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The Resignation of David Sokol: Mountain or Molehill for Berkshire Hathaway?

The Resignation of David Sokol: Mountain or Molehill for Berkshire Hathaway?

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Published by: Brian Tayan on May 10, 2011
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Topics, Issues, and Controversies in Corporate Governance and Leadership
stanord closer look series 1
The Resignation of David Sokol:Mountain or Molehill for BerkshireHathaway?
Governance at Berkshire hathaway
Berkshire Hathaway has many organizational andgovernance eatures that make it unique.
First,the company operates under a highly decentralizedbusiness model. Executives who run the company’ssubsidiaries—which include a diverse mix o insur-ance, railroads, utilities, wholesalers, retailers, andsuppliers—are aorded considerable autonomy tomake short- and long-term business decisions large-ly without the approval o headquarters. Second,the company operates with low levels o internalcontrols. Managers are given general instructionsto grow their businesses with a ocus on improv-ing competitive position, but they are not requiredto submit strategic plans or operating budgets thatproject how they will achieve results. Finally, allcapital allocation decisions at the parent level—those involving the acquisition o new businessesor the purchase o publicly traded securities—aremade exclusively by Chairman and CEO WarrenBuett, in consultation with Vice Chairman Char-lie Munger. Te company does not employ analyti-cal sta nor does an investment committee review or approve investment decisions.
Te success o this system is predicated on theexpectation that Berkshire Hathaway managersoperate with high levels o integrity. In evaluating management, Buett has said that he looks or “in-tegrity, intelligence, and energy,” with an empha-sis on the ormer.
In making decisions, he asksmanagers to consider what he calls the newspapertest: “How would they eel about any given actioni they knew it was to be written up the next day in their local paper to be read by their amily, by their riends, by their neighbors, written by a smartbut unriendly reporter?”
Perhaps his most amous
By dv . l  B tyap 21, 2011
public statement regarding integrity came in 1991 when he said, “Lose money or the rm and I willbe understanding. Lose a shred o reputation or therm and I will be ruthless.”
Munger describes thegovernance system o Berkshire as “a seamless webo deserved trust,” and credits it as instrumental inhelping the company grow rom a market capital-ization o $10 million in 1965 to $200 billion in2011.
DaviD sokol anD luBrizol
David Sokol came to Berkshire Hathaway throughthe company’s acquisition o MidAmerican Energy in 1999, where he served as CEO.
Over the years,Sokol distinguished himsel through his managerialperormance and, in the process, earned consid-erable praise rom Buett. For example, in 2008,Buett wrote in the annual letter to shareholdersthat Sokol’s results were “unmatched elsewhere inthe utility industry.” In 2009, he described Sokolas an “enormously talented builder and operator.”
 Sokol also distinguished himsel or his contribu-tions to Berkshire beyond his role at MidAmerican.In 2008, he few to China to acilitate a $230 mil-lion investment in Chinese automobile and battery manuacturer BYD. Tat same year, he negotiateda $4.7 billion investment in Constellation Energy.
 Buett also expanded Sokol’s operating respon-sibilities by naming him CEO o Johns Manville(2007) and CEO o NetJets (2009). Tese wereunusual moves in that Berkshire managers rarely assumed responsibility or more than one businessunit. Because o his high prole within the com-pany, many observers speculated that Sokol was theront-runner on a short list o potential successorsto one day replace Warren Buett as CEO.
stanord closer look series 2
The ResignaTion of DaviD sokol: MounTain oR Molehill foR BeRkshiRe haThaway?
For these reasons, it came as a shock to many  when Buett announced the sudden resignationo Sokol in a March 2011 press release. Buettexplained that the decision was made or personalreasons and unrelated to Sokol’s perormance atBerkshire. He noted that “I had not asked or hisresignation, and it came as a surprise to me.” Healso noted that Sokol had discussed stepping downrom his roles at Berkshire twice beore in prioryears and “both times, I and other board memberspersuaded him to stay.”More bizarre were the circumstances surround-ing the announcement. Just two weeks beore So-kol’s resignation, Berkshire had agreed to acquirespecialty chemical company Lubrizol in a deal val-ued at $9.7 billion. Sokol had been instrumental inarranging the discussion between Buett and Lu-brizol CEO James Hambrick that lead to the deal. What was bizarre was that in the same press releasethat Buett announced Sokol’s resignation, he alsodisclosed that, unbeknownst to him at the time, So-kol had personally purchased $10 million in Lubr-izol stock just days beore proposing the acquisitionto Buett.Buett did not condemn Sokol or his actions.Instead, he simply stated that Sokol’s “purchases were made beore he had discussed Lubrizol withme and with no knowledge o how I might react tohis idea…. Furthermore, he knew he would haveno voice in Berkshire’s decision once he suggestedthe idea.” For these reasons, “neither Dave nor I eelhis Lubrizol purchases were in any way unlawul.He has told me that they were not a actor in hisdecision to resign.Buett concluded the press release by returning to the topic o Sokol’s resignation:
Dave’s letter was a total surprise to me, despite the two earlier resignation talks. I had spokenwith him the previous day about various operat-ing matters and received no hint o his intentionto resign. Tis time, however, I did not attempt to talk him out o his decision and accepted his resignation.
He ended by stating, “I have held back nothing in this statement. Tereore, i questioned aboutthis matter in the uture, I will simply reer thequestioner back to this release.”
rue to his word, Buett did not make pub-lic comment on the matter in the weeks that ol-lowed.
I he believed that Sokol’s actions were wrong, he expressed that sentiment more by whathe did not write in the press release than what hedid (see Exhibit 1).Sokol, however, was vocal in deending his ac-tions. In a lengthy interview on CNBC, he said, “Idon’t believe I did anything wrong.” He explainedthat he “never had any authority at Berkshire to in-vest a dollar in stocks.” He also said that he didn’tthink there was “even a ve percent chance” thatBuett would agree to the deal. He concluded, “Iguess, knowing today what I know, what I would dodierently is I just would never have mentioned itto Warren, and just made my own investment andlet it alone.” When asked about the implication o his resignation on Berkshire Hathaway’s successionplan, he stated, “It’s just not a job I would aspireto, because nobody is going to do it as well as War-ren does. And there’s going to be a lot o changethat comes with that. But the reality is Warren’s notgoing anywhere…. I admire enormously what he’sdone. But whoever replaces Warren will not get todo it the way he does it (see Exhibit 2).”
reaction anD implications
Tere was considerable public reaction to the news. Although legal experts expected an SEC investi-gation, there was some doubt whether Sokol’s ac-tions constituted insider trading because he didnot have access to material nonpublic inormationat the time o his purchases.
It was also unclearthat Sokol breached a duciary duty to Berkshire,given that he was not involved in the decision toacquire Lubrizol or the negotiation o purchaseprice.
While some speculated that Sokol mighthave violated Berkshire’s insider trading policy, which prohibits trading in securities that Berkshireis “actively considering” taking a public position in,subsequent reports revealed that Lubrizol was noton the list o restricted securities that Buett circu-lated among management (see Exhibit 3).
 Te criticism o Warren Buett, however, tend-ed to be stronger than the criticism o Sokol. Ex-perts contended that he should have asked or more
stanord closer look series 3
The ResignaTion of DaviD sokol: MounTain oR Molehill foR BeRkshiRe haThaway?
details about Sokol’s holdings in Lubrizol when So-kol rst brought up the matter. Others criticizedBuett or not taking a harder line against Sokol’sactions. According to one commentator:
Even i the SEC concludes that Sokol did noth-ing illegal, the known acts suggest that what Sokol did was wrong.... Instead o condemning Sokol, Bufett gave him a pat on the back on the way out the door…. Bufett missed an opportu-nity to show moral courage, stand up or prin-ciple, reinorce to his employees what he expects  rom them, and, not least o all, to live up to his own public reputation.
 Another commentator was more blunt: “Mr. Bu-ett whitewashed Mr. Sokol’s blazingly obvious eth-ical lapse.”
A third asked, “Why hasn’t Mr. Buettbeen ruthless?”
Some blamed the corporate governance systemo Berkshire Hathaway or having lax internal con-trols. According to one journalist, “the unolding events are raising questions about controls andgovernance at the highest levels o his business.”
  Another questioned whether, “Berkshire needsmore compliance programs and people to managethem.”
A third contended that Berkshire Hatha- way’s board was in part to blame: “Te BerkshireHathaway board is ull o independence issues. It’s just that no one seems to care.She accused theaudit committee o being “passive” with regard toBuett and not “proactively probing management,internal auditors and external auditors to gain in-sight and to make oversight decisions that will holdup, i necessary, in court.”
Finally, Sokol’s resignation highlighted the suc-cession challenges at Berkshire. While Buett hadassured investors in the past that “the directors andI have thought through the succession questioncareully and that we are well prepared,” Sokol’ssudden resignation and in particular the commentshe made regarding the challenges o succeeding Buett were troubling.
why this matters
1. Given its size, Berkshire Hathaway has had a relatively clean record on governance-relatedmatters. Tis track record speaks to the quality o corporate governance and the ability o its“trust-based” model to work. Still, the Sokolmatter raises signicant issues or the board:
How much has the reputation o the rm su-ered rom Sokol’s actions? Is this a fash in thepan, or will there be long-term ramications?
Did Sokol violate the company’s insider trad-ing policy?
Did Sokol’s actions reveal shortcomings in thecompany’s governance system that need to beaddressed? Or were they instead an isolated in-cident?
Should the company add additional controlsto prevent similar events rom recurring? I so, what would be the cost o these controlsin terms o decision making, perormance, andculture?
Do potential successors need to be held to a higher standard o conduct so that their actionsdo not negatively impact the reputation o therm?2. Te Sokol matter also raises questions that aregeneral to all organizations. What events mustoccur beore a company decides that changes tothe overall governance system are required? How signicant must these events be, and how willthe board determine i they constitute a “system-ic ailure” or a “one-time event”? I the board de-termines that changes are required, how shouldit weigh the extent and cost o those changesagainst uture perormance?
For more on the governance o Berkshire Hathaway, see: David F.Larcker and Brian ayan, “Berkshire Hathaway: Te Role o rust inGovernance,” CGRP-02, May 28, 2010. Available at:http://www.gsb.stanord.edu/cldr/research/closer_look.html; and David F.Larcker and Brian ayan, David F. Larcker and Brian ayan, “TeManagement o Berkshire Hathaway,” GSB Case No. CG-16, Jan.01, 2009. Available at:https://gsbapps.stanord.edu/cases/.
As with all publicly traded companies, the acquisition o businessesrequires the approval o the board o directors. Acquisitions involv-ing the issuance o Berkshire shares require the approval o share-holders.
Warren Buett, speech given at University o Florida, October 15,1998. Available at: Intelligent Investor Club,http://www.intelli-gentinvestorclub.com/seminars/warren-buett-mba-talk-at-university-o-lorida-video.
“A Conversation with Warren Buett,” Te Charlie Rose Show, Jul.10, 2006.
“Warren Buett, Chairman o Salomon, esties Beore House Sub-committee,”
PR Newswire 
, Sep. 4, 1991.
Wesco Financial, 2007 Annual Meeting, cited in:

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