Warren Buffett, David Sokol, and the Lubrizol Affair: Running Ahead and a Failure of Fiduciary Oversight

runningBased on my understanding of the facts as reported in the Wall Street Journal and the New York Times, any experienced Wall Street trader would immediately know how to describe David Sokol’s trading in Lubrizol with the following sentence: “He ran ahead.”

Running ahead is illegal. According to the Farlex Free dictionary on the Web,

Running Ahead is:

“An illegal act in which a broker or other representative, just before filling a large order on behalf of a client, conducts a transaction in the same security on his/her own account. A large order to buy or sell usually affects the price of a security; the broker conducts the transaction hoping to profit on the movement in price after he/she fills the client’s order. This is a form of insider trading, as the broker filling the order knows something about the market’s probable movement that other market participants do not know. It is also known as tape racing.”

In the classic Wall Street case, the sales trader or other person “in-the-know” would see that customer X had, for example, 1 million shares of a not-very-liquid name to buy before the order was widely known, and he knew that once the order was on the desk and people started making their calls, this would create a lift in the stock price.  So the savvy trader, armed with this little tidbit of tactical trading inside information, would slip in his own personal order for 10,000 shares ahead of the customer and trade in and out of the stock around the completion of the client’s order.

The Sokol Variation is definitely unethical if not illegal.  What surprises me even more is that there was a very easy fix to this problem, one which Warren Buffett could have dealt with the instant that he decided to make the bid for the company and became aware that Sokol owned the stock.  Let’s leave aside Sokol’s trading history in the stock, which makes me extremely uncomfortable on a stand-alone basis given its timing and his senior position as an influencer at Berkshire Hathaway.

If you take the position that Sokol did not violate the Berkshire Hathaway stock trading policy, the simple fix would have been for Sokol to sell his personal position to Berkshire Hathaway at the lower of his cost or the market price at the time that Berkshire decided to make a bid for Lubrizol.  In this way, any losses would have been borne entirely by Sokol and any benefit would have flowed entirely to the Berkshire shareholders.  Sokol would have benefited less amply but still in proportion to his own shareholdings in Berkshire.

Why did they not do this and make a simultaneous disclosure of his holdings?  In my view, he should never have acquired the stock in the first place, and, if he did nothing wrong, his personal stock position should still have been transferred to the company at no gain to him as soon as it was discovered that he had bought the Lubrizol stock.  I see no justification for the personal trade and a serious lapse of fiduciary oversight in the corner office.

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