Berkshire Hathaway, David Sokol, and Much Ado About Nothing

The alleged scandal surrounding once-presumed Warren Buffett heir apparent David Sokol has quite predictably generated all manner of breathy headlines about a Teflon-coated Berkshire Hathaway suffering a besmirched reputation. As if often the case, the supposed ill deed in no way measures up to the hype.

If the media accounts of the story are true, Sokol, in a routine meeting with Citigroup investment bankers eager to pitch deals to serial acquirer Berkshire Hathaway, was presented with Lubrizol as a potential target. Apparently impressed with the company's prospects, Sokol bought shares on his own. Months later, similarly impressed with Lubrizol, Berkshire bought the company, and Sokol, having previously purchased shares, made $3 million.

That Sokol profited from a subsequent Berkshire transaction is the "scandal", but if the media narrative is true, there's nothing untoward to speak of, and Buffett has said just that. A simple review of what seemingly happened reveals why.

First up is Sokol's purchase. It's impossible to know, but it's fair to suggest that on account of the myriad deal ideas sent Berkshire's way, many in the firm's employ do just as Sokol did. It's been asked if Sokol erred by not immediately making known his stock acquisition, but his purchases should be his own private affair.

Of course assuming Sokol had publicized his transaction, it's fair to suggest that he could have profited sooner based on investors bidding up the share price of a company that had won a top-level Berkshire executive's attention. That he did not is immaterial, and presumably normal considering Berkshire is doubtless full of individuals who regularly speculate on the prospects of companies with their own money.

Some argue that Sokol should have revealed his purchase given Berkshire's outsized role in the market for company acquisitions. This, it could be said is a ridiculous assertion because it presumes that once senior Berkshire executives buy shares in anything, that the firm becomes a Berkshire target. Not knowing the inner workings of a somewhat secretive holding company, the very suggestion is laughable.

Berkshire executives are almost certainly approached by investment bankers with great regularity who pitch numerous deals, and for Sokol to guess with any certainty that Lubrizol would eventually become a Berkshire acquisition quite simply defies common sense. He, or any Berkshire executive for that matter, should be extremely lucky if even a small fraction of their personal stock buys actually become Berkshire-owned and operated companies.

But assuming for a moment that stock buys within the firm did and do lead to acquisitions with any kind of frequency, even then Sokol couldn't be sure of achieving profits on his speculation. To name but two Buffett investments, a stake in U.S. Airways long ago didn't quite work out for the Oracle of Omaha, not to mention the near collapse of Goldman Sachs' shares after he made an investment there in 2008.

Some say that Sokol unfairly gained over the long-term for having shares in a company that Berkshire did buy, but even there there's no story. Instead, Sokol should be cheered by investors inside and outside Berkshire for him having risked his own money in Lubrizol such that he provided both sets of investors with precious market signals as to the company's direction. All economic activity is speculation, and Sokol, whether he made or lost money on the investment, provided the markets with necessary information.

Of course some suggest that Sokol's seniority within Berkshire gave him a privileged perch from which to recommend the company's purchase in a way that he profited from. If we ignore first how immaterial $3 million is to someone of Sokol's stature, it's safe to say yet again that irrespective of seniority, Berkshire acquisitions of companies in which its executives already own shares is surely the exception to the rule. Berkshire is inundated with deal ideas, so there was no way Sokol could know with certainty that his stock buy would eventually be followed by a Berkshire acquisition. And as evidenced by the U.S. Airways and Goldman investments, not every Buffett/Berkshire investment goes up.

But let's assume for a moment that as the presumed heir to Buffett, Sokol enjoyed outsized influence on Berkshire's investment committee such that any alleged endorsement by him of Lubrizol increased the odds of the subsequent purchase. If so, is this something that would in any way anger Berkshire shareholders? Not likely.

To see why we need to ask if Berkshire investors would prefer that the executives overseeing their funds have a little or a lot of skin in the game, and a little or a lot of knowledge of the companies they analyze. Logic says they would prefer that individuals like Sokol be shareholders of acquired companies given the logical presumption that as shareholders, their knowledge of the companies purchased would be that much greater. Indeed, it's said that Sokol had a conflict for already possessing a stake in Lubrizol, but assuming he recommended the firm as an acquisition target, the arguably greater conflict as it applies to Berkshire shareholders would have been him recommending a company in which he had no personal stake.

News accounts point to a looming SEC investigation of the alleged Sokol misdeed, but as is often the case with SEC activity, any sleuthing here will be a waste of time. Sokol provided capital to a company whose prospects he liked, and in doing so, he gave investors inside and outside Berkshire important information that is necessary for markets to function.

Ultimately, it has to be remembered that we live in a world of limited capital, and it's the speculations of individuals like Sokol that aid deployment of it as efficiently as possible. For the SEC to penalize Sokol, Berkshire or both for providing information to the marketplace would not only be unfortunate for the man and the firm, it would also be bad for economic growth utterly reliant on information-infused market signals.