Insider Trading Hurts: McKinsey Survives But Target Companies Suffer
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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.
Monadnock Research: 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 PG 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 PG 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.
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.
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
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 Anderson,” 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
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.
In my opinion, 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 the firm.
On the contrary. The firm made him and he’s the one whose currency is now worth less.
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 his association with a prestigious professional services firm.
Reuters’ Westlaw Business has a detailed story about the reputational risk to both inside traders’ firms and the companies they target.
Being an insider with a fiduciary duty sure is risky, as heavyweight Rajat Gupta is now finding out amidst serious SEC charges. So is having board members, as Goldman Sachs and Procter and Gamble are now worrying. Of great concern to each are the reputational risks and attendant costs that this might impose on them.
One thing this story gets slightly wrong is the fiduciary duty of a director. Directors have a duty only to the corporation. That might change some directors’ views of where their bread is buttered. Did Gupta think that if he spread the love around enough, everyone would be happy?
Monadnock Research’s Mark O’Connor cites an interview with Gupta in May 2001 by Wharton Professor Jitendra Singh. [i] In it, Gupta gives some advice to those just starting their careers:
Gupta: …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.
When the Big 4 audit firms are hit with insider trading scandals – and there have been some whoppers recently – they manage reputational risk in two ways:
- They ignore reports in the media, giving either no comment or minimal comments that distance them from the accused.
- They do everything possible to repair relationships with clients, including paying them off.
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. 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. How does an audit firm Vice Chairman “dupe” his fellow partners and professional colleagues more than three hundred times, as Deloitte’s lawsuit against Flanagan alleged?
The SEC gave Deloitte credit for software, manuals, and controls that may have been designed effectively, but those controls surely did not, in the Flanagan case and the hundreds of other examples of non-compliance cited by the PCAOB, operate effectively. Deloitte did not discover Flanagan’s sins. According to the Financial Times, FINRA discovered the abnormalities in activity via normal market monitoring activities during Walgreen’s acquisition of Option Care.
Deloitte’s audit clients – Walgreens, Best Buy, Sears Holdings and others – received calls from the SEC. Then the SEC and the clients called Deloitte. Deloitte forced Flanagan to “retire” and then sued him to assuage their clients.  Deloitte’s claim against Flanagan cited potential costs in reimbursing clients for their investigations.
Deloitte did reimburse some clients: $456 thousand to Sears, $79 thousand to Best Buy, for example. Deloitte’s audit clients, of course, made the quick, universal decision that their auditor was still independent. Those companies would have otherwise experienced the ignominy of admitting that a non-independent audit firm had attested to prior-filed financial statements. Those companies would have been vulnerable to lawsuits, may have had to pay for a new audit for the affected years, and would have had to change auditors in a hurry – a messy and expensive proposition for a large public company.
There are disclosures in almost all the proxies. They look like they were all written by the same lawyer.
Following these investigations, DT and our management advised the Audit Committee that no evidence was discovered that indicated that the former advisory partner had any substantive responsibility for or role in the conduct of the audit. DT delivered a letter to the audit committee stating that, despite the trades in our securities by their former advisory partner and the resulting violation of the SEC’s independence rules, the former advisory partner had not exercised any influence over the conduct of the audit or its conclusions with respect to the audit or accounting consultations, that the objectivity of the persons responsible for the actual conduct of the audit had not been affected by the former advisory partner’s actions, and that DT’s independence was not impaired…
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 MA 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.
Ernst Young has also survived the embarrassment of one of their partners going to jail for inside trading. Even worse, the firm was mentioned in the same news stories as cheater site AshleyMadison.com. But 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 fraud that resulted in Lehman Brothers’ failure.
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.
[i] McKinsey’s Managing Director Rajat Gupta on leading a knowledge-based global consulting organization; Volume 15 No. 2.
By on 08/03/2011