Will the Berkshire Hathaway Trading Scandal Taint Buffett?

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Warren Buffett testifies before the Financial Crisis Inquiry Commission in 2010 (Shannon Stapleton / Reuters)

Warren Buffett could be the latest Wall Street titan to have his reputation trashed.

On Wednesday, Buffett’s Berkshire Hathaway disclosed that David Sokol, one of the insurance company’s top executives, and until yesterday a possible Buffett successor, purchased $10 million in shares for his personal account of chemicals company Lubrizol just weeks before the company agreed to be acquired by Berkshire. Worse, Sokol was the one pushing Buffett to buy the company even after he had made an investment for his personal account. The trade, which raises questions of whether Sokol violated insider-trading rules, netted Sokol nearly $3 million for his own account, a 30% gain in less than three months — impressive even for someone well acquainted with Buffett and his investment prowess. What’s more, Buffett says he knew that his chief lieutenant had bought Lubrizol shares (and therefore stood to profit if Berkshire bought the company) and went ahead with the transaction anyway. The Securities and Exchange Commission is reportedly looking into the transaction.

Sokol has agreed to resign from Berkshire, though he says the move has nothing to do with possible charges of insider trading. On Thursday, Sokol went on CNBC to say that he did nothing wrong. In announcing the resignation, Buffett, too, said he didn’t believe Sokol had violated the law. But at the very least, Sokol’s trade seems improper. Worse, it is another dent in Buffett’s reputation at a time when he has taken an increasing number of hits. Here’s why:

It’s hard to believe that Buffett thinks Sokol didn’t do anything wrong. Sokol first became interested in Lubrizol after meeting with Citigroup investment bankers who presented him with a list of companies they thought would be good acquisitions for Berkshire and that were likely to be interested in being acquired. Nonpublic information is usually defined as something known by company executives and no one else, like a new product launch, profit numbers before they are released or some major setback, like a drug not being approved (I’m looking at you, Martha). And the Citigroup investment bankers could have been guessing about what companies were interested in being bought. But if they had talked to the CEO of Lubrizol, and he said, “Ya know, I would be interested in an acquisition bid,” and they passed that information along to Sokol and he traded on that, then that pretty clearly qualifies as insider information, even if Berkshire didn’t end up acquiring the company. The fact that Sokol then pushed for Berkshire to do the acquisition only makes the trade worse.

Yet Buffett is saying that Sokol’s resignation has nothing to do with the transaction. This is going to make the incident even more of black eye for Buffett, especially if the SEC ends up pursuing Sokol.

Second, in the acquisition filing, Berkshire said the company and none of its affiliates had a financial stake in Lubrizol. Sokol isn’t a corporate entity, but he is affiliated with the company. And Buffett says he knew that Sokol owned shares when he made the case that the company should be bought. Companies routinely disclose, as they are generally required, when executives or board members own stakes in companies they do business with. The fact that a top Berkshire executive stood to benefit from this transaction seems to be a pertinent piece of information that Berkshire should have told its investors in the filing, and a serious omission on Buffett’s behalf.

Third, this isn’t Buffett’s only recent potential run-in with the SEC. In fact, it is the second one the company has disclosed this week. On Monday, Berkshire said it was forced to write down the value of a number of its investments because of an SEC inquiry. Berkshire had been routinely reporting to shareholders inflated values of its investment positions on the logic that Buffett thought the companies were worth more than what their shares were trading for in the market. And yes, Buffett should think optimistically. He is investing in those companies. But he shouldn’t be able to report those wished-for values to shareholders in the same way I can’t go to the bank and say I think my house is worth twice what anyone would pay for it in order to get a loan.

Buffett has been a big backer of investment bank Goldman Sachs and ratings firm Moody’s, both companies thats actions have raised serious ethics issues, before and after the financial crisis. The common wisdom today is that the Sokol departure might put Buffett a little further away from retiring than he was before the incident. Yet with more ethical lapses like this one, Buffett’s departure might be sooner than people think.

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