Berkshire Hathaway, the Shift on David Sokol, and Berkshire's Exposure under the Securities Laws

Berkshire had its annual meeting over the weekend.  From all reports (including some nice blogging at the WSJ), it seems that Warren Buffett and the company are continuing to distance themselves from David Sokol.  Buffett described the purchases as "inexplicable and inexcusable."  He acknowledged that in his view the company had turned over "very damning evidence" to the Securities and Exchange Commission. 

This is a dramatic shift from the earlier position taken by the company (and Buffett).  There are any number of possible reasons for the shift.  It may in fact be the case that the board learned more about what happened.  It may also be the case that the board, which is being sued for breaching its fiduciary duties with respect to the Sokol purchases, understood that action was a better defense than inaction.

It is, however, also possible that the company realized that it had exposure under the federal securities laws as a result of Sokol's trades.  When an officer engages in insider trading, the company is ordinarily not responsible.  Legislation adopted in 1988, however, changed that in a mild way.  Section 21A of the Exchange Act  provides that a company (the statute says controlling person) can be liable for the insider trading of an employee if reckless in allowing the behavior to occur.

Most if not all public companies avoid the risk of liability by putting in place a policy that prohibits employees from engaging in insider trading.  Berkshire has in place such a policy.   Conventional wisdom has it that this is enough to avoid liability under Section 21A.  As the Commission recently described in a Section 21(a) Report:

• we observe that RSA's trading could have been prevented if RSA had adequate policies and procedures to assure compliance with the federal securities laws. Most of the RSA investment personnel involved in this matter, including its CEO, did not have a clear understanding of the securities law duties and risks implicated when they came into possession of material, nonpublic information. . . . If there had been a reasonable compliance program in place at RSA at the time of the events described in this Report, RSA likely would not have purchased Liberty stock prior to the public announcement of the transaction.

Exchange Act Release No. 57446 (March 6, 2008) (Section 21(a) Report).

But even with a reasonable set of policies and procedures, a company may well be treated as reckeless if they remained unenforced.  In other words, policies are not likely to stop insider trading if they are routinely ignored.

The SEC, according to published reports, is looking into the matter, although Berkshire has not yet been subpoenaed.   While the trades by Sokol would be at the center of any investigation, the potential responsibility of Berkshire wouldn't be far behind.   After all, despite the appearance of possible insider trading, Berkshire had demonstrated little interest in pursuing Sokol under its own insider trading policies. 

Indeed, the statement issued by the company had an exonerating tone.  As the press release stated:

• Dave’s purchases were made before he had discussed Lubrizol with me and with no knowledge of how I might react to his idea. In addition, of course, he did not know what Lubrizol’s reaction would be if I developed an interest.  Furthermore, he knew he would have no voice in Berkshire’s decision once he suggested the idea; it would be up to me and Charlie Munger, subject to ratification by the Berkshire Board of which Dave is not a member.

Buffett went so far as to conclude that "[n]either Dave nor I feel his Lubrizol purchases were in any way unlawful."  

Now, the company is, in the words of Steve Bainbridge, throwing Sokol under the bus.  The board is also, apparently, considering a lawsuit against Sokol for violating company policies (the articles in the press note a possible violation of the company's code of ethics rather than the policy against insider trading). 

Most likely the company will not bring the suit.  To the extent trying to avoid liability under Section 21A, the steps taken by Berkshire (including cooperation with the SEC) are probably enough.  Had the company stuck to the original position and the SEC decided that Sokol engaged in insider trading, the possibility of a charge against Berkshire would have been substantially higher.