Why Warren Buffett Probably Knew What He Was Doing

Much has been said about David Sokol, until recently a top advisor to Warren Buffett, and the possible insider trading case against him for his acquisition of nearly 100,000 shares of Lubrizol in early January. Not long after Mr. Sokol purchased the roughly $10 million of Lubrizol shares, Mr. Sokol in late January suggested to Warren Buffett that Berkshire Hathaway acquire Lubrizol.  

Now come reports that Mr. Sokol told Mr. Buffett of his ownership in "passing," which is causing some to question Mr. Buffett's role.  According to the New York Times Dealbook:

Mr. Sokol suggested a Lubrizol deal to Mr. Buffett on Jan. 14 or 15, according to Mr. Buffett’s letter. At the time, Mr. Sokol made a “passing remark” about his stake in Lubrizol to Mr. Buffett, who did not ask about “the date of his purchase or the extent of his holdings.”

Some analysts and corporate governance experts have criticized Mr. Buffett for not demanding further details.

“This is damaging to Berkshire’s reputation,” said Greggory Warren, a senior stock analyst at research firm Morningstar. “It brings up questions about Berkshire’s internal controls.”

Francine McKenna at Forbes.com also weighs in:  Sokol Knew; How Could Buffett Have Not?  She says:

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. (I have no idea what he was actually thinking, of course. This is just my suspicion.  I can't honestly figure out why he would do this at all, given the risks, so I suppose anything is possible.)

But the question has turned now to what Mr. Buffett knew or should have known.   My read of this is not that Buffett didn't know; it's that he (reasonably) did not care to know. That is, he trusted, without regard to Mr. Sokol's ownership, that Mr. Sokol would not suggest a purchase if Sokol didn't think it was a good idea. Mr. Sokol has a track record with Mr. Buffett that certainly seems to have supported that trust.

Perhaps the assertion that Buffett should care because it raises questions about internal controls is accurate in some instances, but I suspect very few Berkshire investors are worried about Mr. Buffett's ultimate decisionmaking.  And note that Mr. Sokol is no longer employed by Mr. Buffett.  It's not as though the transgression went unnoticed or unaddressed.

Recognizing that there may be some other explanation (and smoking gun e-mail), it seems to me, Mr. Buffett could have acted entirely rationally.  He may simply have trusted one of his top advisors, and didn't feel the need to ask additional questions.  Why? Because history suggested that Mr. Sokol made good decisions for Berkshire, and it was not in Mr. Buffett's interest to follow up on a top advisor like Sokol. This is hardly the sick and drunken Mrs. Pritchard leaving the kids to ransack the company.  In fact, had Mr. Buffett pushed on this, he would have found out about Sokol’s holdings, and he then would have had to deal with it in some other manner; a manner that was likely to cause just as much fallout (or more) for his company.  

Mr. Sokol clearly knows that insider trading rules (or should), and he had every reason to be careful. He chose not be. If this activity was an indication that Mr. Sokol had lost his compass (or business sense), better to let him hang himself than leave Berkshire to clean up the mess and possibly need to explain Sokol’s sudden departure.  Given Mr. Buffett's track record, I'm inclined to think, once again, he knew exactly what he was doing. 

--JPF