Insider Trading Liability for Sokol? Not Likely

Sorry for the number of posts today, but there's a news item I couldn't resist.

David Sokol, the chairman of several subsidiaries of Berkshire Hathaway, resigned on March 28. Sokol was one of the potential successors to Warren Buffett, Berkshire Hathaway’s legendary leader, so Sokol’s resignation was surprising to say the least. News stories about the resignation are available here (Wall Street Journal) and here (New York Times).

The reports of the resignation include descriptions of stock trades Sokol made in Lubrizol, a company that Berkshire Hathaway eventually purchased for $9 billion. Some have speculated as to whether Sokol engaged in illegal insider trading. Warren Buffett has an unequivocal answer to that question: “Neither Dave [Sokol] nor I feel his Lubrizol purchases were in any way unlawful.” But, according to the Wall Street Journal, “the SEC is reviewing the Berkshire press release and considering whether to launch an investigation.”

I have no personal knowledge of anything that happened. But, if the public report of the facts are correct, I think it's highly unlikely that Sokol has engaged in insider trading in violation of Rule 10b-5.

Here’s a chronology derived from the Berkshire Hathaway news release  :

1. December 14: Sokol purchased 2,300 shares of Lubrizol.
2. December 21: Sokol sold those 2,300 shares.
3. January 5, 6, and 7: Sokol purchased 96,060 shares of Lubrizol, pursuant to a 100,000-share limit order he had placed.
4. Jan. 14 or 15: Sokol for the first time discussed with Warren Buffett the idea of purchasing Lubrizol. Buffett was skeptical.
5. Jan. 24: Buffett sent Sokol a short note indicating his skepticism about acquiring Lubrizol.
6. Jan. 25: Sokol discussed a possible purchase with James Hambrick, the CEO of Lubrizol.
7. Subsequent to Jan. 25, Sokol reported his discussion with Hambrick to Buffett and the Berkshire Hathaway board approved the purchase.

According to the Wall Street Journal, the profit on Sokol’s 96,060 shares would be $3 million.

Larry Ribstein says whether Sokol is liable for insider trading depends on whether Sokol breached a duty to Berkshire Hathaway when he bought the stock. Larry’s right, of course, that liability for insider trading under Rule 10b-5 requires a breach of fiduciary duty. The Supreme Court’s opinions have made that clear since its Chiarella decision in 1980, and subsequent Supreme Court cases—Dirks v. SEC (1983) and U.S. v. O’Hagan (1997)—reaffirm the breach-of-duty requirement.

But there’s a much stronger reason why Sokol is probably not liable.  One is liable for trading on nonpublic information only if that information is material, and Sokol doesn’t appear to have had any material information when he purchased the stock—at least if we accept the Berkshire Hathaway account.

According to Berkshire Hathaway, Sokol had not suggested the Lubrizol acquisition to anyone prior to his purchases.  He approached Buffett a week after his last purchase and the matter did not go to the full board until much later. Thus, the only nonpublic information Sokol could have had at the time of the trades was knowledge that he intended to suggest the Lubrizol acquisition to Buffett.

Was that material? Fortunately, Basic v. Levinson, decided by the United States Supreme Court in 1988, addresses this very question: whether information about a possible acquisition is material. Basic says that one must consider both the probability that the acquisition will occur and the magnitude of the transaction if it does occur.

It’s pretty clear that the magnitude of the Lubrizol transaction, if it did occur, was fairly high: it was a $9 billion deal offering a substantial premium above the pre-deal price of the Lubricol stock.

But the probability at the time Sokol purchased was extraordinarily low. Basic says to consider “indicia of interest in the transaction at the highest corporate levels.” Some of the indicia Basic points to are “board resolutions, instructions to investment bankers, and actual negotiations between the principals or their intermediaries.”

If one accepts the Berkshire Hathaway account, nothing even close to that had happened when Sokol bought his stock.  The Berkshire Hathaway board had not even discussed the Lubrizol deal, much less approved a resolution to negotiate with Lubricol. Sokol himself was not even a director  of Berkshire Hathaway. As far as is known, no one had contacted an investment banker. And, at the time of the trades, there had been no negotiations.  Sokol himself didn't talk to Lubrizol until after the stock purchases. Under Basic standards, the probability was virtually nil.

Basic says to weigh the probability and magnitude together to determine materiality, and the magnitude is high, but magnitude alone certainly can’t be enough if there is absolutely nothing to establish probable corporate interest in the deal. A thought in one employee’s head (unless, perhaps, that employee were Warren Buffett himself) does not make a possible acquisition material.

-Steve Bradford