Former Warren Buffett Replacement Candidate David Sokol Turns Activist Investor

Sokol reappears several years after falling out with Buffett

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Apr 25, 2016
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David Sokol, the former executive at Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) rumored as the pick to replace Warren Buffett (Trades, Portfolio), has returned to the investing stage making demands at a bank in which he has a large stake, Middleburg Financial Corp., The Wall Street Journal reported.

Sokol resigned from Berkshire in 2011, after buying shares of Lubrizol days before suggesting to Buffett he buy the company. Sokol, who earned $24 million in 2010, netted about $3 million profit from the stock, Buffett said, calling his actions “inexplicable and inexcusable.”

In a statement a month later, Sokol’s lawyer wrote, “Mr. Sokol had been studying Lubrizol for personal investment since the summer of 2010; such investments are specifically allowed by his employment agreement.”

Sokol has since started a private equity firm, Teton Capital, that invests in “lower-middle-market companies” and partners with company management to add value.

He took a 5% passive stake in publicly traded company Middleburg Financial (MBRG, Financial) in 2008, boosting the position to 14.6% in 2009 as the price slid during the financial crisis. From mid-2009 to the day before Sokol sent a letter to the company at the end of March, the price gained 44%. On that news, the gain more than doubled to 93%.

On March 31, Sokol increased his position to 30.5% of the company. In the activist filing, Sokol disclosed that he sent the bank a letter following a discussion with its leaders urging it to find a buyer based on “the financial performance” and “prevailing market conditions impacting community banks.”

“In the current competitive and regulatory environment, it is essential that banks of our size continue to grow in order to leverage operational and compliance costs across a larger platform,” the letter said. “This is especially true for small local banks such as MBRG. I do not believe MBRG has demonstrated the ability to earn a return on average equity (ROAE) that is adequate to cover its cost of capital.”

The letter cited Middleburg’s ROAE of 6.25% against its cost of capital around 12-15%.

Middleburg Financial Corp. is a Middleburg, Virginia-based bank holding company with a market value of $193.68 million. In 2003, Sokol’s daughter had married the wife’s brother of its president and CEO, Gary Shook, two years before he joined the bank as head of one of its subsidiaries.

For the fourth quarter, Middleburg reported net income of $781,000 and 11 cents per share, down from $1.63 million and 23 cents per share for the fourth quarter of 2014. Excluding $3.0 million impairment charge related to a loan totaling $4.0 million, net income would have been $2.22 million and 31 cents per diluted share.

Middleburg’s ROE for the quarter sank to 2.5% from 5.4% a year earlier, and ROA fell to 0.24% from 0.54%, below the banking industry median.

The bank’s total nonperforming assets increased $25.5 million at year-end 2015 from $19.4 million at year-end 2014. It sold $1.02 million in nonperforming loans in the second quarter of 2015 to try to clean up its balance sheet. The nonperforming loans to total loans increased last year to 2.6% from 1.89% the previous year.

For Tier 1 risk-based capital ratio, Middleburg maintained a 16.3% rate, after increasing the ratio annually since 2011. Basel III capital rules, part of an overhaul of bank capital requirements, will require banks to hold more capital than previously, which will pressure community banks.

Satisfying the new requirements may impede the company’s banking operations, net income or its ability to offer a dividend. Basel III rules went into effect Jan. 1, 2015 and will be phased in through 2019.

Differences of opinion have caused tension between community banks and the Federal Reserve. In 2013, when the regulations were completed, the St. Louis Federal Reserve Bank said in a statement, “Based on our estimates, for the majority of community banking organizations, the final rule will have little impact on their capital level and structure. However, for a minority, some capital will need to accrue prior to final phase-in of the new rule.”

Community bankers have said that the rules will harm some of them, however. In an article, “Basel III Pulls the Rug Out from Community Banks,” Vice President of Capital Policy for the American Bankers Associations wrote, “Regulators should not use international capital rules to compromise the relief provided under Volcker. Why pull the rug out from under a recovering market?”

With the pressures, the iShares U.S. Regional Banks ETF declined 1.4% year to date, compared to the iShares Dow Jones U.S. Financial ETF – that includes financial giants like Wells Fargo (WFC, Financial) and Bank of America (BAC, Financial) – which fell 0.8%.

In a second letter, dated April 20, Sokol said he believed “there is no prospect that MBGR’s own growth initiatives can offset the negative market conditions impacting it and other community banks, including increased competition for customers, costly regulatory compliance and general economic uncertainties.”

Sokol also said he hired lawyers and an investment banking firm to further press the company after it took no discernible action since his previous letter and won't support the re-election of the board's director. Middleburg Financial's annual meeting takes place May 4.

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