Wednesday, April 6, 2011
By now, everyone and his brother has had an opinion on the l'affaire Sokol. I've poked around a little and given it some thought. I think there are two issues. First is the corporate opportunity issue. I think that's pretty clear. The second, and more ambiguous issue, is the potential insider trading liability. I have thoughts on that one, but I'm clearly still in the elevator stage of my thinking there.
I found it amusing that in his CNBC "defense" of his trading, Sokol took away from his experience the conclusion that in the future it would be better for managers not to share opportunities with their employers. Uh... no. That's not the right answer. The Lubrizol deal presents a pretty straightforward example of a corporate opportunity. Here's the clearest statement of the doctrine from Broz v Cellular Info. Systems:
The corporate opportunity doctrine, as delineated by [Guth v Loft] and its progeny, holds that a corporate officer or director may not take a business opportunity for his own if: (1) the corporation is financially able to exploit the opportunity; (2) the opportunity is within the corporation's line of business; (3) the corporation has an interest or expectancy in the opportunity; and (4) by taking the opportunity for his own, the corporate fiduciary will thereby be placed in a position inimicable to his duties to the corporation. The Court in Guth also derived a corollary which states that a director or officer may take a corporate opportunity if: (1) the opportunity is presented to the director or officer in his individual and not his corporate capacity; (2) the opportunity is not essential to the corporation; (3) the corporation holds no interest or expectancy in the opportunity; and (4) the director or officer has not wrongfully employed the resources of the corporation in pursuing or exploiting the opportunity.
Now, this doctrine is not a 'check-the-box' approach to corporate opportunities. Rather, directors must consider all of elements as a whole. In any event, Sokol apparently first learns about the Lubrizol in his corporate capacity at a meeting with Citigroup bankers who are pitching potential acquisition targets for Berkshire Hathaway. The bankers say they are "shocked" that Sokol bought shares after their meeting with them. It's hard to imagine too many things that will shock a group of bankers pitching deals, but there you have it. In any event, Berkshire Hathaway is clearly in a financial position to exploit the opportunity to acquire Lubrizol. Berkshire Hathaway is in the business of making acquisitions of promising targets and has an expectation that when such opportunities are presented to its agents that it [Berkshire Hathaway] will have first crack at them. Finally, when Sokol acquired $10 million worth of Lubrizol stock a week before presenting the deal to Buffet, he clearly put his thumb on the scale and put himself in conflict with Berkshire with respect to doing the deal. At the very least, he should have recused himself and not taken the lead with respect to the deal.
I think the case that Sokol, by buying ahead of Berkshire and then pushing the deal on his employer violated his duty of loyalty to the corporate by usurping a corporate opportunity. So what measure of damages is appropriate? Disgorgement of the approximately $3 million of profits he made on his $10 million investment would seem right. He should turn that over to Berkshire on his way out the door.
Now ... on the question of whether Sokol's trading constistutes insider trading, I haven't convinced myself to pull the trigger on that yet. But ... I don't think there is any question that when Citigroup presented a list to Sokol of potential targets for Berkshire that the content of this list was material information. I mean ... would a reasonable investor find it useful to know that of the thousands of companies out there, that Citigroup was pitching twenty or so to Warren Buffet's guys and that a deal might be in the offing? Let me venture a guess that if Rajaratnam knew what Sokol knew, he'd be trading on it and that can't be good for Sokol.
The Deal Professor has some very relevant thoughts on the question of materiality. They're right on point and worth reading.