Inside The Mind of An Inside Trader

No Big 4 audit firms or their partners have been named in the insider trading scandal surrounding the now-defunct hedge fund Galleon Management. But the SEC has accused one of the most prominent businessmen ever implicated in such crimes, Rajat Gupta, a former McKinsey & Company Global Managing Director.

Mark O’Connor, CEO of Monadnock Research, put together a research note for his subscribers that gives us the details of the accusations. He also provides new insight into why a guy like Gupta may have committed these alleged crimes.

Gupta is alleged to have tipped Galleon’s Rajaratnam, a friend and business associate, providing him with confidential information learned during board calls and in other aspects of his duties on the Goldman and P&G boards. Gupta reportedly made calls to Rajaratnam “within seconds” of leaving board sessions where market-moving information was discussed.

The complaint alleges that Rajaratnam then either used the inside information on Goldman and P&G to execute trades on behalf of some of Galleon’s hedge funds, or shared it with others at Galleon, who then traded on it ahead of public disclosure. The SEC claims the insider trading scheme generated more than $18 million in a combination of illicit profits and loss avoidance.

The SEC also says that Gupta was, at the time of the alleged disclosures of confidential non-public information, a direct or indirect investor in at least some of Galleon’s hedge funds, and had other business interests with Rajaratnam.

Gupta, as a McKinsey veteran, embodied the “trusted advisor” consulting ethos and personified the McKinsey “advisor to CEOs” business strategy and brand. The firm’s value to its clients and its effectiveness as an advisor requires knowing their secrets and holding them close to the vest.

Gupta was McKinsey & Company’s worldwide Managing Director for 9 years from 1994 through 2003…Gupta, now 62, stepped down as a McKinsey partner in 2007, and has since served as Managing Director Emeritus, according to his profile at the Indian School of Business (ISB). Gupta was instrumental in co-founding ISB in 2001, and continues to serve as its current Governing Board Chairman and Executive Board Chairman. He is also a current or former board member (or trustee) of AMR Corp., the parent of American Airlines; the Rockefeller Foundation; the University of Chicago; Harman International Industries; Genpact India; the World Economic Forum; the International Chamber of Commerce, World Business Organization; New Silk Route and New Silk Route Private Equity; and the Emergency Management and Research Institute. Galleon’s Rajaratnam was also associated with the New Silk Route ventures, where Gupta continues as Chairman. Rajaratnam is no longer associated with those entities.

Several media commentators have openly wondered whether the accusations against Gupta, and earlier accusations in the same scandal against McKinsey senior partner and Gupta protégé Anil Kumar, strike a deadly blow to McKinsey.

Will Rajat Gupta Destroy McKinsey? John Carney, NetNet, March 2, 2011

McKinsey’s clients are attracted by its reputation for excellence and discretion—and its stellar network of alumni. Its consultants often refuse to even disclose who their clients are.

If the charges against Gupta prove true, it could be a mortal threat to the firm. Even if there’s no evidence that confidentiality was breached while Gupta was at the firm, being led by a man who would later leak insider information would be devastating. If Gupta is shown to have engaged in similar actions while he was at McKinsey, that could be the end for the Firm.

“At that point, I think we go the way of Arthur Andersen,” another former McKinsey consultant said, referring to the once-prestigious accounting company brought down by its connections to Enron.

Loose Lips, Reuters BreakingViews, Robert Cyran and Rob Cox, March 3, 2011

McKinsey’s reputation rests on its ability to keep secrets. Consultancies, unlike investment banks, don’t provide access to financial markets.  All they offer is counsel, which relies partly on confidences revealed by their clients. According to McKinsey, “Our clients should never doubt that we will treat any information they give us with absolute discretion.” The allegations against Gupta make it hard for clients not to wonder.

It’s understandable that, in the heat of this moment, some might naïvely compare the consequences of the criminal indictment of an audit firm with civil charges against an individual, albeit one who trades on – pun intended – his association with a prestigious professional services firm.

It’s not the same thing.

Extrapolating Gupta’s behavior to McKinsey as a whole is a stretch. I’m no McKinsey apologist but one man, even a former Global Managing Director, does not make this firm.

On the contrary. The firm made him and he’s the one whose currency is now worth less.

Let’s look at a few similar examples from the world of the Big 4 audit firms. The accounting firms are actually regulated and they’re still around in spite of inside traders inside of them, trading on their client confidences more than once.

A Deloitte active-duty Vice Chairman, Thomas Flanagan, was accused and settled with the SEC this past summer over insider trading charges related to several Fortune 500 companies. Auditors have a public duty to shareholders and a legal obligation under federal securities laws to maintain engagement confidentiality, in addition to their contractual obligation to do so.  Directors have a duty only to the corporation. And yet, the Flanagan story captured only momentary media attention and no one claimed Deloitte was going down as a result. In fact, the SEC never even charged Deloitte. It was somehow acceptable to the regulator when the firm said they had been duped by their own senior leader.

Closer to the kind of work McKinsey’s Gupta did for clients, we have another senior Deloitte partner accused of insider trading, Arnold McClellan. He advised private equity firms about the tax implications of proposed acquisitions. The level of trust  – and consequences of a betrayal of that trust  – in M&A advisory is akin to the level of trust expected of a company director. Interestingly, the two cases have a company in common – Kronos.

The McClellan case is pending but, in spite of being the second one for Deloitte in such a short time and with allegations of tipping others for profit that covered the same time period as the Flanagan case, Deloitte is still kicking consulting ass and taking names, including for the federal government.

And finally, but certainly not meant to complete an all inclusive list of auditors accused of betraying client confidences in service to insider trading, we have the poor Ernst and Young Tax partner James Gansman. He was lured by the bad, bad internets into a debauched life of inside trading and an illicit love triangle.

In the fall of 2004, a forty-something investment banker named Donna Murdoch logged into Ashley Madison, the discreet dating website married people visit “when divorce is not an option,” and introduced herself to James Gansman, a partner at Ernst & Young in New York. The two struck up a relationship, meeting occasionally in hotels in Philly, New York, and California, and talking on the phone about their lives: James told Donna about how he was kicking ass at work, Donna told James about how she was struggling with her subprime mortgage.

Eventually the two settled into a comfortable day-to-day routine in their respective offices in New York and Philadelphia, staring at the same Yahoo Finance screen.

{…}

Eventually, their conversations about business grew more specific.

Mr. Gansman led Ms. Murdoch in a guessing game about which deals he was working on, she said. “The game was that I wouldn’t be looking and he would give me hints: The market cap of two billion or market cap of 400 billion, and here’s what they do, and he’d read it to me, and ultimately make sure I guessed,” Ms. Murdoch testified. Before long, the guessing game fell away. Mr. Gansman told her more directly about upcoming deals of Ernst clients, she said.

She made $400, 000 off the deal, and the SEC noticed. He made nothing, and now he’s going to jail. The end.

Ernst & Young survived the embarrassment of one of their partners being an inside trader. Even worse, the firm was mentioned in the same news stories as swinger cheater site AshleyMadison.com. Ernst & Young is still working for the federal government and several Fortune 500 clients as an auditor in spite of also being accused of complicity in the failure of Lehman Brothers.

You may wonder why Gupta, a rich and successful businessman, would risk everything to pass inside information to friends. He didn’t need the money. We have not seen any evidence he profited personally from the trades, unless Galleon’s Rajaratnam sent profits to him indirectly through other business interests in India, for example. Monadnock Research’s O’Connor gives us a clue into the gargantuan ego and pure pathology which might help someone like Gupta rationalize the behavior of which he is accused.

Just after starting his third term as McKinsey’s Managing Director in May 2001, Gupta did an interview with Wharton Professor Jitendra Singh for the Academy of Management Executive. [i] The interview was wide-ranging and retrospective on the subject of Gupta’s contributions to McKinsey since his appointment as its leader in 1994, with a special emphasis on his contributions toward policies, processes and systems to support enterprise knowledge innovation at McKinsey.

Monadnock Research co-founder, Mark O’Connor, interviewed Brook Manville, McKinsey’s Chief Knowledge Officer, four years into Gupta’s terms and featured many of the firm’s innovative efforts in his Yankee Group report, Knowledge Management: People and the Process.

Gupta closed the 2001 interview with the following quote, when addressing the question of what advice he would give to young men and women just starting their business and public service careers.

Gupta: “Oftentimes many of us get tied up in what is good for our careers, how to get ahead, what’s the best career to pick. More important is, I think, to develop as a professional, to have a learning mindset, to always learn from every experience and to become a richer human being. If you concentrate on that, then career success automatically follows. If you make career success an over-arching objective, you’ll not become a full human being, a rich human being, a great professional, or a great leader.

The second piece of advice I’d give is that I think it is vitally important to make other people successful. If you have a mindset of always trying to make other people successful, they will in turn make you more successful that you ever dreamed-of. So, I really believe that it’s not about getting ahead at the expense of others, it is getting ahead because lots and lots of people are helping you achieve it.

Singh: “Perhaps together with others.”

Gupta: “Yes. The last thing I’d say is that you have to have a set of values and principles that you really believe in that is your moral compass. Avoid the temptations of doing the politically right things, because the person you have to live with the most in your life is yourself. You have to always be true to your own set of values and principles, even though there may be temporary costs to that.”

McKinsey had that interview posted on its Web site at the time of this writing. Certainly there are many interpretations of Gupta’s words in this passage. The irony of it in support of the SEC’s allegations will almost certainly not be lost on government prosecutors.

What hangs in the balance, beyond the obvious allegations, is what Gupta truly meant philosophically with his advice to our next generation of business and government leaders. The best and worst examples of ethics are evident in his words. Clearly no reader of this interview would have had any question of its meaning in 2001. But there is a clear foundation for questioning it today.

Statement of Gary Naftalis, Counsel for Rajat Gupta

These allegations first made by the SEC are totally baseless. Mr. Gupta’s 40-year record of ethical conduct, integrity, and commitment to guarding his clients’ confidences is beyond reproach. Mr. Gupta has done nothing wrong and is confident that these unfounded allegations will be rejected by any fair and impartial fact finder.  There is no allegation that Mr. Gupta traded in any of these securities or shared in any profits as part of any quid pro quo. In fact, Mr. Gupta had lost his entire $10 million investment in the GB Voyager Fund managed by Rajaratnam at the time of these events, negating any motive to deviate from a lifetime of honesty and integrity.

Main page art is from Damien Hirst’s Sotheby’s sale, “Beautiful Inside My Mind Forever” described here.