David Sokol's Lubrizol Trades May Not Be Illegal, But They Were Certainly Unethical (BRK.B, LZ)

Yesterday, David Sokol, one of Warren Buffett's top lieutenants at Berkshire Hathaway BRK, abruptly resigned his post. Sokol, who many observers believed was going to be tapped as Buffett's successor, ran Berkshire subsidiaries NetJets and MidAmerican Energy Holdings. In his resignation letter, Sokol outlined his desire to focus on his own investments to "create enduring equity value and hopefully an enterprise which will provide opportunity for my descendents and funding for my philanthropic interests." He further explained on CNBC this morning that he wanted to create a "mini-Berkshire." The situation, however, is not that simple. In Buffett's letter announcing Mr. Sokol's resignation, the Oracle revealed that the MidAmerican Energy chief had bought a roughly $10,000,000 stake in Lubrizol LZ prior to Berkshire Hathaway's acquisition of that company earlier this month. Sokol reaped a roughly $3 million windfall as a result of the deal. Bottom line - right from the get go this did not look good at all. Buffett can not be pleased about having to reveal this yesterday nor about the controversy that it has rightfully caused. First, it is important to outline the facts of the situation, which have been presented by Buffett in his letter and elucidated upon by Mr. Sokol this morning on CNBC. In his letter, Buffett says that Sokol brought the Lubrizol (LZ) idea to him and "mentioned in passing" that he owned some of the stock. Specifically, on December 14, around the time that Sokol was meeting with Citigroup investment bankers about possible acquisitions targets, he purchased 2,300 Lubrizol shares at a limit price of $104, which he subsequently sold on December 21. According to Sokol, this purchase was part of a bigger 50,000 share order, which could not all be filled because LZ shares rose above the $104 limit. He told CNBC's Becky Quick that he subsequently sold the stock a week later because he was "doing some tax planning" and was offsetting short-term losses and gains. He further stated that it seemed that he was not going to be able to get anymore stock below $104 and it wasn't worth his time to manage a 2,300 share LZ position, and therefore he sold the stock. Pursuant to his meeting with Citigroup bankers, Sokol had also been attempting to set up a meeting with Lubrizol CEO James Hambrick, which would be done on behalf of Berkshire Hathaway. The next thing that occurred in this entire sequence was that LZ shares fell back below the $104 level again, at which time Sokol put in an order for 100,000 LZ shares at a limit of $104. He was subsequently filled on around 96,000 shares before the price rose again. These transactions took place on January 5, 6, and 7. On January 14, James Hambrick called Sokol after hearing from the Citi bankers about Sokol's, and potentially Berkshire's, interest in his company. The former Berkshire lieutenant said on CNBC this morning that it was right around this time that he informed Buffett about Lubrizol, and it being a potential acquisition target. Subsequently, Berkshire did end up buying Lubrizol in a very hasty deal for $135 per share or roughly $9 billion. At the very least, there is an "appearance of impropriety" here. Both Sokol and Buffett said that they do not believe anything "unlawful" had taken place. An investigation will likely determine if those assertions will be borne out. What is hard to dispute is that this was unethical and not up to the standards of integrity that Berkshire Hathaway espouses. Essentially, Sokol bought $10 million in stock and then presented the company to his boss to buy, which he subsequently did, netting Sokol $3 million in short order. Sokol has repeatedly said that he had no authority whatsoever with regard to the transaction. Essentially, he is saying that he didn't think there was much chance at all that Buffett would acquire Lubrizol, but he thought it was a good company and he was happy to own the stock for his personal account. Notwithstanding Mr. Sokol's assertions, he knew that there was the potential for a Berkshire buyout, which was not public information. Mr. Sokol was FACILITATING the deal. That was not public information. If it had been, the price of LZ would have been moving substantially higher. Henry Blodget over at Business Insider wrote a great article about this entire fiasco today. He argues that "the appearance of impropriety in a case like this is just as important as whether there was actual impropriety." Blodget continues: "The appearance of impropriety is often all that is needed to trash reputations that companies and executives have spent decades building. And trading in the shares of a company that has been recommended by investment bankers as a possible acquisition candidate of the company you work for instantly creates the appearance of impropriety, no matter what was in your head when you bought or sold the stock." Blodget also points out that we already know that Sokol made, at best, a serious mistake. We know this because Buffett spoke at length about the trades in his letter announcing Sokol's resignation and because Sokol himself spent 20 minutes on TV this morning explaining how he didn't do anything "unlawful." Blodget argues, "No executive in a position as powerful as Sokol's should ever do anything that might lead to a 20-minute interrogation on live TV about whether or not the behavior was against the law--especially when the only positive thing that can come out of the behavior is that the executive makes a bit of money." Exactly. Warren Buffett, while gracious in his praise of Sokol's performance at NetJets and MidAmerican Energy in announcing the executive's resignation, cannot be happy. He should be downright angry with Sokol for blackening Berkshire's eye with his Lubrizol trades. Buffett, however, has defended him, publicly. This could prove to be a mistake. The Berkshire Hathaway brand name was built on integrity, transparency, and fairness. Unfortunately, David Sokol has not lived up to the Berkshire legacy.