I’m not easily shocked these days, but I have to confess I gasped out loud when I read that the former managing director of McKinsey, and until recently board member of Goldman and Procter & Gamble, Rajat Gupta, had been charged by the SEC for insider trading. Why would someone with one of the most blue chip reputations in Corporate America, who has clearly done very well financially, risk it all to make a bit more? Not only is the downside considerable, but it also isn’t as if these moves would have made a meaningful difference in his lifestyle. He already had status others would kill for. And passing profitable tips to Raj Rajaratnam was never going to be a ticket to Hedgistan levels of wealth.

But the next interesting bit was to watch the reaction in terms of what this scandal meant for McKinsey. This event was a Rorschach tests on the firm, often with a bit of schadenfreude at another elite name being shown to have feet of clay. And even though I worked for McKinsey over 20 years ago and think the firm has a lot to answer for, some of the charges are a bit barmy.

So let’s dispatch with the uninformed inflammatory stuff first and get to the real dirt. Barry Ritholtz (who I normally like) tried a drive by shooting that went wide of the mark: “Is McKinsey & Co. the Root of All Evil?’ His list of seriously bad ideas that McKinsey recommended to clients, including a strategy that led to SwissAir’s bankruptcy, its involvement in some of Enron’s creative accounting ideas, and its encouraging Allstate not to pay legitimate insurance claims, manages to miss their single biggest value destroyer: the AOL-Time Warner merger, the worst M&A deal of all time. (As much as McKinsey had some fingerprints on Enron, it was central in the AOL-Time Warner deal. It pushed the board to consider it five separate times).

But does it add up to Barry’s charge, “where ever there has been a financial disaster in the world, if you look around, somewhere in the background, McKinsey & Co. is nearby.” Um, no. McKinsey had nothing to do with the 1987 crash or the even bigger value destroying (but less widely publicized) 1994-1995 derivatives wipeout. And I have not seen anything to suggest it played an even secondary role in the global financial crisis. Big dealer firms tend to bring in McKinsey only in the down times; they are strongly of the view that they fact that they make so much more than consultants means they are clearly vastly smarter too, ergo there isn’t anything they could tell them that would be useful. The one exception is private equity, where McKinsey and Bain, to a lesser degree BCG, do a lot of work for the biggest buyout shops, such as KKR and TPG.

Andrew Haldane of the Bank of England has estimated that the global financial crisis cost between 1 and 5 times global GDP. Divide that across, say, 20 banks. McKinsey in its wildest dreams never had the clout to do that kind of damage. (Barry suggests a Taibbi type investigation, but journalists have been trying for as long as I have known anything about McKinsey to do a hit piece, and no one has succeeded).

So why the strong reactions now that McKinsey is in the spotlight? Some of it is no doubt that consultants in general and McKinsey in particular have managed to sail through this period of obvious widespread corruption among the governing and business classes looking clean by virtue of comparison. Bankers have suffered a well deserve plunge in their reputation; everyone knows all the Four accountants help big companies cheat but get away with it because the authorities see them as too big to fail; lawyers are generally not that highly respected, and even the white shoe types have taken a hit as Corporate America has become more mercenary. And McKinsey, by being preeminent but with many people mystified as to why, can quickly become a lighting rod. And that’s the real message of Barry’s list of really bad McKinsey recommendations: not that the firm is “the root of all evil” but a probable phony.

Now is that fair? Yes and no. It’s going to be easy to charge that I am so long out of the firm that I can’t possibly know. All I do is see some fellow ‘zoids at McKinsey alumni parties and get gossip once in a while from other sources. But much of what has happened over time to McKinsey is pretty easy to infer between the inherent problems with big strategy firm consulting and the way McKinsey has responded to economic and cultural changes.

To make a very long story very short, McKinsey was one the successors to a firm started by James O. McKinsey, an accountant, in the 1920s. The original consulting firms were industrial process specialists (time and motion studies were a big deal in those days). Marvin Bower, who more than anyone is responsible for McKinsey’s rise, who had a law degree and had worked at Jones & Day, thought the model was a law firm, to become a trusted counselor and adhere to professional standards. Bower stood for ideas like doing fact based analysis, providing objective advice, and telling the client the truth even if they might not like it. He would sometime sell studies by telling clients that if they didn’t think the work was worth it, they didn’t have to pay the bill. But this was in the day when no one “sold”; you’d build relationships, be visible in the community, publish articles and hold small group meetings to demonstrate intellectual leadership, and wait for the phone to ring. When I was there (the 1980s) that model was intact. The partners kept an “inquiry log” not a “calling list”.

Elite consulting firms had a clear value proposition back then. There were only a very few MBA programs seen as any good; there were not all that many MBAs in big corporations. And McKinsey and its peers were all much smaller then, and hired only from the top 10% of top schools. So even if they met a prospect that did have some MBAs, the firm was presumed to have an intellectual edge, plus its staff usually had a practical advantage by having experience in a broad range of industries on different types of problems and thus had a lot of tools and reference points that would be outside the client’s scope.

But let’s look at the conflicts and perverse incentives in this industry. Remember the lofty goal is giving fact based, objective advice, which by implication means without fear or favor. But the problem with consulting is you are hired by the problem. The relationship (not at junior levels, but between the partner and the client executive) has some elements in common with being a shrink. My impression was that most partners did not tell the unvarnished truth, but instead decided to dole out as much as they thought the client could handle. And some would be much more conservative on how much they doled out than others. As a consequence, the path of least resistance is to dispense what I like to call “leading edge conventional wisdom”.

And that leads to second-order problems. How do you know, to use that ambiguous expression so favored at McKinsey, that you are “adding value”? The truth is, as with therapy, most clients don’t get any better. Now the consultant can rationalize that by telling himself that in the absence of his involvement that the client would have done even worse. That might even be true. But within a year or so of being at McKinsey, I concluded you had to be cynical or deluded to be a partner there (being a engagement manager was actually a great job, but your end product was doing good studies, not trying to change client behavior).

And the business model is actually pretty crappy. Big consulting firms, like big law firms, make their profits by marking up staff time, and non-partner time can be marked up at higher premiums. So that means you have an incentive to carry overhead. And if you have overhead, you need to keep the fees coming in to keep the machine going. But consulting is project based. And capable clients, the sort that might use a consultant only if they faced a special challenge or change of circumstance, can bring a consultant in, be very happy with the work, and not have them back for a very long time. (Not being much of a baby sitter, I like capable clients and am not very good at selling, so I am acutely aware of this conundrum). So if you like working with on the ball managements, you will probably suffer from a lot of churn.

So that brings us to another big implication: The most profitable clients are the most diseased. And the corollary, as stated by a former colleague: McKinsey is in the business of propping up diseased managements. Now that will no doubt offend readers who think their companies are savvy and have still used McKinsey (and the private equity model isn’t terrible: the consulting firms serve as rental staff that gets no carried interest, plus is a marketing plus with investors, so there the concern that the consultant is an enabler isn’t operative). And if an industry is undergoing major change, you might see a good management team want help over a very long period of time. But when I was there, the firm was deep into General Motors (a huge team by the standards of that day), the old AT&T, for instance. I was on the Citibank team, where the client was smart and aggressive but often didn’t apply its energies to the best ends: the joke was that it was a “fire, aim, ready” organization.

There is an additional problem with the law firm model: its controls didn’t scale well. In a law firm, you don’t invite people to join the partnership unless you are pretty certain of their professional competence, their ability to bring in business, and their character. There is usually no supervision of partner work. The problem with that in a large consulting firm is you have a brand and need to have brand consistency. McKinsey achieved that to some degree via a lot of across firm staff training and “firm format” (secretaries were prohibited from producing documents that did not conform). But Goldman exercised far more supervision over partners than McKinsey did.

So, for instance, on a Treasury study in London, the partner announced that we were going to find a way to beat the foreign exchange market. And by the way, all we had was four months of end of day trading data in four currencies versus the dollar. When I proceeded to tell the partner this was not gonna fly (I didn’t even mention efficient markets, merely told him there were too few data point and it was the wrong data too, we’d need intraday prices from everyone in the market, not just our client, there was no way were were going to get that), I was deeded to have Bad Attitude. I concluded I had no interest in being a partner in a place that would allow partners to engage in obvious stupidity at client expense.

On a different axis of lack of supervision of partners, one of my buddies attended an alumni meeting for former partners not long after Enron went bankrupt. One of the participants asked, “How many of you worked with Jeff Skilling?” About a third of the hands in the room went up. Next question: “How many of your are surprised he was involved in something that did not pass the smell test?” No hands went up.

The firm was lax on some other fronts. One partner in my day completely made up data for a very splashy report published jointly with a Wall Street firm. And it was an obvious falsification to anyone in that field; the information was simply not obtainable. Yet nothing bad happened to him. Similarly, a guy on the verge of making partner was found to have charged personal tickets to Asia to the firm. At Goldman, a guy committing a similar scale offense (charging a closing dinner that never took place) was fired immediately. This fellow, who offered the dog-ate-my-homework excuse that his secretary has made a mistake, merely made partner a year later than he would have otherwise. He left the firm to work for a hedge fund….and paid the SEC $3 million to settle insider trading charges.

In the later 1980s, as pay on Wall Street escalated, the firm got into a panic as it began to have trouble recruiting from the top 10% of MBA programs and lot of mid level people left (I doubled my pay by quitting). It responded by figuring out ways to increase partner compensation (so the argument was that the lifestyle was not as awful as Wall Street, the work was more interesting, and directors, which was the tenured partner group, made a very nice living). The biggest was to raise the fees. The other was to get more serious about partner utilization rates (in the old days, less productive partners were simply paid less). Rajat Gupta was apparently a big mover on pushing the firm for more growth.

Over the next decade, I heard complaints about the quality of McKinsey work. I’m not certain it was any worse, but if you sell basically the same product for two or three times as much as it cost five years ago, customers will have higher quality expectations. But McKinsey has long had a big internal PR department; it was the sixth largest in the US in the 1990s, so that probably offset some of the image concerns.

The firm has also become very aggressive about selling work (Marvin Bower would be spinning in his grave). I’ve had executives give me long form accounts that I found appalling. Very much shortened version: McKinsey guy says; “Here is what we think you need and how we can help you.” Potential client: “Thanks, that’s useful input but we really think our challenge is Y and we are in the process of dealing with that internally.” McKinsey guy: “No, you really need us and here’s why.” Ahem, has no one told them the customer is always right?

A final tidbit: for many clients, the reason they hire McKinsey is not mainly to get the analytical work, but to get the advice of a director with whom they have a relationship. CEOs are isolated, and they don’t have many business savvy sounding boards they can confer with. But the deal at McKinsey is you can’t just get the director, you need to have an engagement (yes directors might have an occasional lunch with a CEO prospect, but there are limits to what you can get on the cheap and a counselor can’t be very useful unless he has a sufficiently in depth grasp of the situation). So the “consultant as therapist” can be the main driver for the relationship.

And that the real reason the Rajat impropriety has struck at the heart of the McKiney brand. He wasn’t just the head of a firm that did a lot of fancy studies; he was the counselor/confessor for a lot of CEOs. How would you react if you learned your therapist was a wifebeater or dealt drugs? You’d feel betrayed. That’s the same sort of visceral reaction that a lot of top brass had when they read about the charges against Rajat.

But this outcome is the inevitable result of the decay in morals that has taken place in a remarkably short time, via the mobility-induced erosion of relationships in workplaces and communities, and the promotion of values that place monetary success over standards of conduct. The people at the top of the food chain are now seeing that if loyalty to you is merely bought, you can always be outbid by someone else.