Liquidity is underrated.  What’s that, you say?  You are earning nothing on your slack cash balances?

Well, welcome to the club.  I am earning nothing there as well.  To earn money on short duration assets in this environment means taking risks, like Pimco does with its ETF with the ticker MINT.

Now, many will offer yield in an environment like this, but at a cost — a long surrender charge.  The long surrender charge hides the transfer of future yield to the present.

I am talking  about more than annuities here.  There are other illiquid investments being proffered today that offer a high “yield,” notably fixed payment streams from insurance companies that are life-contingent.

This is the deal:  There are some annuitants who would rather have a lump sum than a payment stream.  Some firms will buy the payment stream at a price attractive to them.  Then they try to sell the payment stream to an investor at a higher price, thus eliminating their risks on the annuitant prematurely dying.  But how good as an investor would you be at evaluating the risks?

• You do realize that you aren’t buying a bond here — at the end you are not getting your principal back.  So what’s the yield? — it isn’t the annual payment divided by the purchase price because part of each payment is an uncertain partial return of principal.  Do you have your own actuarial consultant to calculate the yield, or are you blindly trusting the seller?
• So you bought out the annuity of another person.  How certain are you that he will live a long time?  Why are you smarter than the seller regarding  his own life?
• Unlike an annuity on your own life, the payment stream may end before or after you die — a classic asset/liability mismatch.
• Is there any possibility that you will not get paid?  Is your contract illegal?  Have you retained your own counsel in the matter, or are you trusting the seller?
• Do the IRS immediate annuity tax rules apply in this situation?
• If you need cash, you will have a hard time selling this — one of the few potential buyers is the friendly guy that sold it to you.  The price spread between selling and buying is huge, and not in your favor.
• You do realize that unlike an annuity on your own life, this is not judgment-proof.

There are all manner of illiquid investments offering yield, but almost all of them lock the investor up for a time.  Think of them as quirky Certificates of Deposit, minus the FDIC.  Particularly egregious are EIAs with long and high surrender charges.  (The agents are paid a lot to sell those.  Never trust an insurance agent who is receiving a large commission to sell you an annuity.  Note: if they won’t disclose the commission, know that it is roughly the size of the initial surrender charge.)

The Cost

Illiquidity means a loss of flexibility.  If your money is tied up during a fall in the market, you will not be able to take advantage of what could be a 30-50% return over one or two years when the market bounces back.  That is a lot to give up for a little bit of yield.  Personally, I prefer flexibility.

The costs of illiquidity are quiet.  The extra yield seems free until there is a need for ready cash, whether to spend or to take advantage of investment bargains.  Personally, I’ll take the loss of income, and keep the flexibility.

Also, avoid unusual investments that are hard to evaluate unless you have expertise greater than that of the seller.  Don’t buy what someone wants to sell you; buy what you have researched and want to buy.

PS — this is another reason why I encourage people avoid “sales loads” in investing.  Mentally, it ties your hands, because you want to recoup the load, or not incur the surrender fee.

Full disclosure: I have one client that owns MINT in his portfolio with me as a cash substitute.

Why did Madoff’s Ponzi scheme last so long?

• He didn’t take that much from it.  If the gross exposure was $60 billion, he took only 1/2% of it — $300 million.
• The growth rate was high enough to attract investors but slow enough to not exhaust cash rapidly.
• The SEC was clueless, with little expertise in quantitative investing, and little basic auditing knowledge where one traces every transaction back to the source, which would have revealed Madoff in an instant.  There were no assets in the accounts.
• He had a reputable business that produced significant profits, and was viewed by many as an industry leader.  Many Europeans, among others, thought he was front-running, and Madoff implicitly encouraged that idea while explicitly denying it.  The idea of “front-running” was a honey pot to distract regulators from the idea that a Ponzi scheme was going on.
• The marketing club.  You are the lucky one who is invited to partake of the gravy train.  Don’t question, just enjoy, and refer friends, maybe we will consider them.
• Feeder funds that were looking for looking for a high-ish return and a low standard deviation found Madoff irresistible.
• “Pus luck.”  There were many times where the scheme almost died, but new cash flows bailed them out.  The term, “pus luck” was unique to my block where I grew up in Brookfield, Wisconsin, and described a situation of undeserved luck.  A brother of my friend, and a friend of my brother always seemed to get the lucky break at unusual moments.  We called it “pus luck,” perhaps in an effort to denigrate his skill in unlikely situations.
• Madoff did not encourage a marketing frenzy.  He tried to keep it low-key.  That kept it below the radar, and allowed it to be marketed to a wide number of people who would not fall for a hard sale.

And so it was for Madoff, skating through unlikely situations where others would have easily died, until it got too big, as all Ponzis do.

We know when it ended, but have no idea on when it started, ’60s, ’70s, ’80s, ’90s…  We really don’t know.   Madoff has revealed a lot, but he has never given a date earlier than 1992.  His associate, DiPascali, suggested it may have started in the late ’80s.  There is some evidence that it may have gone all the way back to the ’60s.

I find DiPascali’s words to be more reasonable than Madoff’s.  The late ’80s were more desperate than the early ’90s.  If you could survive ’87 and ’89, you could likely survive ’92.

Recoveries?

When the Ponzi was revealed, few thought there would be any significant recoveries. But now, net losers from the Madoff Ponzi may get back over 50% of their money.  Why?

• The Picower family gave in, and released their profits from the Madoff scheme.
• Many large financial companies played small roles in the scheme, and they will all probably pay something to make the lawsuits go away.
• Some net losers were involved in money laundering and are unlikely to pop their heads above water to make a claim on their ill-gotten funds.  More for the rest.

In one sense, the slowness of the Madoff Ponzi allowed for a less wasteful class of investors to be bilked.  Including Madoff, these were not the sorts of people that were big spenders as a fraction of their income.  Many investors were buy and hold with Bernie, and indeed, he encouraged that.

So the endgame may not be as bad as expected.  Many will get a large portion of their net investment back.  There will still be regrets, but they will be much reduced.  Good for them.

This is the best book that I have read on the Madoff scandal so far.  Why is it great?

• It is well written.
• There are few if any factual errors in the text.
• She talked with a wide number of people to try to get the full story.
• It’s neutral.  it doesn’t takes positions on a wide number of unanswered questions, and treats what Madoff says with skepticism.
• It takes you through the previously unwritten history of the scam, where the only real doubt is when the scam started — did it start in the early ’90s, late ’80s, or in the ’60s?  We still don’t know.

Now, I have reviewed the books by Markopolous, and the Madoff “victims.” Each tries to make themselves look good.  The author of this book has no dog in the fight, and nothing to prove.

According to this book, Markopolous discredited himself via crude behavior, fear of retaliation, and inability for the SEC to understand simple quantitative investing concepts.  The “victims” did not exercise common prudence.  The biggest red flag over any investment business is no independent custodian, and that was glaring with Madoff.

Yes, they were victims, but they were people who should have known better.  To call oneself a victim here is to call oneself stupid.

There will be another article after this one to explain why the Madoff Ponzi lasted so long, and why the recoveries ended up so much higher than anticipated.

Book Structure

The book starts with the blow-up, and then reverts to telling the life story of Madoff, progressing to the eventual demise, but with many blow-ups averted in the interim.  After that, one-third of the book deals with the aftermath, with the suicides, estrangement, and aggressive lawyers that recover far more than was originally expected.

It’s quite a tale.  I learned a bunch here, and recommend the book to you.

Quibbles

None.

Who would benefit from this book:

If you want to understand how Madoff did it, this is the book to read.  If you want to get a feel for how to avoid con men, this book will also be useful.  Give it to your overly credulous brother-in-law.

If you want to, you can buy it here: The Wizard of Lies: Bernie Madoff and the Death of Trust.

Full disclosure: The publisher asked me if I wanted it.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

During hard economic times, fundraisers for charities get desperate.  Their endowment, if any, has shrunk, former less-well off patrons are less certain of their wage incomes, and are less prone to give; well-off patrons have fewer appreciated assets to offer.

I’ve been getting a spate of such calls recently.  I tell them that I plan my giving each year, and do not give to anyone else, no matter how worthy.  If they want to be considered for next year, send data to me via postal mail.

They never send it, at least not yet.  They only want the money now, not in one year.  If that ‘s the attitude, I don’t want to give.  For years I have wanted to give money to the local volunteer firefighters, and I talked to the chief, and said that I would give, but for my charitable giving trust, I needed their tax ID number.  He said that he would certainly get it to me.  He never did.

We all have different goals for charitable giving.  I’m not telling you where to give.  But analyze how much is spent on the mission in question versus supporting organizational infrastructure.  You want to see a high ratio there.

I only give to organizations where I know those that run the place; sometimes I help out.  But when I trust an organization entirely, my gift goes to  “where most needed.”  Why? Because someone has to support the internals of the organization in order for the mission aspects of the organization to operate.  If you know that the leaders are minimizing costs, acting honestly, and dead-set on pursuing the mission, give without restrictions.

And that brings up another aspect of my giving.  Give big to a few, and nothing to others.  The few that you support you should know well, to the degree that you might not only give money but time.  Charitable giving should be an expression of what you value most in society.  And by focusing, you will only support worthy causes, rather than “a little here and a little there,” where you lack of oversight allows charities to misspend money.

Final notes: by planning your giving, you eliminate those that make emotional appeals, and give rationally to what you would like to see prosper.  At worst, leave a small percentage of total giving for unexpected appeals.   One value of this is that it starves the paid fundraisers that eat up a large part of the money given, who are not a charity at all, and charities should be discouraged from using them.

In the end this will reward the best charities, and starve the worst, which is a win-win.

Given all the brouhaha that exists over redistricting, I thought I would give one simple idea that would free our nation and states from tyranny.   Turn the job over to a computer.  Yes, take the blood and politics out of it, and let computers make fair districts.

How do we do that?  Simple.  You need a computerized map of the political entity being divided, and the locations of the voters.  You give the computer a simple instruction: minimize the length of the internal boundary lines within the political entity, subject to the districts being roughly the same population.

No one can argue that such a method is not fair.  It produces compact, convex districts that look  fair, and no one needs to say a word — just accept the output of the computer.

What would be the benefit?  Districts would be a lot less polar, and seats would not be as safe for incumbents.  And when the new census comes out — boom! Many politicians would find themselves fighting for their lives in new districts that don’t fit them.

This could herald the return of the citizen-lawmaker, because it would be difficult to maintain a seat for a long time.  Perhaps with some help, such as permanently disallowing politicians from being lobbyists, it could make a genuine change in the way our government works.

PS — In my life, I have been approached by others to use my math skills to gerrymander a large state in the US.  I refused (at age 29), though I knew how it could be done.

This book is unusual.  Let me give you my quick view: this is a book written by an Orthodox Jew regarding an unscrupulous Jew who used his abilities to communicate to swindle others in a Ponzi scheme.  This is a surmise, because of all the ill-will toward Jews created after the scandal broke, the author tries to differentiate between one who is nominally/ethnically a Jew, and one who takes the ethical principles of Rabbinic Judaism seriously.

As such, this is really two books.  One on the author’s congregation, friends, and extended family, and the good things that they have done as Orthodox Jews, and a book on how the author concluded earlier than anyone else that Scott Rothstein was a fraud, and probably running a Ponzi scheme.  (Alternatives were money-laundering, drug transport, etc.)

I appreciate the logic that the author brings to the table in the book.  I myself have uncovered a variety of investment scams from life settlements, collateralized stock loans, Nigerian schemes, and penny stock promoters.  The author zeroed in on the lack of data to verify the cash flows, and the unlikelihood of so many cases being handled by one man, Scott Rothstein.

As an aside, always be wary when you meet someone that wants a lot of information, but is averse to sharing information.  Divide-and-control is an excellent way to gain power in an organization.  Fight it by connecting with others.

Once the author came to a firm conclusion that Scott Rothstein was dishonest, he faced the question of where to take the information.  Because Rothstein had used some of his clients’ money to buy favor with state and local officials, he decided to go to the FBI as the most competent interested federal organization.  After less than two months after talking to the FBI, the Scott Rothstein’s organization collapsed from a lack of cash flow, partly due to the efforts of the author to convince potential investors not to invest.

And now Scott Rothstein and more than a dozen of his associates are doing time in jail, because of a $1.4 billion Ponzi.  Not the hugest, but give the author credit, he kept it from becoming bigger.

One final note: the title of the book is delicious, because the author and the felon were miles away in distance, but worlds apart in what they valued.

Quibbles

There are a few misspellings, but nothing major.

I understand why he brings up the good deeds of Orthodox Jews, but to have it occupy so many pages of a book dealing with financial fraud will leave some cold.

Also, I disagree with the way Rabbinic Orthodox Judaism interprets the Law (Torah).  We are not to create a hedge around the Law, as the author states.  We cannot be holier than God.  To add to God’s Law is to take away from God’s Law and substitute Man’s Law in its place.  Far better to understand the Law the way Y’Shua Ha’Mushiach (commonly called Jesus) did, and understand that it applies to our hearts and actions, as best expressed by the Larger Catechism Questions 91-153.

Who would benefit from this book:

Most people would benefit from this book — it will make you aware of financial fraud on two levels: the way that the finances of a fraud don’t make sense, and the outward aspects of the life of one committing fraud.  If you end up more suspicious of those offering opportunities that are too good to be true, that will be worth more to you than the price of the book 100 times over.

If you want to, you can buy it here: Miles Away… Worlds Apart.

Full disclosure: I asked the author for this book, and he sent it to me.  I read and review ~80% of the books sent to me, but I never promise a review, or a  favorable review.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

I have written reviews on two Madoff books, No one Would Listen, and The Club No One Wanted To Join.  In the latter of those book reviews, I argued that the Madoff fraud was detectable in advance, which offended one who was defrauded by Madoff.  Ken Fisher lays the blame at her door; she should have been able to see it coming.

Look, I sympathize with her loss, but there are basic rules that are common sense for any investment where discretion is given to a money manager.  I am such a money manager, but I consider it a benefit to me and my clients that I have no ability to touch their funds.  The third-party custodian takes care of that.

Imagine playing a game — before we enter the game, both teams want to know that the umpires will be neutral.  So it is in investment management — we need neutral custodians to assure fairness between investment advisors and clients.

Ken Fisher manages ten thousand times more money than I do.  But he is aware of the many ways that people get skinned by fraudsters.  The leading way is to get investors to give the investment advisor both discretion and custody over the assets.  That opens the door for unscrupulous advisors to misappropriate assets.

This is critical.  Don’t entrust your assets to an advisor without a neutral third party providing custody.  This is more than normal — it should be expected.

There are four other lesser signs of fraud:

• Returns are too good to be true — volatility that is too low, or returns that are too high.
• Not being able to understand what is going on as the money is invested.
• Being blinded by the trappings of wealth.
• Trusting the opinions of others, rather than doing your own due diligence.

You have to understand that there are no magic bullets, and those who have great past returns should be willing to undergo extra due diligence, because great returns are rare, and need extra due diligence to prove that they are valid.

Beyond that, don’t be greedy or credulous.  Ignore wealth, and do your own due diligence — the book provides a good outline for doing so.  And unless you are so wealthy that you hire someone else  to hire your asset managers, don’t hire any manager whose processes you don’t understand.

These are basic rules that all investors should heed.  Enough said.

Quibbles

None.

Who would benefit from this book:

Most average investors would benefit from this book, because they are the ones who get targeted for fraud — not that all of them will be defrauded, but all of them need the warning, so that they can be prepared against those who defraud.  I wish I had read this when I was 25.

If you want to, you can buy it here: How to Smell a Rat: The Five Signs of Financial Fraud (Fisher Investments Series).

Full disclosure: I asked the publisher for this book, and they sent it to me.  I read and review ~80% of the books sent to me, but I never promise a review, or a  favorable review.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

I would like to start this with the public counterarguments from Sokol’s attorney:

I am profoundly disappointed that the Audit Committee of Berkshire Hathaway would authorize the issuance of its report to the public without the care and decency to ask even a single question of Mr. Sokol. Mr. Sokol had been associated with the Berkshire Hathaway companies for 11 years. During this time, his indefatigable efforts helped create enormous value for the Berkshire shareholders. He deserved better. While I take issue with much of the Committee’s report, I briefly make the following points. If the Audit Committee had asked, it would have learned that:

• Mr. Sokol had been studying Lubrizol for personal investment since the summer of 2010; such investments are specifically allowed by his employment agreement.
• Mr. Buffett was told twice, not once, about Mr. Sokol’s ownership of Lubrizol stock before Mr. Buffett engaged in any discussions with Lubrizol.
• Contrary to the Audit Committee’s statement, Mr. Sokol’s Lubrizol shares were not acquired pursuant to a “100,000 limit order.” Rather, they were purchased as a result of several limit orders, over a period of days, at specified prices, for the day only, in order to acquire the stock at low prices. At that time, Mr. Sokol had no reason to anticipate that Mr. Buffett would have any interest whatsoever in Lubrizol.

I have known Mr. Sokol and have represented his companies in business litigation since the mid 1980s. I know him to be a man of uncommon rectitude and probity. He would not, and did not, trade improperly, nor did he violate any fair reading of the Berkshire Hathaway policies.

Okay, let’s take the three points in order:

1) Yes, Sokol may have looked at Lubrizol prior to December 2010, but he only chose to invest in Lubrizol in December 2010.  Personal investments might be allowed by his employment agreement, but not those where BRK might have an economic interest, at least not without full disclosure to the relevant powers inside BRK.  Remember, though Buffett acts as a sort of King inside BRK, even he is subject to the corporation and the committees set up by the board.

2) And that is relevant to Sokol telling Buffett twice, something that was already known.  Buffett is not the head of compliance.  Sokol needed to give full disclosure to the CFO and the Audit Committee

As the audit committee wrote:

• “All actual and anticipated securities transactions of Berkshire and its subsidiaries that have not been publicly disclosed should be considered material.”
• “Other public companies to which this prohibition is applicable include those that may be involved in a significant transaction with Berkshire. . . .”
• “If a . . . Covered Employee is aware that Berkshire has taken or altered a position in a public company’s securities or that Berkshire is actively considering such action, trading in any securities of such public company ... [trading in the securities] is expressly prohibited prior to the public disclosure by Berkshire of its actions . . . (or until the [employee] becomes aware that Berkshire did not take and is no longer actively considering such action).”

and wrote again:

• “Covered Parties who have access to confidential information are not permitted to use or share that information for stock trading purposes or for any other purpose except the conduct of the Company’s business.”
• “Covered Parties are prohibited from taking for themselves opportunities that are discovered through the use of corporate property, information or position without the consent of the Board of Directors of the Company.”

And further wrote:

All of these internal policies are underscored by the law of Delaware, where Berkshire Hathaway is incorporated. Under Delaware law, corporate representatives owe their company a duty of loyalty. The duty of loyalty includes  a duty of candor, which requires them to disclose to the corporation all material facts concerning corporate decisions, especially decisions from which they might derive a personal benefit. Mr. Sokol’s actions did not satisfy the duty of full disclosure inherent in the Berkshire Hathaway policies and mandated by state law. His remark to Mr. Buffett in January, revealing only that he owned some Lubrizol stock, did not tell Mr. Buffett what he needed to know. In the context of Mr. Buffett’s question how Mr. Sokol came to know Lubrizol, its effect was to mislead: it implied that Mr. Sokol owned the stock before he began considering Lubrizol as an acquisition candidate, when the truth was the reverse. A candid disclosure would have revealed the timing and size of the purchases, and the communications with Citi concerning obtaining a meeting to mutually explore interest in a potential acquisition that had preceded them. Knowledge of those facts would likely have prompted further questions by Mr. Buffett and could have allowed Berkshire Hathaway to evaluate measures that could have been taken to alleviate the problem before negotiations proceeded with Lubrizol.

Mr. Sokol’s answer to Berkshire Hathaway’s CFO, Mr. Hamburg, concerning the investment bankers similarly fell short of the degree of candor required of a corporate fiduciary, and suggests his answer to Mr. Buffett’s earlier inquiry noted above was intended to deceive.

The main idea here, as I have written about before, is that Sokol owed a duty to BRK as an employee.  Could he buy stocks of companies, as specified by his employment agreement?  Sure, but within limits which he violated.  BRK deserved the initial benefits of his work, when the data was intended for BRK and not for Sokol.

3) That the orders were not 100,000 share limit orders is not relevant to the case at hand.  Mr. Sokol, if your attorney is making such bogus arguments, either you have a really bad case, and should compromise, or you need a better attorney.

As I commented to the excellent Colin Barr, in his early piece on the topic:

Well, now we have a court case against BRK and the possibility of BRK proceeding against Sokol.  Both of my tort remedies might happen.

But What About Buffett?

I think Warren Buffett can defuse most of his troubles through a heartfelt apology at his annual meeting.  Something like, “Yes, I blundered.  I should have asked Sokol for details, but I was rushed that day.  I still firmly believe in the ethics that I have promulgated for BRK, but I slipped in not enforcing them as best I could.  I gave him the benefit of the doubt, because he was so valuable to us, and I should not have done that.”  And before that, go to those suing BRK and seek a resolution.  Your reputation would prevail, Warren.

Look, I try to be an ethical guy, but I make mistakes also.  The greater error as to deny guilt/fault when it is obvious to many.  I have confessed fault freely during the times I have blown it, and have ended up stronger for it.  Warren, the same would be true for you.  People will forgive you if you accept your responsibility in the matter.

Remedies

This is not the end of the Audit Committee’s work. Still under way are:

• Work with Company management and legal counsel to identify and implement lessons learned from these events, including possible enhancements to its procedures.
• Cooperation with any government investigations relating to this matter, and monitoring any developments that may emerge from them.
• Consideration by the Board, or the Audit Committee, or such other committee as the Board may think appropriate, of possible legal action against Mr. Sokol to recover any damage the Company has sustained, or his trading profits, or both, and of whether the Company is obligated to advance Mr. Sokol’s legal fees associated with proceedings in which he is named.

They may go after Sokol.  The damages are far greater than the gain of $3 million on the takeover.  As Buffett said he cannot afford to lose any of his firm’s reputation.  Now may Buffett heed his own advice.

Part of being a shareholder is corporate governance.  It is incumbent on us to vote the proxies we receive.  To my left, I have ten or so proxies I will vote tomorrow.

If we don’t vote our  proxies we have no right to complain about corporate governance.  And, for those who own mutual funds, have you told your mutual fund company what you care about?  They may or may not listen to you, but if they hear a decent number saying the same thing, they might take your position, multiplying your opinion by ten or more.

Voting proxies is a matter that helps keep shareholder capitalism morally legitimate.  Without it, corporation managements are tempted to do as they please, which generally leads to worse results for all but management.

And if I might get on the soapbox for a moment, I would like to say that we all as investors should begin to vote down management pay and incentive packages where we can.  Let’s engage in brinkmanship.  They are paid well enough already.  If they don’t get the increase, where will they go?  And, isn’t there a lot of talent in the wings that could replace them?  My view is the best management teams are those that love what they do for the challenge, rather than the money.

Incentives for the rank and file are another matter, and should be approved, unless they are excessive.  Also, ignore the special interests of the loony left who own stock only to affect corporate policy.

That’s all.  I have been traveling and am rather tired.  But vote your proxies!

I am republishing what I added to yesterday’s post, and adding onto it, because many readers would have missed it.

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In the cold light of morning, I have thought of one more issue… why is Buffett so loosey-goosey with things that ought to be mandatory disclosures for avoiding potential conflicts of interest?

Every firm I have worked for, and even now at the current small firm that I run, there were/are mandatory disclosure rules. My promise to clients is that I get the same results they do, win, lose or draw.

Regardless, it highlights a weakness in Buffett’s highly qualitative way of managing his company and managers. You not only have to avoid breaking the law; you have to avoid the appearance of breaking the law, or even the “fairness code,” however defined. And, he has said as much to his managers in his biannual memo to them:

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 about 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. Whenever somebody offers that phrase as a rationale, in effect they are saying that they can’t come up with a good reason. If anyone gives this explanation, tell them to try using it with a reporter or a judge and see how far it gets them.

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.

And Buffett implicitly confirms such a view by accepting Sokol’s resignation, with no hint that he tried to argue him out of it, as he did twice before. Implicitly, Sokol’s unethical behavior led to him leaving Berkshire Hathaway — one can try to dress is up otherwise, but it fails the smell test.

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There are other issues in play here.

1) Sokol received a list of possible takeovers from Citi.  He was acting as an employee of BRK at the time.  As such, BRK should get the first benefit of his insight.  Yes, BRK is an industrial/financial conglomerate, and not a mutual fund.  But the first duty of an employee is to use data given to you for the benefit of the firm, and use it for the benefit of the firm.  Citi was not offering data to David Sokol as a retail client.

I faced similar situations at a fund that I worked for, where I did not make my case well enough for the portfolio manager.  After he did not want to buy my idea, I asked for the freedom to buy it myself.  It was not granted, and I did not buy it.

2) Sokol sent an assistant to hand Buffett the resignation letter; he did not want to face Buffett.  I suspect he knows that he disappointed Warren, and did not want to face him.

3) Buffett comes off high-handed in that he deems his initial letter to be all the data anyone will get on the matter.  I’m sorry, Warren, but the SEC may have a lot to say here — they don’t know that all of the relevant data has been disclosed.  Maybe you don’t either.  Sokol withheld material information from you; might he have withheld even more data from you?

4) Look, give Buffett some credit here — after so many years of doing business and trusting his managers, he has one blowup from a fellow who is temperamentally hotter than most of his managers.  This incident does not characterize Berky, but it does point out a weakness.  If I were talking to Warren, I would say this:

Look, Warren, you can centralize your company now, under your terms, while you are still alive and thinking clearly, or the company will do so after you die, and you will have no influence in the matter.  The failure with Sokol is basic, and you should have admitted fault in not asking him the size of his position, since you have been informal in requiring disclosure of investments from high-ranking employees.  Start analyzing Berkshire now, as an integrated company, and ask what you want centralized, and what you leave to the subsidiaries.

5) Sokol did not follow BRK’s ethics rules:

All directors and executive officers of the Company, and the chief executive officers and chief financial officers of Berkshire Hathaway’s subsidiaries, shall disclose any material transaction or relationship that reasonably could be expected to give rise to such a conflict to the Chairman of the Company’s Audit Committee. No action may be taken with respect to such transaction or party unless and until such action has been approved by the Audit Committee.

and

Covered Parties are prohibited from taking for themselves opportunities that are discovered through the use of corporate property, information or position without the consent of the Board of Directors of the Company. No Covered Party may use corporate property, information or position for improper personal gain and no employee may compete with the Company directly or indirectly. Covered Parties owe a duty to the Company to advance its legitimate interests whenever possible.

Sokol had the idea of Lubrizol as a result of his position at BRK.  That data belonged to BRK, not Sokol, and he should not have used it for personal gain.

6) Is Buffett too trusting?  I would say no, but would add “Trust, but verify.”

7) As for Charlie buying shares of BYD, Charlie was not an employee of BRK, but a director, and as such, has a different standard of duty to BRK.  Sokol was an employee, and as such owed a duty to BRK to use data he received for the benefit of BRK first.

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I intend this as my last comment on Sokol, unless some amazing new data arrives.  Sokol and Buffett both blew it, but in different ways.  Sokol could have:

• Left years ago.  Why wait to pursue a dream when you are already rich?
• Told Buffett the full story voluntarily.  He had a lot of credibility inside Berky, so why not?
• Donated all profits to charity.  (Weak, but mighta worked.)

Buffett could have:

• Asked for the position size.
• Asked him to sell as a condition of the merger.
• Had better more regular disclosure of brokerage accounts from top employees.

What a mess.  Buffett should say more on this matter.  I believe he will be hurt if he says nothing more, without government coercion.