The Other Big Goldman Story: Insider Tips From a Director?

The media went wild with the story of Goldman Sachs' (GS) fraud lawsuit -- slicing $12.4 billion off of its stock market value. But if the investment bank settles this case for $45 million (three times its $15 million fee) as Time thought it could, that amounts to a mere 0.05% of its net worth and 0.36% of the amount of shareholder value it lost on Friday.

Goldman is a trading firm, and making money from trading is all about information asymmetries -- knowing more than your counter-party. If the Abacus deal is the only one where Wall Street profited from those information asymmetries, I will eat my hat. What's special here is that the Securities and Exchange Commission appears to have evidence of the fraud -- that a Goldman vice-president lied to investors about who was picking the securities for Abacus, the mortgage investment that was designed to fail.

Bigger Story of Insider Trading

However, a much bigger story yesterday slipped under the media's radar -- Goldman director Rajat Gupta is being probed on whether he collaborated with hedge fund Galleon Holdings, whose manager has been indicted on insider trading charges. And Gupta used to be the top executive at the world's most prestigious consulting firm, McKinsey & Co., which has a director who pleaded guilty in the Galleon case. This raises the question of how deeply insider trading is embedded in our financial markets and corporate governance at the highest levels.

According to The Wall Street Journal, Gupta, McKinsey's former worldwide managing director and a Goldman director since 2006, is being probed by federal prosecutors. They're trying to find out whether Gupta shared insider information about Goldman with Raj Rajaratnam, who ran $3.7 billion hedge fund Galleon and has been accused of insider trading in at least 20 stocks, including Goldman's. Prosecutors allege Rajaratnam conspired to obtain nonpublic information about Goldman earnings in June and December, 2008, and Berkshire Hathaway's (BRK.A) September, 2008, investment in Goldman before their public announcement.

Gupta told Goldman he won't stand for reelection to the board after prosecutors told him they were "reviewing recorded telephone calls between him and Rajaratnam," reports the Journal. No doubt, the Goldman director has a pretty clear recollection of what's on those recordings. Gupta told the Journal that "other commitments" is why he's quitting.

Close Ties at the Top

To fully grasp the significance of this, it's important to understand more about Gupta's former employer. McKinsey, as every top MBA student and Ivy League undergraduate knows, is considered the ultimate place for a consultant to start his or her career. It's a secretive place where smart, young people work with top corporate executives and government officials to solve problems like figuring out who to fire in order to meet profit goals or analyzing where to find new revenue sources.

As a result, McKinsey has access to very important confidential information about what public companies are going to do. Of the 21 people charged in the Rajaratnam case, 11 have pleaded guilty to criminal charges. And the 11 include a McKinsey director, Anil Kumar, who pleaded guilty to tipping Rajaratnam about five of his McKinsey clients in exchange for $2 million (and $600,000 in additional investment profits). "Kumar had a close relationship with Gupta," according to Reuters.

Rajaratnam and Gupta were also close, according to the Journal. They were among the co-founders of a hedge fund that was originally called Taj Capital when it started in 2006. It currently manages $1.4 billion and has been renamed New Silk Road. Another co-founder was Mark Schwartz, a former Goldman executive. Rajaratnam has severed his ties with New Silk Road.

Clients Should Watch Out

All this suggests there are some pretty strong reasons to wonder whether McKinsey and Goldman clients ought to be trusting these consulting and banking leaders with their secrets. The interesting twist here is that consultants get paid much less than bankers even though both graduate at the top of their classes in business school.

But the Gupta and Kumar examples suggest that they may have supplemented their paltry multimillion dollar earnings with fees from tipping off a hedge fund -- whose managers get paid more than even the bankers do. The 25 highest-paid hedge fund managers earned a total of more than $25 billion in 2009.

I hope the SEC keeps going in its efforts to uncover evidence of this unscrupulous behavior and that regulation is passed and enforced to make sure it can never happen again. As long as this conduct continues at the highest levels of the economic pyramid, it's hard to see how anyone can put their trust in our securities markets.