Berkshire, Lubrizol, Sokol, and Insider Trading/MNPI – or Not

We’re back again with another edition of “Is this insider trading?”  I’ve addressed the topic of what constitutes illegal insider trading based on material nonpublic information a handful of times on this blog previously.  Today we have another case to discuss.  Calling all legal eagles – please keep your responses as simple as possible.

Quick summary:  David Sokol, an influential person (CEO, Chairman) at multiple Berkshire Hathaway subsidiaries and possible heir apparent to Warren Buffet’s CEO throne, resigned.  Part of the back story is that Sokol bought shares in Lubrizol ($LZ) prior to Berkshire Hathaway making a bid for the company, although Warren Buffet says in a press release that Sokol claims those purchases had no impact on his decision to resign.

As relevant evidence, I point you towards

1) The Lubrizol proxy statement, especially page 18 (more on this shortly)

2) Warren Buffet’s Berkshire Hathaway press release on Sokol’s resignation

I am focused on the following, first from the proxy statement:

David L. Sokol is the Chairman, President and Chief Executive Officer of NetJets and the Chairman of MidAmerican Energy Holdings Company, two subsidiaries of Berkshire Hathaway. From time to time, Mr. Sokol meets with various investment banking firms, including Citi, to discuss capital-raising and transaction ideas. During the Fall of 2010, in the course of general discussions between Mr. Sokol and Citi, Mr. Sokol requested more information regarding possible transactions in several industries, including the chemical industry. Using publicly available information, Citi generated a list and descriptions of 18 companies, including Lubrizol, in the chemical industry.

On December 13, 2010, Mr. Sokol and Citi met to discuss the list of companies. During the course of the meeting, Mr. Sokol said that the only company on Citi’s list that he found interesting was Lubrizol. When Mr. Sokol learned from Citi’s representatives that Citi had an investment banking relationship with Lubrizol and its Chairman, President and Chief Executive Officer, Mr. James L. Hambrick, he asked one of the Citi representatives to inform Mr. Hambrick that he was interested in speaking with him and discussing Berkshire Hathaway and Lubrizol, if Mr. Hambrick were available. Mr. Sokol also advised Citi that Berkshire Hathaway does not engage in hostile transactions, and that Mr. Hambrick should understand that if they met and nothing came of the meeting, their meeting would remain confidential. Thereafter, Citi made Lubrizol aware of these discussions, as more fully described below.

On December 14, 2010, the Board convened a regularly scheduled meeting and discussed a number of matters, including the status of Lubrizol’s investigation and evaluation of a number of opportunities for Lubrizol to make acquisitions.

On December 17, 2010, Citi called Mr. Hambrick and relayed the substance of the conversation between Citi and Mr. Sokol on December 13, 2010. Mr. Hambrick indicated that he would inform the Board of Berkshire Hathaway’s possible interest.

On January 6, 2011, the Board convened a special meeting. During the course of the special meeting, Mr. Hambrick outlined Berkshire Hathaway’s possible interest as he understood it from his conversation with Citi. The Board engaged in an extensive and thorough discussion about Berkshire Hathaway’s possible interest. The Board determined that it needed to retain outside legal counsel and financial advisors to assist it in connection with any response to Mr. Sokol, including the process that the Board should undertake in connection with its review of Berkshire Hathaway’s possible interest in acquiring Lubrizol. The Board decided to engage Jones Day and Evercore to assist it.

later:

On January 14, 2011, Mr. Sokol and Mr. Hambrick had a telephone conference during which they generally discussed the corporate cultures and philosophies of both Berkshire Hathaway and Lubrizol, and arranged to have an in person meeting on January 25, 2011.

Note the dates, because we get the information about Sokols’ purchases of LZ stock from Buffett’s press release:

“Finally, Dave brought the idea for purchasing Lubrizol to me on either January 14 or 15. Initially, I was unimpressed, but after his report of a January 25 talk with its CEO, James Hambrick, I quickly warmed to the idea. Though the offer to purchase was entirely my decision, supported by Berkshire’s Board on March 13, it would not have occurred without Dave’s early efforts.

That brings us to our second set of facts. 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.

Shortly before I left for Asia on March 19, I learned that Dave first purchased 2,300 shares of Lubrizol on December 14, which he then sold on December 21. Subsequently, on January 5, 6 and 7, he bought 96,060 shares pursuant to a 100,000-share order he had placed with a $104 per share limit price.

Dave’s purchases were made before he had discussed Lubrizol with me and with no knowledge of how I might react to his idea. In addition, of course, he did not know what Lubrizol’s reaction would be if I developed an interest. Furthermore, he knew he would have no voice in Berkshire’s decision once he suggested the idea; it would be up to me and Charlie Munger, subject to ratification by the Berkshire Board of which Dave is not a member.

As late as January 24, I sent Dave a short note indicating my skepticism about making an offer for Lubrizol and my preference for another substantial acquisition for which MidAmerican had made a bid. Only after Dave reported on the January 25 dinner conversation with James Hambrick did I get interested in the acquisition of Lubrizol.

Neither Dave nor I feel his Lubrizol purchases were in any way unlawful.”

Now, the timeline is important.   I see the story as follows:

On December 13th, Sokol met with Citigroup bankers to talk about M&A ideas.  Citi gave him a list, derived from their research, all from public information,  and he liked one name – LZ.  Sokol asked Citi to inform LZ that he’d be interested in talking with them.  Sokol was not, according to Warren Buffett, in any position to make decisions on behalf of Berkshire Hathaway – he was just researching ideas.   On December 17th. Citi made LZ’s CEO, Mr. Hambrick, aware of Sokol’s request, and Hambrick said that he’d inform his Board of Directors.  In the meantime, Sokol purchased shares of LZ on January 5,6,7 2011 (I’m going to ignore the small lot of shares that he bought on Dec 14th and then sold on Dec 21st).  LZ’s board met on January 6th, discussed the possibility of BRK interest in LZ, and retained outside council and advisors.   On January 14th, Sokol and Hambrick had a phone conversation about corporate cultures at the two firms and agreed to have an in person meeting.

So, my questions and answers are thus (keeping in mind the standard I AM NOT A LAWYER disclaimer):

1) Is Sokol guilty of trading on material non-public information? If so, what was the MNPI?

(my answer: no: unless LZ called him and told him that they were having a board meeting about his potential interest prior to his purchase of the shares.  I don’t thing that Sokol telling Citi that he’d be interested in speaking with LZ’s CEO can be MNPI.  After all, what if he’d bought the shares in his own account BEFORE telling Citi of his interest?  Sokol’s interest is something that’s in his own brain – he already knows it even if he hasn’t discussed it with Citi yet.  He can’t un-know it.   I think that the material information is Lubrizol’s reaction – not Sokol’s interest.  An analogy:  think of two potentially star crossed lovers: Young Johnny wanting to ask Jane out on a date.  The important information isn’t when Johnny asks Jane’s friend Sandy to tell Jane that he would like to take her out on a date – the important information is Jane’s reply – does she say “yes” or “no” ?  Ok – I’m getting a little abstract here, but this is an essential point.  Johnny is Sokol, Sandy is Citi, and Jane is Lubrizol. Now you know.)

2) If Sokol was guilty of trading on MNPI, at what point did Sokol become ineligible to trade LZ in his personal account?

(my answer:  The key date would be Jan 14th – when he had the conversation with Hambrick indicating that LZ was potentially interested.  Since he bought his shares before that, I don’t think it’s trading on MNPI. As I noted in my answer to question 1, I don’t see how the “dividing line” can come earlier, as Sokol always knows what his own intentions are – yes, I understand this is getting weirdly metaphysical.  At Lubrizol’s Jan 6th board meeting, the proxy notes: “The Board determined that it needed to retain outside legal counsel and financial advisors to assist it in connection with any response to Mr. Sokol” which implies that they had NOT yet given any reply to Sokol. I believe that any response from LZ to Sokol could certainly constitute MNPI, yet he had received none as of yet, which was the time he was buying the stock.)

3) Buffett seems to be trying to say that Sokol did not violate any duty he may have had to Berkshire:

Dave’s purchases were made before he had discussed Lubrizol with me and with no knowledge of how I might react to his idea. In addition, of course, he did not know what Lubrizol’s reaction would be if I developed an interest. Furthermore, he knew he would have no voice in Berkshire’s decision once he suggested the idea; it would be up to me and Charlie Munger, subject to ratification by the Berkshire Board of which Dave is not a member.

Is that a decision that Buffett can even make? Ie, can he absolve Sokol of wrongdoing, or is it up to The Law to do so?  Stated differently, what if Berkshire has no written policy in place regarding personal account trading for persons of interest such as Sokol?

(my answer: no – I doubt that Buffett can “pardon” Sokol.  However, I don’t think that Sokol violated any duty he had.  He seems guilty of “talking his book” but it’s clear that Buffett was the one making the decisions, with the help of Berkshire’s board, of which Sokol was not a member.)

EDIT: I had another epiphany this morning:

4) Can the same piece of information be illegal to trade on depending on who trades on it?  In this case, I believe that the piece of information “David Sokol would like to talk to Lubrizol” is ok for Sokol to trade on, and yet, it seems like it would be clearly wrong if the Citi salesman that Sokol talked to had traded on this same information!

EDIT II: Here’s the video of Sokol from this morning on CNBC:



Have at it, and try to keep it simple, although I know I asked a bunch of nested questions here…

-KD

 

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