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Corporate America’s Benedict Arnold question

March 2, 2011, 4:30 PM UTC

How do you solve a problem like Rajat Gupta?

The question is sure to vex managers and directors in the wake of Tuesday’s insider trading bombshell. Securities regulators charged Gupta, a former McKinsey & Co. senior partner who as recently as last year sat on five corporate boards, with feeding more than $17 million worth of insider trading tips from his perch on the Goldman Sachs (GS) and Procter & Gamble (PG) boards.

Adopting best practices and emphasizing strong governance are all well and good. But how far should companies go to protect themselves against corporate turncoats?

The government’s allegations “open up a whole can of worms for companies and their boards,” says Mark Rifkin of class action law firm Wolf Haldenstein in New York. “They have a duty to show their boardrooms don’t have a culture that fosters this sort of behavior.”

To which Gupta replies, what behavior? He insists the Securities and Exchange Commission’s charges are baseless and promises to fight to the end.

So far, his benefactors believe him: He remains a director of two public companies, American Airlines operator AMR (AMR) and car stereo maker Harman (HAR), and is nonexecutive chairman of a third, Genpact (G).

Genpact, the only one of the three companies to comment on its relationship with Gupta, kept him on after he “unequivocally declared to us that he has done nothing wrong.” It added that he “has made invaluable contributions to Genpact.”

Yet standing by a director who allegedly compromised the integrity of two boards that he sat on puts companies in a ticklish position.

Take Goldman, for instance. Gupta quit Goldman’s board last year, just before news broke of his alleged involvement in the Galleon insider trading ring.

Goldman declined to comment, but were the firm to answer for this latest brush with scandal it would surely begin by noting the presumption that Gupta is innocent till an SEC administrative law judge says otherwise. It might well then ask what it could have done to rein in an independent individual whose alleged actions were clearly proscribed by law – or to investigate his actions after the fact.

Even so, the SEC case “clearly deals a blow to Goldman’s efforts to rebuild its reputation,” says Kathleen Wailes of communications consultant Levick Strategic Communications in Washington. “They owe it to their clients and shareholders to show they are serious about dealing with this.”

Also under the gun is P&G, the Cincinnati-based maker of Tide and Crest. It said Gupta stepped down “voluntarily” from P&G’s board Tuesday afternoon, about two hours after the SEC filed its case.

“There have never been any specific allegations against Mr. Gupta until today,” says Paul Fox of Procter & Gamble. “Given the specific allegations made by the SEC today, Mr. Gupta voluntarily resigned from the P&G Board of Directors. He has vigorously denied the SEC’s accusations but stepped down in the interests of P&G because he did not want it to be a distraction to our Board or our business.”

Yet just last fall, P&G chief Bob McDonald had stoutly defended Gupta before a shareholder named Helga Schwab at the company’s annual meeting. Bear in mind that he did this months after the Wall Street Journal reported securities regulators were investigating Gupta’s alleged tipping off of Berkshire Hathaway’s (BRKA) $5 billion investment in Goldman at the height of the 2008 financial crisis.

Schwab: Good morning gentlemen and ladies. I do have a question pertaining to Mr. Gupta. It’s my understanding that he used to be a director at Goldman Sachs and he resigned because some implication of insider trading with some Indian company earlier this year, I believe it was in April of this year he resigned. Could you be a little bit more specific why he still would make a good director for this company?

McDonald: Thank you for your question, Miss Schwab. Rajat Gupta is a valued director of the Procter & Gamble Company. He resigned from the board of Goldman Sachs before any allegations were made against him. All allegations were proved false. We value his contribution to our board greatly and we are glad that he is a member of our board and standing for election today. Thank you.

The presumption of innocence is certainly a worthy principle, but it’s hard to follow McDonald’s claim that Gupta had been exonerated before charges were even brought. Did the P&G board trust Gupta too much?

It is certainly something directors are going to have to consider.

The Gupta episode “raises a question whether board of directors should dump a director whenever SEC action is filed against him/her for anything,” says James Post, a management professor at Boston University. “P&G is now paying the price of misplaced loyalty.”

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