lubrizol just over a week before he suggested to Mr. Buffett that Berkshire should acquire the company. ...
"Dave's purchases were made before he had discussed Lubrizol with me and with no knowledge of how I might react to his idea," Mr. Buffett said in a news release on Wednesday. "Furthermore, he knew he would have no voice in Berkshire's decision once he suggested the idea."
Mr. Buffett said in the news release: "In our first talk about Lubrizol, Dave mentioned that he owned stock in the company. It was a passing remark and I did not ask him about the date of his purchase or the extent of his holdings."
Mr. Buffett told me on Friday that "everything in [the news release] is accurate." All he would add is that "I don't know of anything even remotely material that was omitted from the release."
Mr. Sokol's trading falls under what Stephen Bainbridge, an expert on securities ..., calls "an enormously gray area of the law."
Upon his return, Bill sent along this comment by email:
I just returned and read your post on Sokol and insider trading. I can understand the interest in whether there was a 10b-5 violation and the difficulty with finding one, but I think Sokol did wrong and wonder whether it might make sense to think of Reading v. Regem. Sokol received information about Lubrizol in his capacity as representative of Berkshire, not in his capacity as a prospective private investor. Forget about whether he intended to pitch the company to Buffett. Suppose that based on what he learned he concluded that the company was a dog and he then sold it short. And assume (as seems likely) that Berkshire does not engage in short selling. It seems to me that under Reading v. Regem, which is consistent with my ethical intuitions, that Sokol should not be allowed to keep his profit. One other angle: what would firms making pitches to Berkshire think if they knew that they were dealing with someone who might be looking out for his own private profit as well as the interests of his employer or maybe instead of the interests of his employer? Didn't Sokol impair the reputation of Berkshire among firms seeking a buyer and among investment bankers representing such firms?
I think that's almost certainly correct. The case to which Bill refers, Reading v. Regem, is a U.K. case we excerpted in our Business Associations case book. As I explain in my book, Agency, Partnership & Liabilitiy Companies (Concepts & Insights):
A British soldier stationed in Egypt during World War II fell into bad company—to wit, a smuggler who prevailed upon the sergeant to abuse his position with the military. While in uniform, the sergeant escorted the smuggler’s trucks through the streets of Cairo. By virtue of the sergeant’s presence, the trucks were allowed to pass civilian police checkpoints without being inspected. For these services, the smuggler paid the sergeant some £20,000. The army’s Special Investigation Branch found him out and seized his bank account and cash found in his apartment. Cheekily, the sergeant sued to recover the money.
The court rejected the sergeant’s claim, holding that an agent is required to pay over to the principal—here, His Majesty’s Government—any secret profits made as a result of his misuse of the agency position. The sergeant “[took] advantage of his service and violate[d] his duty of honesty and good faith to make a profit for himself.” Where “the wearing of the King’s uniform and his position as a soldier is the sole cause of his getting the money and he gets it dishonestly, that is an advantage which he is not allowed to keep.”
Although it is hard to see how His Majesty’s Government was injured in this case, as is often true in such cases, the law nevertheless holds that taking secret profits constitutes a breach of duty. Put another way, part of the agent’s duty of loyalty includes a responsibility not to use the agency position—let alone the principal’s property or facilities—for the agent’s own benefit without the principal’s consent.
We believe the same result would hold true on US law. And I agree with Bill that Reading teaches that Sokol would have state agency law problems even if he escapes, as I think he will, inside treading liability.