Slippery People: Corporate Governance at Berkshire HathawayBy Francine • Apr 24th, 2011 • Category: Food for Thought, Latest, Pure Content
Warren Buffet announced the sudden resignation of his heir apparent, David Sokol, on March 30, 2011. Berkshire Hathaway shareholders, fundamental style value investors, law professors, and the business media have been talking about it ever since. However, Buffett doesn’t want us to question him further and is not willing to say anything more…
I have held back nothing in this statement. Therefore, if questioned about this matter in the future, I will simply refer the questioner back to this release.
The Berkshire Hathaway Annual Meeting is typically a marathon of openness and transparency. Buffet has been known to stay on stage at the revival-style event, this year scheduled for April 30, for up to eight hours. But Berkshire Hathaway has an Achilles heel. Buffett’s storied forthcoming manner is not going to carry over to this case:
Alice Schroeder, author of “The Snowball: Warren Buffett and the Business of Life”: ORIGINALLY I didn’t think Buffett was going to entertain questions on this subject at the meeting. I think he’ll talk about it for maybe five or ten minutes in a statement at the beginning of the meeting, much of which time will be a recap of what happened. He could then cite litigation as a reason for why he can’t have an open-ended discussion and take questions.
I’ve written several articles about this case because it fascinates me to see an iconic figure stumble. Call it schadenfreude. Or just call it my natural cynicism. Either way, I’m gratified that my first hunch – it’s not a case of insider trading but one of an agent/fiduciary taking advantage of his trusted position to benefit himself first – has been ratified.
On April 4: I wrote, The Gnome of Nebraska: Warren Buffett, Berkshire Hathaway, and Self-Dealing, for Forbes:
When asked by CNBC what he’d learned from the controversy over the transaction, Sokol responded:
“Knowing today what I know, what I would do differently is I just would never have mentioned it to Warren, and just made my own investment and left it alone…”
On April 11, Professor Stephen Bainbridge reconsidered his and others’ idea that this was an “insider trading” case. His reconsideration is based on, reportedly, an email from his co-author Bill Klein.
Professor Bainbridge doesn’t mention that I sent him an email on April 8 in response to his March 30 post discussing the insider trading theory and drawing his attention to my April 4th post at Forbes. I asked him to consider the possibility that Sokol had “usurped a corporate opportunity” and breached his fiduciary duty to Berkshire Hathaway. Bainbridge never responded to me.
Bainbridge does not expand on the agency, fiduciary duty, and usurpation theories until April 20, after the shareholder derivative lawsuit is filed against Sokol and the Berkshire board for breach of fiduciary duty. The suit also asks for disgorgement of Sokol’s gain on his investment of Lubrizol stock.
In the meantime, I wrote quite a few more more posts at Forbes and on this site, including one about the lawsuit.
My posts and links to my opinions were as follows:
April 4: My first post included this quote:
So, what, you might ask, is wrong with Sokol taking a little bit of the action ahead of his typically successful dealmaking for Berkshire Hathaway? After all, as he told CNBC, Charlie Munger did it.
Jonathan R. Macey of Yale, in his 1991 article, Agency Theory and the Criminal Liability of Corporations, tells us:
…[C]orporate actors do not engage in criminal activity to benefit the firms for which they work but to benefit themselves. In some, but not all cases, these activities will benefit the firms for which the corporate actors work. But the basic motivation for the behavior is self-interest.
Professor Macey told me he doesn’t think this is an insider trading issue at all unless Sokol failed to disclose his interests and his trading to Berkshire, according to their policies.
April 5: I posted here at re: The Auditors about my April 4th post at Forbes with some additional information including a link to Sokol’s interview on CNBC:
The insider trading label really didn’t sound right to me. I read the transaction timelines in the New York Times Dealbook and listened to Sokol describe how investment bankers send him “packages” to evaluate all the time. It sounded less to me like inside trading and more like a guy who relished being a “player”.
Granted, the deals he invested in for himself he also, at times, brought to Buffett’s attention. Sometimes Berkshire officially acted on these recommendations. This is what happened with Sokol’s Lubrizol deal.
But what about the ones he didn’t tell them about? And what about the other Berkshire insiders who also used the Berkshire brand and their association with it to take advantage of pitches and opportunities that never made it to their boss’s desks?
According to two law professors – Professor Lymon P.Q. Johnson of Washington & Lee University School of Law and Professor Jonathan R. Macey of Yale Law School – there’s a word for that kind of unethical and actionable behavior:
April 7: My April 4 Forbes post was linked to by Daily Speculator, a blog of Victor Niederhoffer and Laurel Kenner.
April 11: Expanding on the theme of loose corporate governance at Berkshire Hathaway, I discussed independence issues and how significant equity ownership by the board, especially the audit committee, combined with minimal other compensation could lead to disincentives to good corporate governance.
I propose an alternative, in particular for audit committee members, and shoot down the notion that because Berkshire board members are rich and important they are above self-interest, self-dealing, or potentially illegal acts:
What if you paid independent directors a healthy flat fee and forbid them from owning the stock of the companies where they serve? I’d like to see this approach especially for audit committee members. If it were me, my mission would be clear: Do my job to protect the corporation and its shareholders with no equity stake in the outcome.
Given the stature and personal wealth of the Berkshire board members, it may be argued that their direct holdings are not material enough to motivate them to increase share price in an unethical or illegal way. But Berkshire board membership bestows honor and access that is rivaled by few others. As we have seen in the Gupta insider trading case, money is not the sole motivation for betraying the trust of a prestigious board membership.
April 12: Writing at Forbes, I discuss new information about the timeline revealed in a Lubrizol SEC filing:
A new regulatory filing by Lubrizol indicates that David Sokol was aware in December that Lubrizol’s chief executive planned to discuss a possible acquisition with the board — a couple weeks before the top deputy bought shares in the lubricant manufacturer.
CNBC interviewed Omega Advisors’ Leon Cooperman for their Squawk Masters series. Cooperman has this to say about the Sokol-Lubrizol fiasco:
Sokol should have sold the shares before he spoke to Buffett. Buffett wasn’t focused on this. They’ll send a “red border” policy memo around like we used to see at Goldman Sachs reminding everyone of the policy.
April 13: Professor Joshua Fershee writes on the Business Law Professors’ Blog:
Once Sokol had a $10 million stake in Lubrizol, his natural inclination would have been, as traders have told me, to “talk his book” and raise the price Berkshire would pay, not get the best deal for Berkshire. Berkshire agreed to pay a huge premium over the stock’s price in December of 2010 when Sokol first bought shares.
Maybe that’s right, but I suspect that the price only would have become a major concern to Mr. Sokol if the purchase was not going to come at a premium, and that was not going to happen. The bigger risk was that Mr. Sokol would push to close a deal at any price. He is certainly savvy enough to know that if a deal moved forward, it would be at a premium, which would mean a tidy profit for him. The key to Mr. Sokol profiting, then, was a deal closing.
April 20: A summary of the shareholder derivative lawsuit against Sokol and the Berkshire board:
Francis Pileggi of the Delaware Litigation blog gives me a quote for the April 20 Forbes piece. Later that evening he summarizes the Delaware issue and links to the Forbes piece and Professor Bainbridge’s post on April 20 on the lawsuit. This is where Bainbridge mentions for the first time the “usurpation of corporate opportunity” possibility and links to my Forbes piece where he says a there’s reportedly a quote from Pileggi.
I left a comment on Professor Bainbridge’s post, reminding him again of my April 4th Forbes piece:
With regard to to the concept of “usurpation of corporate opportunity”, the lost opportunity for Berkshire is clear to me.
Once Sokol bought the shares, it was in his best interest to make sure Berkshire paid more for Lubrozol, not less. In presenting the opportunity to Buffett, and then supporting its completion, Sokol was “talking his book” as the traders say. That’s stealing a bargain from the shareholders of Berkshire. Berkshire paid a large premium for Lubrizol. How many more times did it happen?
I wrote about the “usurpation of corporate opportunity” theory here on April 4, with quotes from additional legal sources.
On April 22 Kevin LaCroix writes up his thoughts – as a directors and officers liability insurance guru and as a Berkshire Hathaway shareholder and Buffetteer. LaCroix is torn. He’s having a hard time with the idea Buffett took his eye off the ball on this. He’s having an even harder time wrapping his head around the value of a shareholders’ derivative lawsuit for a measly $3 million disgorgement of Sokol’s Lubrizol profits. I left a comment:
I guess I have a hard time understanding why Berkshire Hathaway shareholders or anyone else fails to see the possibility that this was not a one-off situation. Maybe $3 million is not a lot of money to those shareholders or Berkshire. Multiply the potential overpayment Berkshire made for Lubrizol because of Sokol’s conflict of interest with the potential for overpayment for other companies. This usurpation of a corporate opportunity and the profits other officers and directors made when they used their Berkshire connection to similarly “talk their book” and increase the price of their holdings, whether Berkshire ever pursued the target or not, do not belong to them but to Berkshire. If it happened once and was dismissed so cavalierly, I suspect it has happened before.
On April 23, Professor Bainbridge writes again about the question of liability for Berkshire’s board. He tells Kevin LaCroix that he thinks there’s none.
I disagree. And I think there should be.
That feeling is best explained by a quote of mine that ended up in a paper dated April 21 by Stanford University Graduate School of Business Professor David Larcker and his research associate, Brian Tayan.
Larcker and Tayen explain the Berkshire Hathaway corporate governance conundrum:
Berkshire Hathaway has many organizational and governance features that make it unique. First, the company operates under a highly decentralized business model. Executives who run the company’s subsidiaries—which include a diverse mix of insurance, railroads, utilities, wholesalers, retailers, and suppliers—are afforded considerable autonomy to make short- and long-term business decisions largely without the approval of headquarters. Second, the company operates with low levels of internal controls. Managers are given general instructions to grow their businesses with a focus on improving competitive position, but they are not required to submit strategic plans or operating budgets that project how they will achieve results. Finally, all capital allocation decisions at the parent level—those involving the acquisition of new businesses or the purchase of publicly traded securities—are made exclusively by Chairman and CEO Warren Buffett, in consultation with Vice Chairman Charlie Munger. The company does not employ analytical staff nor does an investment committee review or approve investment decisions.
The success of this system is predicated on the expectation that Berkshire Hathaway managers operate with high levels of integrity.
The New York Times DealBook reiterates the Buffett “management” of Berkshire contradiction in a piece dated April 24:
The controversy exposed a paradox: Mr. Buffett may be considered one of the world’s best managers, but he doesn’t actively manage the hundreds of businesses that Berkshire owns.
“Did Sokol’s actions reveal shortcomings in the company’s governance system that need to be addressed?” asked Stanford University’s Graduate School of Business…
The Stanford GSB paper, a step meant to encourage the development of more case studies on the subject, ends with a quote from me:
A third contended that Berkshire Hathaway’s board was in part to blame: “The Berkshire Hathaway board is full of independence issues. It’s just that no one seems to care.” She accused the audit committee of being “passive” with regard to Buffett and not “proactively probing management, internal auditors and external auditors to gain insight and to make oversight decisions that will hold up, if necessary, in court.”
Take it as a preview of topics I plan to explore further, both here and at Forbes. I’m going to the Berkshire Hathaway Annual Meeting this weekend. Those of you who have seen me cover a conference know that my standard practice is to ask questions - pointed ones.
If I get the chance with Buffett, I certainly will.
Postscript: I found this particular comment at the Wall Street Journal unnerving. Are these three journalists going to get favored treatment? Two out of the three will never ask a tough question, I suspect. What about other media there? Does Buffett view these three as wranglers or “stunt” journos, making sure no one else does?
Buffett has started alternating questions at the annual meeting between investors in attendance and the trio of journalists on hand to keep the Q&A on track. Surely one of those folks — Fortune’s Carol Loomis, a longtime Buffett chronicler and buddy; Becky Quick of CNBC; and Andrew Ross Sorkin of the New York Times — will press Buffett on Sokol?
Here’s a great soul version of the Talking Heads “Slippery People” from the Staple Singers. Sounds like something that would have accompanied opening credits of a Sopranos episode.