Say It Ain’t So, Warren
Q. Is there a question about the right way for publicly traded companies to report financial information?
A. I think the principles are cut and dried. The problem often lies in the interpretation of the principles. The basic principle is that anything, positively or negatively, that occurs inside a company or has a reasonable probability of occurring that could be viewed as impacting the information needs of an investor needs to be made public. You need to make it public to everybody at once, not just a select group, or not just dribble it out – fair, prompt and full disclosure.
—David Sokol, from “Businesses can avoid trouble by telling truth, Sokol says,” by Steve Jordon, Omaha World-Herald, March 17, 2002
A single, big mistake could wipe out a long string of successes.
—Warren Buffett, Chairman’s Letter, Berkshire Hathaway 2006 annual report.
We were about to begin editing the final draft of our soon-to-be-published ebook, “Secrets in Plain Sight: Business and Investing Secrets of Warren Buffett,” when the David Sokol news hit the tape, generating simultaneous emails, phone calls and instant-messages that made it impossible to focus on the task at hand.
David Sokol, as everyone except perhaps a few nomads in the Empty Quarter of the Arabian Peninsula knows, is the Berkshire Hathaway executive who “resigned” suddenly and unexpectedly last month, shocking Wall Street in general and Berkshire Hathaway-watchers in particular.
Why all the shock?
Well, for one thing, Sokol was widely seen as The Successor who would someday take Warren Buffett’s place as CEO of the Berkshire Hathaway family of companies.
That’s a big deal, considering the fact that Warren Buffet is the most successful investor of his times (not hyperbole), and that Berkshire Hathaway, which his investment acumen created, today has more than a quarter-million employees generating close to $150 billion a year in revenues. That’s almost as big as General Electric.
Unlike GE, however, Berkshire’s home office doesn’t occupy a tree-shaded headquarters building in a leafy Connecticut suburb on 68 acres of land with 600,000 square feet of space, dozens of sharp-elbowed Vice Presidents jostling for position, and hundreds of home-office types toiling away.
No, the stingy and bureaucracy-shy Buffett runs Berkshire with the help of just 20 other professionals, in leased space on one floor in downtown Omaha, and he has been publicly discussing what he’s looking for in a successor with the same thoughtful deliberation he uses when discussing stock-picks, the state of the economy, and acquisitions like the recently announced $9.2 billion Lubrizol purchase.
Of course, David Sokol was never actually named Buffett’s successor. Buffett likes the limelight, for one thing; for another, he’ll run Berkshire until he drops dead; and for a third, until that time he can always change his mind about who should succeed him.
Still, so many signs pointed to Sokol over the years that Barron’s once picked him as the heir-apparent in a front-cover story.
Whatever David Sokol’s true position in that horse race, last month’s very public disruption of Buffett’s long-considered plans was surely a shock to the Oracle of Omaha himself, for Buffett thinks not in terms of months and quarters but in terms of years and decades, and he does not often see his well-made plans disrupted—especially not in such an ugly, public way—with the actions and integrity of a Berkshire “All-Star,” as Buffett refers to his managers, suddenly called into question.
This leads to the second, and bigger, reason for the stunned reaction to the Sokol Affair: what Sokol actually did before he “resigned.”
What Sokol did was this: he traded—quite profitably, it appears—in shares of Lubrizol while lobbying Buffett to have Berkshire buy the company. This kind of trading-in-advance-of-someone-with-deeper-pockets-than-you is known as “front-running” on Wall Street, and it is one of the first things even a summer intern learns never—ever—to do.
Sokol, of course, is no summer intern. He’s a veteran, not merely of board rooms but also of the ways of Wall Street. And as the quote at the start of this piece indicates, he is quite familiar with the rules of disclosure for public companies.
Indeed, Sokol’s first experience as president of a public company dates back to 1992, when he took the helm of an obscure but memorable outfit known as JWP (the old Jamaica Water Properties—‘Jamaica’ as in Queens, New York; not as in Bob Marley and the Wailers), where his Chief Financial Officer uncovered questionable accounting practices which Sokol admirably disclosed before submitting his resignation and moving on to the predecessor to MidAmerican Energy, even as JWP was moving on to Chapter 11.
Nor is Sokol some underpaid subaltern for whom the lure of a quick buck might seem too great to pass up.
During his 2000-2010 tenure as Chairman of Berkshire’s MidAmerican Energy group, Sokol earned, by our calculations, total salary of $8.8 million and bonuses of $53.9 million, plus a $26.25 million payout thanks to MidAmerican’s “Incremental Profit Sharing Plan.”
But that was not all David Sokol earned at MidAmerican, for not only did he work at MidAmerican, but Sokol was an owner of MidAmerican.
That’s because Sokol, Walter Scott (a Berkshire board member) and Greg Abel (a longtime MidAmerican executive who replaced Sokol as Chairman of MidAmerican when Sokol “resigned”), invested alongside Berkshire to buy MidAmerican in what was, in many respects, a good old-fashioned $2.2 billion leveraged buyout. (Berkshire owned 75% of MidAmerican when the deal closed; today it owns roughly 90%.)
Now, leveraged buyouts can be risky. On the other hand, they can be highly rewarding, too, as Sokol’s experience shows. All told, from 2000 to 2010, MidAmerican’s filings report he sold a total of $145.5 million in MidAmerican stock or stock-equivalents back to MidAmerican, taking his ownership as of 12/31/10 down to zero.
And Sokol certainly earned his good pay, at least when measured by the gain in MidAmerican’s value over the years. When the Buffett and Sokol/Scott/Abel investor group bought MidAmerican in 2000, they paid $35.05 a share. Five years later, MidAmerican paid an implied $145 per share to buy back stock from Sokol, and by 2009 the valuation had increased to what appears to be $175 per share for Sokol’s remaining shares.
It is no wonder Buffett wrote in his March 30 letter, “Berkshire is far more valuable today” thanks to Sokol. And it is unlikely Buffett begrudges one dime of Sokol’s compensation, for Warren Buffett is, as he likes to say, “A pay-for-performance kind of guy.”
Yet Warren Buffett is also a Wall Street veteran. (He first visited the floor of the New York Stock Exchange when he was 10 years old.) And if anybody in the financial world knows “front-running” when he sees it, it would be Warren Buffett.
This brings us to the third, and biggest, shocker of the Sokol Affair: Warren Buffett’s own handling of it.
The way Buffett handled it was through a press release written in the form of a letter that first praised Sokol’s work for Berkshire and then divulged the stunning news that Sokol had bought, then sold, and then bought shares of Lubrizol during a period of time in which Sokol was encouraging Buffett to buy Lubrizol lock, stock and barrel for Berkshire Hathaway—which Buffett eventually would do.
Buffett summed up the matter, and simultaneously tried to close the door on it, by writing, “Neither Dave nor I feel his Lubrizol purchases were in any way unlawful.”
To understand why this rationalization was so head-scratchingly, stop-the-presses stunning, one must understand that for a quarter-century Warren Buffett has been sending a version of the following memo to his managers (David Sokol, no doubt, included) defining what he calls Berkshire’s “top priority”—and that priority is not money:
This is my biennial letter to reemphasize Berkshire’s top priority….
The priority is that all of us continue to zealously guard Berkshire’s reputation. We can’t be perfect but we can try to be. As I’ve said in these memos for more than 25 years: “We can afford to lose money – even a lot of money. But we can’t afford to lose reputation – even a shred of reputation.” We must continue to measure every act against not only what is legal but also what we would be happy to have written on the front page of a national newspaper in an article written by an unfriendly but intelligent reporter.
Sometimes your associates will say “Everybody else is doing it.” This rationale is almost always a bad one if it is the main justification for a business action. It is totally unacceptable when evaluating a moral decision….
If you see anything whose propriety or legality causes you to hesitate, be sure to give me a call. However, it’s very likely that if a given course of action evokes such hesitation, it’s too close to the line and should be abandoned. There’s plenty of money to be made in the center of the court. If it’s questionable whether some action is close to the line, just assume it is outside and forget it.
As a corollary, let me know promptly if there’s any significant bad news. I can handle bad news but I don’t like to deal with it after it has festered for awhile. A reluctance to face up immediately to bad news is what turned a problem at Salomon from one that could have easily been disposed of into one that almost caused the demise of a firm with 8,000 employees.
Somebody is doing something today at Berkshire that you and I would be unhappy about if we knew of it. That’s inevitable: We now employ more than 250,000 people and the chances of that number getting through the day without any bad behavior occurring is nil. But we can have a huge effect on minimizing such activities by jumping on anything immediately when there is the slightest odor of impropriety….
—Warren E. Buffett, July 26, 2010 (“Memo to Berkshire Hathaway Managers”)
That letter was reprinted in the 2010 annual report that went to all Berkshire shareholders a month before the Sokol Affair exploded, and it needs no elucidation.
After all, the sentiments expressed are exactly what Buffett and his long-time business partner, Charlie Munger, have been telling shareholders at his annual shareholder meetings for decades.
Indeed, Munger has proven to be even more emphatic than Buffett when it comes to what constitutes appropriate conduct—“being an exemplar,” as he likes to say. In a speech at Harvard Law School that still circulates on the internet, Munger once discussed the “isolated example of a little old lady in the See’s Candy Company, one of our subsidiaries, getting into the till”:
“And what does she say? ‘I never did it before, I’ll never do it again. This is going to ruin my life. Please help me.’ …. Well in the history of the See’s Candy Company they always say, ‘I never did it before, and I’m never going to do it again.’ And we cashier them. It would be evil not to, because terrible behavior spreads.”
Interestingly enough, Sokol tried to throw Munger under the proverbial bus in a CNBC interview shortly after the Lubrizol trades came to light by claiming his Lubrizol trades—unreported to Berkshire shareholders until after the fact—were somehow similar to Munger’s longstanding and fully disclosed interest in Chinese car company BYD, in which Berkshire subsequently took a stake. (Munger, appropriately, took no part in Berkshire’s BYD investment process—in fact it was Sokol who went to China to look at the company for Berkshire.)
So what did Munger—the man who spoke so sternly about the ‘little old lady’ at See’s Candies—have to say about Sokol’s Lubrizol trades? He called it “a glitch.”
Warren Buffett was right when, explaining the kind of risk-conscious individual he was looking for to succeed him as the Chief Investment Officer at Berkshire Hathaway, he wrote this line in 2006:
A single, big mistake could wipe out a long string of successes.
At the time, of course, Buffett was referring to financial mistakes—the kind of mistakes that brought down Bear Stearns, and Merrill Lynch, and Fannie Mae, and so many others just a few years later.
That those financial mistakes did not happen at Berkshire Hathaway during the worst financial panic since the Crash of 1929 was entirely due the rational, thoughtful, forward-looking individual at the helm of Berkshire Hathaway. Owing to that foresight, Berkshire Hathaway will continue to thrive under Warren Buffett and beyond thanks to the collection of durable companies that now make up most of Berkshire’s assets, even though it will never be the growth machine it was during his stock-picking years.
But the reputational mistake from that single, awful line, “Neither Dave nor I feel his Lubrizol purchases were in any way unlawful”—a line that, while factually very likely the truth, just wiped out a long string of reputation-building successes—is not so easy to fix.
What you are reading and hearing is from people who believed—thanks to years of careful studying of what Buffett wrote in those annual letters and careful listening to what he said at those annual meetings—that Buffett meant what he said and said what he meant.
And they cannot believe what they have just read.
Jeff Matthews I Am Not Making This Up
© 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.