Sunday, July 10, 2011

Munger’s Revenge, Part VI: What Bothers People

“What I think bothers people is that there wasn’t some big sense of outrage or something in the [press] release, and, you know, I plead guilty to that.”
—Warren Buffett, Berkshire Hathaway shareholder meeting, April 30, 2011.

 “The facts were complicated, and we didn’t foresee appropriately the natural reaction.  But I would argue that you don’t want to make important decisions in anger.  You want to display as much ruthlessness as your duty requires, and you do not want to add one single iota because you’re angry.”
—Charlie Munger.

 Thus two longtime business partners summed up their disconcertingly un-Berkshire-like handling of the David Sokol Affair in front of 36,000 Berkshire shareholders in Omaha this spring.
 Of the two, Charlie Munger came closer to answering the question than Warren Buffett, who used the old politician’s trick of phrasing the question that he wanted to answer, rather than the one that was asked.
 While Buffett held nothing back about the Sokol Affair throughout the six-hour Q&A session—fielding every Sokol-related question without a pause or a ‘no comment’—the question that was actually asked was not about Buffett’s lack of “outrage” in the press release.  It was about Buffett’s lack of “ruthlessness”—an adjective lifted straight from his Salomon Brothers Congressional testimony that is played for shareholders before the start of every annual meeting: “Lose money for the firm and I will be understanding/Lose one shred of reputation and I will be ruthless.”
 Letting Sokol resign from Berkshire—a money-saving move, to hear Buffett’s subsequent rationalization at the annual meeting—and repeating, in the press release, Sokol’s assertion that the Lubrizol stock purchases “were not a factor in his decision to resign,” is hardly “ruthless.”
 But what really stunned longtime Berkshire investors from that press release—and we’re not talking about the masses who jumped on the Berkshire bandwagon as Buffett’s celebrity profile rose in recent years and were more inclined to wonder what all the fuss was about with Sokol’s stock purchases and Buffett’s handling of the affair: we’re talking decades-long investors whose names a reader would recognize—was the single sentence in which Buffett excused the entire episode with the kind of defense you’d expect to hear from a Wall Street fat cat, not from “The Oracle of Omaha”:
 “Neither Dave nor I feel his Lubrizol purchases were in any way unlawful.”
 (As one Berkshire regular said, “Dennis Kozlowski didn’t feel he did anything wrong either.  Who cares what the guy feels, and since when did Berkshire Hathaway start doing business based on that standard anyway?”)
 No, Berkshire shareholders were not looking for “some big sense of outrage,” as Buffett put it; they were looking for a straightforward acknowledgement that what happened didn’t pass Buffett’s simple smell test for operating a business:
 “If it’s questionable whether some action is close to the line, just assume it is outside and forget it.  There’s plenty of money to be made in the center of the court.”
 And they would have expected a more ruthless exit strategy for an individual Buffett clearly believed violated Berkshire’s principles than the mere acceptance of that individual's resignation.

 But there’s a second issue raised by the Sokol Affair, and one that has not been addressed by either Buffett or Munger to this day: how do they and the rest of the Berkshire board of directors know that nothing like the Lubrizol purchases ever happened before at Berkshire Hathaway?
 All we’ve been told is that Berkshire’s own law firm, Munger, Tolles & Olson, “worked with the Lubrizol counsel in pulling together what Warren described as Lubrizol’s proxy…” and that was according to Ron Olson, a partner at Munger, Tolles & Olson and a member of Berkshire’s board of directors.
 Leaving aside the obvious question—why a law firm founded by Charlie Munger and which today has a partner who also serves on Berkshire’s board of directors, was in charge of examining the Sokol Affair for the Berkshire board, rather than an outside firm without the obvious and multiple conflicts of interest—David Sokol was involved in plenty of Berkshire deals in the past.  He vetted the BYD investment for Buffett; he came up with the enormously profitable Constellation Energy investment during the financial crisis, and he presumably was involved in the PacifiCorp, Northern Natural Gas and Kern River Transmission acquisitions for MidAmerican.
 So how does Berkshire’s board of directors know that nothing like this occurred previously?  We’re not suggesting anything did occur: but, as a Berkshire shareholder, it seems like a logical question to ask, and if we were on the board, it’s a question to which we’d want the answer.

 And there’s a third issue raised by all this: how close did Berkshire come to naming David Sokol as the eventual replacement for Warren Buffett, and what does it portend for Berkshire shareholders when Buffett is no longer alive?
 One shareholder almost got the answer when he asked, “How can you ensure that there are no more Sokols in the lineup of successional managers that you have?”  But Buffett dismissed the notion that Sokol was indeed the successor-in-waiting, without disclosing what name actually appears in the envelope Buffett keeps in his desk for the day the unthinkable occurs:
 “Yeah, he made an assumption there about Sokol being the next in line, which I’m not sure was warranted….”
 Buffett then added, “That is one of the reasons that I think it’s a good idea if my son, Howard Buffett…be the chairman after I’m not around because you can make a mistake in selecting a CEO.”
 How Howard Buffett will handle that kind of mistake compared to how his father handled David Sokol is not clear.
 What is clear is that, given the high profile David Sokol carried at Berkshire Hathaway, Warren Buffett’s life work may have come uncomfortable close to being run by a guy who saw (and still sees) nothing “close to the line”about doing something (trading stock while  sniffing around potential acquisitions in what the investment bankers surely presumed was his role as a representative of Berkshire Hathaway) that his boss (Warren Buffett) would never, ever, have dreamed a CEO of his would be doing.
 And maybe that’s why attendance at this year’s meeting was down—for the first time in Berkshire history—and why Charlie Munger was unusually talkative at the meeting.
 The fallout from the David Sokol affair may not be over.

To be continued…

Jeff Matthews
Author “Secrets in Plain Sight: Business and Investing Secrets of Warren Buffett”
(eBooks on Investing, 2011)    Available now at

© 2011 NotMakingThisUp, LLC
The content contained in this blog represents only the opinions of Mr. Matthews.   Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations.  This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever.  Also, this blog is not a solicitation of business by Mr. Matthews: all inquiries will be ignored.  The content herein is intended solely for the entertainment of the reader, and the author.


Anonymous said...

Jeff, let me ask the stupid question. I understand the whole issue is based on the core assumption that the front running is a damage for corporation. How is it justified if the corporation makes huge money on the front runner's tip? Isn't it rather the insider trading issue between the front runner himself and the stock market regulator?
Thank you for the great job, by the way. I really appreciate that from across the Atlantic.

Jeff Matthews said...

Not a stupid question, but the issue of whether the corporation makes money from the acquisition (which may not be clear for years) is not part of the equation in determining why front-running isn't (or shouldn't be) done.

Why front-running isn't done is this: front-running (every CFA is taught this--I learned it almost 30 years ago) hurts the acquirer by theoretically raising the cost of the acquisition thanks to the impact of the front-runner's purchases ahead of the transaction announcement.

That's true not just for major corporate transactions, it's true for mutual funds and any investment firm--analysts at Fidelity, for example, can't trade in stocks FIDO might be buying, for precisely that reason.

When front-running becomes "trading on material inside information"--for example, if Sokol had actually known Berkshire was going to bid $135 a share for Lubrizol, and had then bought $10 million worth of stock based on that inside knowledge--is a different matter, and would presumably have transformed the issue from something that's "too close to the line" to something that's illegal, outside the line.

But nothing in what we've heard or has been discussed publicly suggests Sokol acted on material inside information--i.e. knowledge the Berkshire was in fact going to buy Lubrizol at a specific price.


Anonymous said...

Jeff, more infrequent posts on the same old overly-dissected subject which is now over two months old? Are you losing your motivation for maintaining the blog? I miss the old JMINMTU!

Jeff Matthews said...

Me too!

Patience, thanks.


Anonymous said...

Jeff, I second the above motion to drop this piece and return to the old blog. You used to post every day or two with something relevant and insightful. If there is a dramatic conclusion to this Sokol piece, I beg you to get to it quickly and move on. Otherwise I fear you will lose your fan base and your motivation to write. That would be a real shame because this used to be one of the best blogs out there.

Jeff Matthews said...

Understood, and appreciated.

Keep in mind that the handiwork of the most successful investor in the world nearly came to grief this year when his likely successor pulled a stunt that has implications beyond a few million dollars in trading profits. Those implications--for Buffett and for Berkshire and its shareholders--are large, and it seems worth getting it right.

But the fun stuff will resume when the important stuff concludes.