Case Study - See the attachment

Case 7 Rajat Gupta and Insider Trading

AUTHOR BIOGRAPHY

Kelly Mullen is an assistant professor of finance at Trinity Christian College in Palos Heights, Illinois. Her research interests include real estate tax-credit and municipal finance, leadership, and business ethics, with a special interest in managerial ethics in the financial services industry.

CASE OVERVIEW

One of the most high-profile insider trading events in recent history went to trial in 2012 and involved Rajat Gupta. Gupta was the former managing director of McKinsey Consulting, a highly prestigious global consulting firm that provides expertise and advisory services for many of the world’s highest profile companies, governments, and nonprofit organizations. The case against Gupta grew out of the investigation of his friend and business associate Raj Rajaratnam, who in 2011 was convicted on multiple counts of conspiracy and securities fraud. Surveillance of Rajaratnam indicated that Gupta was an informant who had been sharing insider trading tips about Goldman Sachs and other firms. Because of Gupta’s high status, his reputation, and the trust he engendered in the marketplace, he was considered an extraordinarily high-profile subject.

WHO IS RAJAT GUPTA?

Rajat Gupta had the rare honor of being the first foreign-born managing director McKinsey Consulting (1994–2003) had ever had. He also served on several highly prestigious corporate boards, including Goldman Sachs and Procter & Gamble. In addition, he was a board member for the Rockefeller Foundation, the World Economic Forum, the Millennium Promise, and the Gates Foundation, among several other high-profile nonprofits and nongovernmental organizations (NGOs).1 Gupta was also heavily involved in higher education in India. He was cofounder and served as chairman of the board for the Indian School of Business, and he was on the dean’s advisory board for the School of Economics and Management at Tsinghua University.

After graduating from the Indian Institute of Technology–Delhi, Gupta attended Harvard University where he earned an MBA and graduated with distinction; from there he joined McKinsey. Gupta spent three decades with McKinsey and earned a reputation for integrity, intelligence, and great business skill; he achieved remarkable success in the marketplace and was known across the globe for his business acumen and philanthropic endeavors.2 McKinsey’s managing director serves a three-year term and limited to serving three terms. After Gupta’s third term ended in 2003, he became senior partner again. In 2007, Gupta became a senior partner emeritus for the firm, where he continued to serve in an advisory capacity. All of these accomplishments occurred before his arrest and imprisonment for insider trading.

WHAT IS INSIDER TRADING?

In simple terms, insider trading involves the beneficial use of nondisclosed, confidential corporate (company) information in stock trades. According to the U.S. Securities and Exchange Commission (SEC)’s website, an “insider” is a person who is in possession of material, nonpublic information about a security and breaches a fiduciary duty or relationship of trust and confidence through the illegal trading (buying or selling) of that security.3 Insiders are key personnel (senior management-level staff, or those in advisory roles such as members of a board of directors), but the insider description may also extend to third parties who provide professional services to a company and may be privy to their plans and activities.

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Insider trading violations can include sharing (“tipping”) sensitive information to an uninvolved party. Having insight into a company’s stock price enables the insider to make trades that generate above-market financial returns or substantially avoid financial losses from market fluctuations in stock price. When an insider is privy to information that is expected to have a likely positive effect on a company’s share price, the insider may illegally buy securities in advance of the stock price increase, taking action before the marketplace becomes aware of a company’s good news. An example of this is the insider trading case involving SAC Capital Advisors’ use of pharmaceutical study results before their release in the marketplace.4 In other cases, the insider will sell securities before public disclosure of bad news, thereby limiting potential investment losses that occur when a security’s price declines in the market. The Enron senior management team’s use of insider information before the company’s imminent collapse involved this type of illegal insider trading.5

Research confirms that insider trading often occurs secondhand through insider tips received from friends, rather than firsthand where someone effectively uses information he or she has obtained from his or her work environment.6 When a second party becomes involved in insider trading by using an insider tip, it makes the insider trading harder to detect; for this reason, estimates of the prevalence of insider trading may be inaccurate (i.e., research suggests that insider trading likely occurs more often than is known).7 The SEC reports that the number of insider trading cases grew more, in the aggregate, between 2013 and 2016, than in previous years.8 Because of the covert nature of this crime, law enforcement agencies use an array of tools, including wiretapping, to solve these crimes. Preet Bharara, former U.S. attorney who was involved with high-profile insider trading prosecution, said, “When sophisticated business people begin to adopt the methods of common criminals, we have no choice but to treat them as such.”9

Still, it is important to remember that insiders can legally purchase their company’s stock. Many managers, in fact, receive stock options and bonuses based on stock performance. This makes sense because managers and company employees who have invested in their company’s stock will have a strong alignment with the company’s goals and objectives and will be motivated to see the company succeed. Insider trading laws are not designed to prohibit insiders from legally trading, but rather to block the insider’s ability to trade on the nonpublic, confidential information about a company’s plans and performance that they have access to through their work.

WHY ALL THE FUSS? WHY IS INSIDER TRADING AN ETHICAL ISSUE?

Participants in public capital markets benefit from a regulated and transparent trading environment. To the degree that market participants trust that the market is a level playing field, they will invest capital by purchasing stocks and bonds. This transparency and sense of fair play is secured by policies and regulations (e.g., those established and enforced by the SEC). Insider trading (i.e., using information that is otherwise unavailable to the investing public to make trades) lowers investor trust in the capital markets. When the sense of market fairness diminishes, investors become reluctant to invest, with negative implications for economic growth. Hence, the soundness and trustworthiness of the capital markets matters greatly. This also helps us understand why the capital markets are regulated and why laws and regulations have been designed to protect the marketplace from the damaging effects of insider trading.

Insider trading is viewed as a critical issue by investors and market participants for at least three reasons10:

1.   If insider trading is widespread, this will influence investors’ willingness to trade; if investors lose confidence in the fairness of the marketplace, a loss of both market liquidity and capital investment may occur.

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2.   Policy makers and regulators have concerns about the effectiveness of insider trading policy and regulations.

3.   Senior executives often receive stock options or stock-related benefits as part of their overall compensation package; this is done with the intent of aligning manager interests with shareholder interests. Greater stock ownership by managers, however, may have the unintended consequence of enhancing managers’ abilities to take unfair (and illegal) advantage of their insider status and the nondisclosed, confidential corporate information they may have.11

HOW IS INSIDER TRADING DISCOVERED?

An insider trading investigation may start with the SEC, the Federal Bureau of Investigation (FBI), the Department of Justice (DOJ), or the U.S. Attorney’s Office. Information on trading irregularity may be discovered and presented to the SEC and then travel to another branch of the government, or it may come from the Financial Industry Regulatory Authority (FINRA), which has a surveillance division that may identify unusual movements in a stock price. Corporate insiders are required by the SEC to report trade activity, and because authorities can conduct surveillance activity on stock trades, corporate insiders may be deterred from conducting illegal trades in their own names, instead passing the information along to a friend, business associate, or relative. Thus, their insider status is concealed even if evidence suggests irregular or sudden stock price movement.12

Insider trading activity may result in civil lawsuits and related fines or in criminal charges against the violator. Criminal insider trading charges are normally contingent on the appearance of three factors:

1.   The significance of the wrongdoing (amount of money involved, complexity/number of people involved in trade, and the duration of the insider trading activity)

2.   Confirmation of wrongdoing provided evidence (testimony, taped conversation, or related evidence)

3.   Repeat securities violations; recidivism

The DOJ normally handles criminal cases, often working in collaboration with the SEC. The SEC may notify the DOJ of a likely criminal case, and the DOJ will then verify the appropriateness of the charge as part of its handling of the case. FINRA also presents criminal cases to the DOJ.13

The case against Rajat Gupta came by way of another, more elaborate criminal insider trading case that was being conducted against his friend and business partner, Raj Rajaratnam. Rajaratnam, a hedge-fund manager for a company called Galleon Group, had attracted the attention of the FBI, which had placed him and a network of trade conspirators under surveillance using, among other means, wiretapping. Investigators captured him on the telephone advising co-conspirators on how to disguise their insider trading activity. Among the network of participants, Gupta was identified as an informant to Rajaratnam. The tips Gupta shared with Rajaratnam regarding Goldman Sachs and other firms proved lucrative. Rajaratnam cleared approximately $840,000 in one day from a tip about plans by Warren Buffett’s Berkshire Hathaway to invest $5 billion in Goldman Sachs.14 Gupta’s boardroom leaks to Rajaratnam generated approximately $17 million in profits.15 Overall, it is estimated that Rajaratnam earned over $80 million in profits from insider tips he received from a broad network of corporate informers.16 As a part of this network, Gupta faced criminal insider trading charges.

Despite the fact that Rajaratnam’s criminal activity involved greater dollar figures, commentators on the two cases suggested that Gupta was a professional of a much higher stature. Because of his membership on the board of several top companies, Gupta was in a trusted position to guard the confidential information of global companies whose decisions and activities affect the lives of hundreds of thousands of corporate stakeholders.17 The many accolades Gupta had received throughout his career made his indictment particularly shocking. “I think the record, which the government really doesn’t dispute, bears out that he [Rajat Gupta] is a good man . . . but the history of this country and the history of this world, I’m afraid, is full of examples of good men who do bad things,” said Judge Jed Rakoff, presiding judge at Rajat Gupta trial.18

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DIGGING DEEPER INTO THE GUPTA STORY

His Friendships

Two names consistently appear in conjunction with Gupta’s trading activity: Anil Kumar and Raj Rajaratnam. Kumar, esteemed as Gupta’s protégé at McKinsey, was a technology consultant and also a graduate of Indian Institute of Technology. Both Gupta and Kumar were involved with establishing the Indian School of Business (ISB) and the school’s ongoing performance. Gupta’s relationship with Kumar was built through career and direct business dealings.19

Kumar and Rajaratnam both studied at the University of Pennsylvania’s Wharton School of Business. While still a consultant at McKinsey, Kumar was approached by Rajaratnam, a hedge-fund manager, who proposed a secret side-consulting business for Kumar with Rajaratnam’s firm, Galleon Group. Kumar agreed to the illicit consulting arrangement with Rajaratnam, despite the fact that this agreement violated the terms of his employment with McKinsey. Kumar earned approximately $1 million a year for this arrangement and eventually became an important source of insider information to Rajaratnam.20

Through Kumar, Gupta’s and Rajaratnam’s paths merged. Gupta and Rajaratnam did not share an alma mater, but they did share an interest in the private equity fund called New Silk Route Partners that Gupta and Kumar launched. Later, business associates Parag Saxena and Victor Menezes joined the equity fund and Kumar exited. Rajaratnam at one point invested $50 million in New Silk Route fund, prompting communication between himself and Gupta, and the two eventually became friends and confidantes. During the years leading up to Gupta’s conviction, Kumar and Rajaratnam occupied important roles in Gupta’s business activity, and both Kumar and Gupta shared nonpublic and confidential information with Rajaratnam about the companies they served in a professional capacity. As a fund manager, Rajaratnam was able to parlay that information into quick profits for Galleon Group, to the tune of approximately $17 million from Gupta’s tips alone. In court, Gupta asserted that he did not profit from Rajaratnam’s trading activity.21

Sadly, but perhaps not surprisingly, these friendships ended badly. Kumar ultimately served as a key witness in the criminal cases against Rajaratnam and Gupta. Kumar himself was convicted of securities fraud, fined $2.8 million by the SEC and sentenced to 2 years of probation.22 Rajaratnam was convicted on 14 counts of conspiracy and securities fraud, and sentenced to 11 years in jail and $150 million in fines.23

The Gupta Insider Trading Trial

Gupta’s trouble with the law began on March 1, 2011, when the SEC filed a civil complaint for insider trading against Gupta and Rajaratnam. Later, on October 26, 2011, the U.S. Attorney’s Office filed criminal charges for securities fraud (including insider trading) against Gupta. He was arrested and released the same day on $10 million bail. At that time, Gupta asserted that he was not guilty, but he faced an uphill battle because his deep involvement with Rajaratnam was drawn out and put on display during Rajaratnam’s trial. Wiretaps used on Rajaratnam captured Gupta actively sharing insider tips with him.24 In addition, in Rajaratnam’s trial, the chief executive officer (CEO) of Goldman Sachs testified that Gupta shared confidential information about the firm with Rajaratnam. Even though Gupta was not on trial at the time, he was identified during that trial as a key informant to Rajaratnam.25

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Gupta’s jury trial began on May 22, 2012.26 By June 15, 2012, Gupta was found guilty on three counts of securities fraud and one count of conspiracy for sharing confidential information with Rajaratnam; he was found not guilty on two other securities fraud charges.27 The jury took less than 2 days to reach its verdict, and it relied on phone and transaction records rather than the wiretaps that were used in Rajaratnam’s trial.28 Gupta faced a maximum sentence of 20 years in prison for securities fraud and 5 years for conspiracy.29

The attorneys prosecuting the case pushed for a 10-year prison term for Gupta, with one prosecuting attorney stating, “Gupta intentionally betrayed his duties to Goldman Sachs as a director of the company, refused to take responsibility for his actions, and put the government through a long and exhaustive trial, costing taxpayers millions.”30 Gupta’s punishment was part of a message the prosecutors hoped to send to the marketplace that people entrusted to serve in a fiduciary role for corporations will be held to the highest standards of professional conduct.31 The severity of the proposed prison sentence underscored the magnitude of the professional responsibility that Gupta had betrayed.

Meanwhile, Gupta’s attorneys fought for probation and community service that would leverage his extensive business skills. Gupta’s attorney argued that Gupta’s offense was “aberrational behavior” for him—normally an upstanding member of the community—and that Gupta should not be punished because he had suffered a “fall from grace of Greek tragedy proportions.”32 “This was an iconic figure who had been a role model for countless people around the globe,” his attorney argued.33

On October 24, 2012, Judge Rakoff of the U.S. District Court in Manhattan sentenced Gupta to 2 years in prison.34 Though Gupta appealed the conviction, it was upheld by a federal appeals court on March 25, 2014. On June 11, just one week before his jail term began, the U.S. Supreme Court denied Gupta’s request to postpone the prison time while an appeal was in process. Gupta began his jail sentence one week later, on June 17, 2014.35

The Question of Motive

The question of motive for Gupta’s crime remains unanswered, though speculation abounds. In one recorded conversation, his friend Kumar suggested to Rajaratnam that Gupta was dissatisfied with his level of wealth and desired to join the more financially elite.36 Before his involvement with insider trading, Gupta’s net worth was estimated at $130 million.37

Alternatively, a senior attorney for the SEC involved with the case suggested that it was not money that Gupta was after, as evidenced by the fact that Gupta did not receive a cut or a payment in exchange for the tips he provided; rather, the attorney suggested, the motive for Gupta was friendship.38

Providing yet a different perspective on motive, Judge Rakoff speculated that Gupta may have crossed a professional line that resulted in criminal activity because he “longed to escape the straitjacket of overwhelming responsibility, and had begun to loosen his self-restraint in ways that clouded his judgment.”39

It seems likely that the question of motive for Gupta was a complex and multifaceted one. It is not feasible, however, that a person who had spent a lifetime guarding the confidentiality of high-profile companies was unaware of the potential ramifications of sharing corporate secrets. During his career, Gupta likely signed dozens of confidentiality agreements in which he committed himself to protect and guard from public disclosure the organizational information of the companies he served. It therefore appears certain that Gupta’s decision to divulge confidential information was not the result of inexperience or a lack of understanding about the potential consequences of his actions.

The Monetary and Reputational Costs Gupta Incurred for Insider Trading

Before his conviction, Gupta’s net worth was estimated to have been approximately $130 million.40 The insider trading conviction was costly for Gupta. Some of the expenses he incurred included these:

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•    A 2-year jail sentence41

•    A lifetime ban by the SEC on serving as an officer or director of a public company42

•    $30 million in legal fees43

•    $25.8 million in fines and penalties as follows:

○   $5 million fine, paid to the U.S. government44

○   $6.2 million reimbursement of legal fees to Goldman Sachs45

○   $13.9 million reimbursement to the SEC for legal activities46

EPILOGUE: WHERE IS RAJAT GUPTA TODAY?

On January 5, 2016, Rajat Gupta was released from federal prison to his Manhattan home to finish out his jail sentence under house arrest.47 The house arrest ended in March 2016.48 In addition, in February 2016 the U.S. Second Circuit Court of Appeals in Manhattan agreed to hear Gupta’s appeal to overturn his conviction, and as of September 2017 the appeal is still being reviewed.49 Upon release from prison, Gupta disclosed plans to publish an autobiography about his life and experiences.50 Gupta also returned to rekindle relationships with close colleagues and a large professional network around the world. It seems likely that Gupta’s impact on business and society will persist, though the avenues he travels may diverge from where he had traveled in his former life.

See Table 1 for a timeline of events follows.

TABLE 1  A TIMELINE OF EVENTS*

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Source: Rawat, S. R., Raj, V., Manoharan, A., & Vineet, S. (2013). Rajat Gupta: An American dream upturned: A case study. Indian Journal of Corporate Governance, 6(2), 42–51.

Critical Thinking Questions

1.   Research suggests that different countries have different perspectives on insider trading. Gupta and his friend, Kumar, were originally from India; Rajaratnam was from Sri Lanka. An aspect of their willingness to engage in insider trading might be rooted in their culture of origin. Does this information alter your perspective on the conduct of the three? Would it make them somehow less guilty of the crime? Explain.

2.   When Gupta’s case went to trial, over 400 people wrote letters to the judge attesting to his good character—among them Bill Gates and former UN Secretary Kofi Annan. That said, Gupta’s business partners in his New Silk Route private equity venture had received penalties from the SEC before their involvement with him for dubious business dealings. Is this simply a case of poor selection of friends, or was something else going on with Gupta that, though undetected for years,culminated in his shady business dealings in the later years of his life? Explain. If it is true that bad company corrupts good character, how might you effectively use this information as you select friends and associates in the business arena?

3.   Illegal insider trading is considered an ethical issue, in part, because it involves fair play and justice. Some research indicates that there is no one particular profile for those willing to engage in illegal insider trading, but other research using simulation testing suggests that individuals with lower ethics scores are more likely to engage in illegal insider trading. If both studies are true, what does this suggest about building an ethical organization? With these studies in mind, what workplace practices might you consider endorsing?

4.   If it is true that the use of insider trade tips from friends is difficult to detect and that those who get charged with insider trading seem to bounce back in society fairly well (e.g., Michael Milken, Mark Cuban, Martha Stewart), is it worth it, in your opinion, for our regulatory agencies to seek out illegal trading activity and to prosecute violators of these laws? How do you rationalize the great expense involved in these search and prosecution efforts if the criminals seem to suffer no lasting ramifications from these crimes?