The Downside

Category: Getting Blinded by the Upside, one of the Seven Deadly Stupidities.

Rajat Gupta had retired as head of McKinsey & Co., the world’s top consulting firm and he sat on the boards of some of the most prestigious companies in the world, including Proctor & Gamble and Goldman Sachs. While at McKinsey, Gupta oversaw the dramatic growth of a global business and was an adviser to presidents, heads of state, titans of industry, and philanthropists.

He counted Bill Gates and Bill Clinton among his close friends. Gupta was reported to be worth more than $100 million and to many, was one of the most accomplished and respected individuals on the planet.

Gupta’s story is an incredible one. He was born into poverty in India, attended the prestigious Indian Institute of Technology (the top college in India), and earned his MBA from Harvard. He joined McKinsey and 20 years later in 1994 rose to the position of Worldwide Managing Director. He was the leader of the firm. Gupta was a man who came from little and used his intellect and ambition to make it to the top of the business world.

At the height of his visibility and influence, Gupta met Raj Rajaratnam. The two were raising money for the Indian School of Business. Compared with the urbane and sophisticated Gupta, Rajaratnam was a bear. He ran the Galleon hedge fund and spent most of his day eating at his desk on the phone with different sources of information trying to get what traders call an “edge,” or the piece of information or insight that will give the trader an advantage in buying or selling stocks or other securities. 

As their relationship matured, Gupta would hang around the Galleon offices and eventually entered a series of business transactions with Rajaratnam. In one of the deals, Gupta formed venture capital firm New Silk Road and Rajaratnam invested $50 million in it.

Having spent more than a decade in consulting, I have noticed something I call the Consultant’s Paradox. Most high-level consultants like Gupta attended the best schools and scored the best grades. They went on to work at the best firms. The problem for this “elite” group is that at every client company that hires them, the managers and leaders did not go to the best schools and did not score the best grades. 

So, after a long day at the company identifying and fixing what are obvious problems to the consultants, the consultants sit around at dinner and talk amongst themselves about how inept management is and how everything was so fixable. By the time dinner is over and the team is on its second or third round of cocktails, the conversation shifts to a discussion of how the inferior CEO, an inferior human to some consultants, has a net worth 50 times more than the consultant and once the project is finished, it will go to 100 times more. In a perverse way, we can see the frustration on the part of the consultant. There is a good chance the Consultant’s Paradox trapped Gupta and drove his behavior.

Insider trading occurs when an individual uses non-public information to buy or sell publicly traded securities. For example, the CFO of a public company tells you his company will announce a super-large new order his company is about to get. You think the company’s stock will go up once the announcement of the order is made, so you hurry home and buy the stock in advance of the announcement.  The stock goes up after the announcement and you sell and collect what is known as an “ill-gotten gain.” You broke the law and can be prosecuted and go to jail. This is not an obscure corner of the finance world. There are plenty of examples out there. Go to Google and enter “insider trading scandals” and see what I mean.

During the height of the financial crisis in 2008, everybody was scared.  Investment banks like Bear Stearns and Lehman Brothers collapsed and were absorbed by other banks or liquidated. Bank America did a rescue purchase of Merrill Lynch. We are now at the point in the relationship where Gupta and Rajaratnam are pals. They see each other often, stay at each other’s homes, and talk on the phone all the time. 

Let’s get back to the decision to make that 15-second phone call. Gupta sat on the board of Goldman Sachs. Goldman formed the cornerstone of the financial markets. There were few things Goldman did not do. It traded every type of security or commodity, it made investments all over the world, it was the go-to lender for much of corporate America and was the premier global deal maker. Given the unstable financial markets of the 2008 financial crisis, Goldman was on shaky ground, just like all other financial institutions during those difficult times. It needed to make a move to shore up confidence in its brand and by extension, the entire financial system

Corporate board meetings are typically held quarterly or monthly. In certain circumstances such as a pending acquisition or large lawsuit, a “special” meeting of the board can be called on short notice. The board represents the interests of the shareholders and has a fiduciary duty to behave as such. For example, the board gathers information from expert compensation firms to help set the pay for the CEO, instead of the CEO deciding how to spend the shareholders’ money on himself.

The board meeting in question was the special meeting of the Goldman Sachs board on September 23, 2008. In that meeting, the board discussed a $5.0 billion investment from Berkshire Hathaway, a firm controlled by Warren Buffett who is considered to be the greatest investor of the last century. Amid the 2008 financial crisis, a large investment would do much to improve the outside world’s confidence in Goldman, but a $5.0-billion investment from Warren Buffett would be over-the-top good.

At 3:58 p.m. (stock markets closed at 4:00 p.m.) and immediately after the completion of the Goldman board meeting discussing the Buffett investment, Gupta called Rajaratnam, and they spoke for about 15 seconds. (This was really stupid.)  Records show that 16 seconds after the call, Rajaratnam-controlled Galleon bought a block of Goldman stock just before the markets closed. After the Buffett investment news about Goldman became public and Goldman’s stock increased in value, Rajaratnam sold his Goldman shares for $800,000+ of profits. Not bad for a 15-second phone call and an investment holding period measured in hours.

Anybody with an undergraduate degree in business would know that what Gupta did was pass along inside information and that Rajaratnam was certainly going to trade on it. Gupta, if he was thinking clearly, surely would have realized the downside to his decision to make the phone call. 

Gupta made an emotional decision (I want to please Rajaratnam and get more for myself) from a distorted point of view (Why can’t I be super-rich like these other guys?). Did Gupta knowingly consider the risks when making his decision?  Obviously not because he would have realized the cataclysmic downside far outweighed his vision of the upside.

Coda

Rajaratnam was convicted of a series of illegal trading activities (including the Goldman trade) that were fed by his mostly illegal network of tipsters. The SEC claimed Galleon made more than $90 million of illicit profits from using inside information. More than $23 million of the total was generated from trades based on information provided by Gupta. Rajaratnam was sent to prison for 11 years. 

As the authorities were closing in on Rajaratnam, wire taps recorded additional inside information regarding Proctor & Gamble passed to him by Gupta. Gupta was convicted of several counts of insider trading and served 19 months in prison – the same prison that housed Rajaratnam. 

The downside of the decision to make that 15-second phone call extended beyond the ruin of Gupta’s reputation. Between SEC fines, penalties, and restitution plus amounts owed to Goldman Sachs for legal fees, much of his net worth is gone. Gupta moved his primary residence to Florida; a state in which the bankruptcy court cannot claim your home. Years after his release from prison, Gupta continued to profess his innocence.

Getting Blinded by the Upside is a huge complication when making a Tectonic Decision. Learn more below.