Galleon scandal's executive conundrum

If straight-arrow McKinsey allowed one of its stars to get involved with Raj Rajaratnam, what are other top execs at other companies involved in?

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By Duff McDonald, contributor

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McKinsey director Anil Kumar is escorted by an FBI agent in New York on Oct.16.
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NEW YORK (Fortune) -- When last week the federal government arrested Raj Rajaratnam of the Galleon Group for masterminding a $25 million insider-trading ring, the biggest head-scratcher was the inclusion of Anil Kumar in the government's complaint.

Kumar is a director of consulting powerhouse McKinsey & Co., owner of one of the world's most respected brands, and he is accused of passing Rajaratnam information about semiconductor maker Advanced Micro Devices, a McKinsey client.

Kumar was also an investor in a hedge fund associated with the Galleon Group. So one unintended consequence of the government's unfolding case against Galleon may be that some of America's most reputable corporations are forced to reexamine their policies about how their officers invest in other companies.

Tangled up in an insider-trading scam is the last place one would expect to find a McKinsey man. This is a firm that prides itself on its integrity, its standards, and, above all, its absolute dedication to clients' interests.

McKinsey professionals sell clients the words out of their own mouths, and in the process give them their word that they won't tell anyone what they learn while they're on the job. Kumar, it seems, may have been speaking out of both sides of his mouth.

Kumar isn't some fly-by-night success at McKinsey. Good friends with McKinsey's senior partner emeritus Rajat Gupta, Kumar helped Gupta found and sat on the board of the Indian School of Business along with other Indian business luminaries including Lakshmi Mittal of steel giant ArcelorMittal (MT).

He was also one of the pioneers in the field of knowledge process outsourcing, or KPO -- the outsourcing of information-related work -- and had McKinsey experimenting with outsourcing parts of its own business to India as far back as 1995.

If the allegations against Kumar prove to be true, he took the whole premise of McKinsey's business -- client confidentiality -- and threw it out the window for a few dollars. Through his lawyer, who called Kumar "a man of integrity," Kumar has emphatically denied all charges.

Yes, all the criminal charges. But what of McKinsey's own standards? The company that calls itself "the Firm" has what it considers best-in-class policies regarding outside investments by consultants. Starting with the obvious, there is a ban on anybody buying or selling securities based on nonpublic information.

But McKinsey also has a stricter-than-usual internal policy that forbids its employees from investing in the securities of not only just clients, but also companies they're trying to get as clients. That said, the Firm has no explicit prohibition on, say, investing in hedge funds that may or may not invest in the securities of clients.

But let's be fair here: It's doubtful that any company has such a policy; it would simply be too hard to either obey or enforce. (Some investment banks however do handle their partners' taxes -- Goldman Sachs, for example.)

Short of that, internal guidelines that keep their employees on the straight-and-narrow are pretty much all one can ask for. And that's what a majority of professional firms do. But they do vary widely in scope.

Employees of Fidelity Investments who are in a position to influence mutual fund investment decisions, for example, must recommend any personal investment ideas to Fidelity before taking advantage of them for their own account, and are barred from transacting in a security within 60 days of the firm doing so.

The SEC has mandated that auditors cannot own stock in the firms of their clients. And investment banks have so-called "restricted lists" of stocks that various officers and employees are and aren't allowed to trade at any point in time.

It gets more complicated, though, when it's not as cut-and-dry as the above. Citigroup, as Ben Stein recently wrote in Fortune, doesn't seem to mind that its chairman Dick Parsons is also a senior advisor to Providence Equity Partners, a client of Citi's.

And many investment bankers are on the boards of companies the stock of which their own employers buy and sell for themselves and for their customers. The Ford Motor Company (F, Fortune 500), for example, is a long-time client of Goldman Sachs (GS, Fortune 500), and for years, there was invariably a Goldman partner on the car company's board.

Currently, there isn't one, but former Goldman partner John Thornton (and current Ford board member) sat on Ford's board while working at Goldman from 1996 through 2003.

In these and other more convoluted cases, the only thing stopping people from dubious activities is the hope that they understand what is and what is not appropriate.

So what can corporations do to make sure that an officer's extracurricular investment does not impact its brand equity or its bottom line? (After all, it appears that the government, it seems, came across Kumar while it was investigating Rajaratnam, and not the other way around.)

It's hard to say. Especially because there aren't even laws requiring officers or directors of public companies to disclose their ownership in securities other than those of the company they're working for.

Section 16 of the 1934 Act requires them and holders of 10% of more of a company's shares to make periodic disclosures, but beyond that, there's no way for the Feds to even know just what other securities executives own.

It gets even more complicated with someone like Kumar, who doesn't even work for a public company -- McKinsey is and always has been private.

What's more, the SEC's jurisdiction over hedge funds is also fairly limited. There's been a long-running movement to give the SEC more oversight over both the holdings and trading records of hedge funds, but it's a big jump from watching a hedge fund make a winning bet on some company's stock to wiretapping that hedge fund's phones and finding out they're talking with a guy at the consulting firm who's advising the company the hedge fund just bet on.

Considered in that light, the SEC is to be roundly applauded for roping in the likes of Kumar (if all are found guilty) in its investigation.

It seems all we have left are cops at the company level itself. According to SEC spokesman John Heine, the most likely and effective place to rein in inappropriate investing behavior by corporate executives is in a corporation's own bylaws.

What Kumar is accused of, though, is not breaking company policy but the law. Even the most stringent of policies isn't much use when dealing with a rogue consultant -- even if he does work for the most respected firm in town.

--Duff McDonald is the author of the recently published Last Man Standing: The Ascent of Jamie Dimon and JPMorgan Chase To top of page

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