Berkshire Hathaway and Why We Have Insider Trading Laws
Finance professor Nejat Seyhun examines Berkshire Hathaway's recent acquisition of Lubrizol Corp.
ANN ARBOR, Mich.—David Sokol of Berkshire Hathaway stunned the markets recently by announcing that he had purchased some $10 million worth of the shares in Lubrizol Corp. at about $100 per share in early January, prior to Berkshire Hathaway's offer to purchase the chemical company in March for $135 a share. He followed the revelation of his two-month, $3 million gain by saying, "I don't believe I did anything wrong." Berkshire Chairman Warren Buffett further fueled the controversy by stating he did not think that Sokol's purchases were "in any way unlawful." Sokol then promptly resigned from the firm.
What is wrong with this picture? Neither Sokol nor Buffett considers there is anything wrong. But there are just too many problems here.
First, Sokol's original purchases in early January would appear to violate Section 10(b)/Rule (10)b-5 and Section 14(e)-3 of the Securities and Exchange Act's anti-fraud statutes that prohibit insiders from purchasing shares when they possess material, nonpublic information in the context of a takeover. These statutes provide for felony penalties for any violations (up to 10 years in prison for each offense and treble damages in fines). The law states that managers in bidder firms cannot simply buy shares for their personal account in a target firm that their employer is considering acquiring. This can be a sure-fire way of profiting from inside information and also one that is rigorously prosecuted.
Sokol's defense is that when he purchased the shares he did not know for sure if Berkshire Hathaway would be interested in going through with the acquisition. This brings up the question of whether a recommendation by Sokol to Buffett and the Berkshire Hathaway board to acquire Lubrizol is material information. It also might depend on the estimate of the likelihood that Sokol thought Buffett would follow his advice. I think this will meet or exceed any reasonable definition of materiality. The proof of materiality is in the following scenario: Most lucky investors in possession of information that Sokol has invested in a company and is recommending it as a takeover would most likely want to acquire the stock and thus, in the case of Lubrizol, increase market price or vaulation of the Lubrizol stock.
This points out the second area of concern. Any investor who discovered Sokol's purchases (including brokers, market-makers, and others) might have piggy-backed on this information leading to the increase in Lubrizol's market price. The result likely would be an increase in the acquisition price that Berkshire Hathaway eventually would pay for Lubrizol (which ended up at $135). This price run-up prior to public announcement of a deal is an added cost to Berkshire Hathaway's shareholders. It is quite possible that some Berkshire shareholders could be unhappy about this and they might want to sue.
Third, as best I can tell, Sokol, at a minimum, might have violated Berkshire Hathaway's ethical code of conduct, which requires disclosure of all transactions that might give rise to a conflict of interest. Certainly, the fact that Sokol now owned (or just bought) $10 million of Lubrizol shares could or might influence whether or not he might recommend this stock to Buffett. It is not necessary that a conflict already has occurred. The point is that such a large purchase could possibly cause conflict and, therefore, it should have been reported, investigated, and resolved prior to continuing the takeover. Apparently, this was not done.
Fourth, Berkshire Hathaway's stock price declined by 2.1 percent on March 31. Some shareholders might see this as another channel by which Sokol's action hurt Berkshire Hathaway's shareholders. The revelation of lax corporate governance or potential violations of the code of ethics might explain the stock price decline and could very well open Berkshire Hathaway to derivative shareholder suits.
Finally, even if Buffett had rejected Sokol's suggestion to purchase Lubrizol, there are still problems. Suppose that Buffett had learned about Sokol's $10 million purchase, and because of his concern about the appearance of a conflict of interest, rejected the takeover suggestion even though Buffett thought it would benefit Berkshire Hathaway shareholders. Such an action would have deprived Berkshire shareholders from engaging in a value-increasing takeover as a result of Sokol's action. This would still have been costly for Berkshire Hathaway shareholders.
Sokol and Berkshire Hathaway easily could have avoided all of this unwanted attention by fully revealing Sokol's position and agreeing to sell back his shares to Berkshire at cost if the company decided to proceed with the takeover. This simple maneuver would have removed any appearance of impropriety, any insider trading allegations, and any potential conflicts-of-interest charges. Unfortunately, neither Sokol nor Buffett did this.
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