Warren Buffett is a called an oracle and a cult hero not just because he's made himself one of the world's richest people, but because he comes across as folksy and, above all, honest.
Now, he's found himself in the unusual position of having to explain a top Berkshire Hathaway executive's questionable behavior.
The situation: A key executive thought to be a potential successor to the 80-year-old Buffett persuaded Buffett to buy a chemicals company that the executive had personally invested in. The executive, David Sokol, saw his investment grow by $3 million, or 29 percent, after Berkshire bought the company, Lubrizol.
Berkshire announced Sokol's resignation late Wednesday.
On Thursday, the company's stock fell 2.1 percent as investors worried whether the incident would tarnish Berkshire's sterling reputation or become a distraction for the company.
Sokol's actions may not have been illegal, experts say, but are still likely to attract the attention of investigators. And for a company that has carefully cultivated a squeaky-clean reputation, it is a rare black mark.
"For a company that prides itself so much on its reputation for integrity, you can't do stuff that doesn't look right," says Meyer Shields, an analyst at Stifel Nicolaus.
Both Buffett and Sokol have said the transaction had nothing to do with Sokol's resignation. But in an unusual two-page letter announcing the resignation, Buffett laid out a timeline of events that suggests that Sokol used his influence in Berkshire to recommend a deal that would benefit him personally.
This was the third time Sokol tried to resign in recent years. The other times Buffett convinced him not to. This time, Buffett didn't even try.
Sokol's sudden resignation raised alarms for investors because Sokol was seen as one of four possible successors to Buffett. While it is unclear if Sokol was indeed a candidate given his earlier resignation attempts, the issue of succession at Berkshire has long been a nagging concern for investors.
The Securities and Exchange Commission declined to comment. Sokol said in an interview with CNBC Thursday morning that he has not been contacted by investigators and that he had done nothing wrong.
Buffett declined Wednesday to answer questions about Sokol's resignation beyond what he said in his statement. And Buffett did not respond to questions Thursday about whether Sokol's actions had hurt Berkshire's reputation.
Lubrizol officials also declined to comment on Sokol's resignation or his stock purchases beyond the information disclosed in filings with regulators. But Lubrizol CEO James Hambrick did send a brief note to employees to reassure them that Sokol's resignation won't jeopardize the deal.
Jacob Frenkel, a former SEC enforcement lawyer now at the firm Shulman Rogers in Rockville, Md., says Sokol's actions likely do not constitute insider trading. Because Berkshire hadn't made an offer to buy Lubrizol at the time Sokol bought shares, it appears Sokol wasn't using significant confidential information — the definition of illegal insider trading.
But Steve Thel, a professor of business law at Fordham Law School said the Supreme Court has found that even if the chance of success of an acquisition was small, the potential impact if it did succeed was big enough to make the information significant.
For now, at least, Frenkel said the issue is mainly a problem of appearance.
For Buffett and Berkshire, appearance means a lot.
Every two years Buffet sends a letter to his managers reminding his managers to guard the firm's reputation "zealously." In his 2010 letter he repeated a favorite saying of his: "We can afford to lose money — even a lot of money. But we can't afford to lose reputation — even a shred of reputation."
In the letter, Buffett tells his manager to look beyond whether something is illegal when making a decision.
Sokol first bought shares in Lubrizol Corp., a maker of specialty chemicals, a day after meeting with a Citigroup investment banker to discuss a list of possible investments that included Lubrizol. Sokol says he does not have the authority to buy stocks for Berkshire and the investment banker presented these companies to him for his personal investment consideration.
Sokol bought 96,000 shares in the company at about $104 per share about a week before he suggested to Buffett that Berkshire buy Lubrizol. Sokol told Buffett that he owned shares in Lubrizol, but he did not tell him when those shares were purchased.
Buffett says he was "unimpressed" by the company, but Sokol had dinner in the following weeks with Lubrizol's CEO and approached Buffett again about buying the company.
It is unclear what new information Sokol gathered, but Buffett changed his mind about the company. On March 14, Berkshire announced it would buy Lubrizol for $9 billion, or $135 per share. The company's shares now trade at $134.
Whether or not his actions were illegal, Sokol pushed a deal to Buffett that would benefit him personally. Berkshire investors, and perhaps investigators, may wonder if Sokol had Berkshire's interest or his own in mind.
Even though Buffett ultimately makes the investment decisions, he had made it clear that he had deep trust in and admiration for Sokol.
In an appearance on CNBC television Thursday morning, Sokol said he had purchased shares in companies and then suggested Berkshire buy them in the past. Buffett has declined, and Sokol no longer holds shares in any of those companies, except for a small bank Sokol says Berkshire would never want to buy.
Some business ethicists questioned the rationale.
"If I make toasters for somebody, I can't take a few toasters home for myself," says Anthony Sabino, a professor of law and business at St. John's University in New York. "If I work in a business that runs on information, like a company that invests in other companies, I can't take that information home and invest my own money."
There is at least some precedent for this approach at Berkshire. In July 2008, Berkshire Vice Chairman Charlie Munger bought a stake in BYD, a Chinese maker of rechargeable batteries and electric cars. Soon after, Munger and Buffett asked Sokol to look at BYD as an investment for Berkshire too. In September, Berkshire paid $230 million for a 10 percent stake in the company.
The value of the stake was $1.18 billion at the end of 2010, according to Buffett's latest letter to shareholders.
Robert Miles, a longtime Berkshire shareholder and author of three books on the company, says if Munger was an owner in BYD before Buffett invested in it, "why not hold Charlie to the same standards?"
Berkshire has suffered a few black eyes in the past. Buffett's 1998 $22.3 billion acquisition of reinsurance General Re, Berkshire's biggest investment at the time, generated huge losses for the company.
In February 2008, four executives of General Re and one executive of insurer American International Group were convicted and sent to prison on charges of conspiracy, securities fraud, mail fraud and making false statements to the SEC. Prosecutors say the executives participated in a scheme in which AIG paid General Re in a secret side agreement to take out reinsurance policies with AIG in 2000 and 2001, propping up AIG's stock price and inflating reserves by $500 million.
Still, analysts say the outsized reputation of Berkshire and Buffett will likely survive. "It's not going to stick to Warren," says Sabino.
There is one major exception to Buffett's culture of openness. Only he and his board know who is on a list of potential CEO successors. That list recently grew to four people, though since Sokol's resignation, it may have been reduced back to three. Not even the people on the list know who they are.
"It's another indication of really how little investors know about what's going on inside Berkshire," Shields said.
The issue of succession at Berkshire has long worried investors because the company's consistently good performance is largely seen as a result of Buffett's ability to find undervalued companies.
"The successor at Berkshire will be chosen like the Pope — only upon news of his death do the cardinals decide who will be the successor," Miles says. "In this case it will be the board."
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