Suppose I took a call from a banker-friend at Citigroup on December 13, 2010, and he informed me that he had just observed other Citi bankers meeting with David Sokol, an executive of Berkshire Hathaway and possible successor to Warren Buffett, the CEO. He discovered Sokol expressed interest in a company called Lubrizol and requested a meeting with the company's president.
Buffett himself made it public that Sokol investigated a Chinese battery and electric car maker, BYD, in which Berkshire made a substantial investment. The shares subsequently soared in value.
I would have no way of knowing for certain that Sokol would bring the opportunity to Warren Buffett. I would have no way of knowing for sure whether Berkshire Hathaway would invest in Lubrizol. But if I bought shares in Lubrizol the next day, I would expect that the Citi banker would be investigated by the SEC for passing along insider information, and I would be investigated for trading based on insider information.*
Yet David Sokol, who bought shares in Lubrizol the day after his meeting with Citi's bankers, told CNBC he did nothing inappropriate. His actions were absolutely inappropriate -- front-running is an offense for which a banker or investment banker would be fired.
"When bankers from Citigroup Inc. met David Sokol late last year to talk about potential transactions, they thought they were dealing with him as a senior executive of Berkshire Hathaway Inc., according to people familiar with the matter."
"It... came as a shock to the Citigroup bankers when they learned Mr. Sokol bought roughly $240,000 of shares of Lubrizol corp. a day after their meeting, sold them, and then purchased $10 million shares about two months before Berkshire's $9 billion deal unveiled March 14... [T]he shares are valued at nearly $13 million now." [It's unclear if Sokol still owns them.]
Excerpt from: "Mixed Signals Marked Sokol Meeting: Bankers Thought Pitch was for Senior Berkshire Executive, Not High-Powered Individual Investor," by Gina Chon and Serena Ng, Wall Street Journal, April 2, 2011.
Berkshire Hathaway has a bigger problem than Sokol's actions. Its reputation has revolved around the lip-service paid by Warren Buffett to a high standard of corporate governance. His actions and attitude to this matter raise serious questions for the future of Berkshire Hathaway. The moral tone set at the top is now being publicly questioned as well as his seeming support of Sokol's actions:
"Neither Dave nor I feel his Lubrizol purchases were in any way unlawful. He has told me that they were not a factor in his decision to resign."
Source: Berkshire Hathaway via Business Wire: ","Warren E. Buffett, CEO of Berkshire Hathaway, Announces the Resignation of David L. Sokol March 30, 2011
Why didn't Buffett ask for Sokol's resignation? Sokol's behavior was unethical, and it may even go beyond that. There may be further inquiry to determine the legality of Sokol's purchases.
During an initial meeting with Sokol about Lubrizol, Buffett wrote that Sokol mentioned he owned shares in the company, but Buffett didn't ask him for further information including details of the timing, price, and number of shares.
Warren Buffett says he plays bridge around 12 hours per week. The first thing one does is engage in an auction in an attempt to determine the value and number of cards in each suit held by one's partner. Yet Buffett states he did not inquire further about a senior Berkshire Hathaway officer's investment in an acquisition candidate.
In isolation, investors might be willing to overlook this as misplaced loyalty on Warren Buffett's part. But a series of issues have surfaced about Berkshire Hathaway's practices. Most recently, the Securities and Exchange Commission wrestled with Berkshire Hathaway's CFO to make the company take a fourth quarter write-down:
"Despite [the Chief Financial Officer's] objection, the company recorded $938 million in impairment charges in the fourth quarter to reflect declines in shares of Swiss Reinsurance Co., U.S. Bankcorp and pharmaceutical firm Sanofi Aventis S.A."
"Berkshire Wrote Down Stocks After SEC Query," by Erik Holm, Wall Street Journal, March 29, 2011.
The SEC and the financial press may not have noticed that Berkshire Hathaway had the last word: "such losses that are included in earnings are offset by a corresponding credit to other comprehensive income."** Note added April 3: As David Merkel and a commenter have noted, there must be this adjustment to avoid double counting; it is a non-issue other than the original point that Berkshire resisted taking the impairments as a charge to net income. Berkshire had the last word when it came to Kraft and Wells Fargo, two other stocks. Wells is of particular interest since its value has long been touted by Warren Buffett, particularly at the 2009 shareholder meeting. Older purchases have gains, but recent purchases have unrealized losses. There may have been reluctance to highlight the latter by taking the write-down, particularly after the controversy over a September 2008 favorable tax rule implemented by Treasury, I.R.S. Notice 2008-83, to facilitate the Wells/Wachovia merger. Only Congress has the authority to do that, and it was repealed in 2009.
Berkshire Hathaway is a conglomerate, and the nature of accounting for conglomerates is opaque and messy. Warren Buffett's reputation has been crucial to Berkshire Hathaway's perceived value. Investors may now challenge their previous perceptions.
* Even if Berkshire Hathaway decided not to invest, and I sold the shares I bought before the general public became aware of the lack of interest, I could avoid a potential loss if the shares went down in value on the news. Martha Stewart allegedly sold shares ahead of bad news after a tip from her stockbroker and avoided a loss of around $50,000. She went to prison for allegedly not coming clean when questioned by authorities.
** Berkshire claimed its favorite holding period is forever, yet it took billions in losses when it sold it's position in Conoco Phillips, so it doesn't necessarily hold forever. Yet it tried to use this argument to avoid taking unrealized losses on the three stocks. On part of its Wells Fargo and Kraft holdings, it won its argument with the SEC and avoided writedowns on unrealized losses (It also had unrealized gains) on parts of those positions. David Merkel ofAleph Blog notes that comprehensive income factors in changes in unrealized capital gains or losses. If Berkshire Hathaway takes a writedown, it reduces net income, but this does not change the result for comprehensive income, because everything is marked to fair value already. Thus one reconciling net income to comprehensive income pre and post the writedown would notice that the adjustment is different by the amount of the writedown, hence the "corresponding credit to comprehensive income." That's the way the math works; nothing wrong with it.
VIDEO: "Backdoor Dealings," First Business Morning News, April 1, 2011.
"Warren Buffett, Stop Using My Credit Card!" - TSF - November 23, 2009
"Warren Buffett and Charlie Munger: Winning the Class War," Huffington Post, September 21, 2010.
Disclosure: I currently hold no position, long or short, in Berkshire Hathaway.