After the very successful fourteen years of Sir Terry Leahy’s leadership ended in 2010, Tesco has been finding life increasingly difficult.
His successor, Philip Clarke, arguably made a strategic error in taking too long to change strategy on its overseas adventures, particularly its heavily loss-making Fresh & Easy chain in the United States. Its businesses in Asia were also absorbing much management time in China and Japan, and its Korean Homeplus unit is currently being investigated for selling customer data.
Recently, in an attempt to broaden its offering domestically, he made purchases like Blinkbox and the Giraffe restaurant chain, which did nothing to reduce the negative impact on sales of low cost rivals Aldi and Lidl. Investors were presented with the image of a new CEO floundering in the face of the challenges and increasingly flailing around in a desperate attempt to find the answer. This clearly caused intense pressure over recent months and years as the company and its management struggled to achieve targets against deteriorating performance and increasing market competition.
The impact on governance appears to have been dire. Apparently Philip Clarke exhibited increasingly stressed behaviour, bullying and not listening to those who disagreed with him. At an operational level, the pressure to make demanding target numbers drives people to push the boundaries from good practice through permissible but not good practice into unquestionably bad practice. At this stage the managers concerned hope that, like the office thief stealing the petty cash, they will somehow be able to pay it back before they are found out. But usually they are found out first. In a bullying office culture where results come first, the messenger is usually shot, so messengers either don’t come forward or they become whistleblowers.
At a top management level, the pressure seems to have caused the progressive departure, voluntarily or by firing, of many of the most experienced people. Thus by the time of the latest crisis, the board had no-one with any direct experience of retailing and it is reported that the Finance Director, Laurie McIlwee, who resigned in April, had not been on speaking terms with the CEO for some months. Moreover, after resigning, he was asked to make himself available when asked, but not to set foot in Tesco’s headquarters. Nor, in fact, was he asked again.
Following his departure, a finance committee was set up including Carl Rogberg, the regional finance director. This committee was responsible for producing the (unaudited) half year trading forecast for the 6 months to 23 August. This was the forecast which a senior manager, believed to have worked under Carl Rogberg, felt unable to accept during its preparation. He became a whistleblower and prepared a short presentation pointing to his areas of concern and reporting to the CEO. Philip Clarke was still in charge and the whistleblower’s report got nowhere. Meanwhile the board signed off the forecast with its questioned assumptions and issued the estimate of £1.1bn first half profit on 29 August.
On 1 September the new CEO, Dave Lewis, arrived and the whistleblower took the opportunity of a new broom to take his concerns to Tesco’s general counsel, who immediately took the presentation to the CEO. Dave Lewis took prompt action, summoning a team of senior people to spend the weekend considering the implications. On the Monday they made the official announcement that the estimate of two weeks earlier had overstated profits by some £250m, or 25%. Carl Rogberg and several other top managers were suspended, accountants Deloittes and lawyers Freshfields were tasked with finding out exactly what had happened, and the Financial Reporting Council, the Serious Fraud Office and the Financial Conduct Authority are all now involved. The new CEO had listened to the whistleblower and perhaps averted an even bigger disaster to come.
The problems derive from the accounting practice known as revenue recognition – when to take credit for income. It is a well-known area of controversy and companies looking to show impressive growth, or to cover up shortfalls in forecast revenue, are vulnerable to the temptation to pull forward revenue which more properly belongs to a later period. It was revenue recognition that was at the heart of the dispute after HP had acquired Autonomy, and that saga has yet to reach a conclusion.
In Tesco’s case, its auditors, PwC, had earlier been asked by the board to look into the revenue recognition practice at the end of the last financial year in February, and had warned of the susceptibility to manipulation citing the materiality of the amounts involved and the degree of judgement required, while giving it an OK at the time. The issue is what is called Commercial Income, relating to the company’s relationships with suppliers. This is a complex area but essentially relates to rebates and discounts negotiated with (or forced on) suppliers based on various things like support with new product launches, volume of sales achieved etc. By its nature it is difficult to forecast and the dangers are made worse by the fact that the deals done may enable the company to take credit today while agreeing to future costs. So the effect is to pull revenue forward while deferring the related costs. When sales and profits are under pressure, the temptations here are obvious. And the conclusion of the hasty investigation following the whistleblower’s report was that the earlier forecast contained £250m of profit brought forward from the second half of the year.
Now what was the board doing all this time? The Chairman, Sir Richard Broadbent, was made aware of investors’ concerns about performance for many months and, it was argued by an insider before the event, engineered the sacking of the CEO to protect his own position. So the board should have been looking very closely at the results they were presented, to check for inconsistencies and any sign of “cooking the books”. As we said earlier, however, none of them had any hands-on experience of running a retail business and as the chairman, rashly, said: things are never noticed until they are noticed – this from a man with a strong financial background.
However, the board was warned by a City analyst working for Stockbroker Cantor Fitzgerald last year that margins seemed implausibly high against a background of falling sales. Costs were rising faster than gross income so how could margins be stable. It suggested that this could be due to demanding or booking monies from supplier accounts. All this should have been perfectly clear to the board, but the company apparently sent them a threatening letter. The chairman is now, of course totally exposed, having been seen to preside over a board which by his admission knew nothing of what was going on.
Successful entrepreneur Luke Johnson, who sold his Giraffe business to Tesco last year suggested that the pressures arose because “possibly the business is hooked on unsustainable profit margins”. He points out that currently there is only one executive director on the board, the CEO, and he has no retail experience as an executive, like the other nine Non Executive Directors. He says “Tesco’s recruitment policy for directors clearly does not include the requirement for them to have any hands-on background in their specific industry at all”. How can they challenge the executives if they have no real familiarity with the trade? Interestingly, are there not parallels here with the criticism that was made of the boards of the major banks that got into trouble in the financial crisis of 2008? The Walker Report made clear recommendations that these boards should include people who knew the banking business.
It’s difficult enough when the CEO is an experienced retailer, as we recall from Arthur Kendall’s experience in advising the CEO of a multi-billion pound retail business that some of the figures in his regular reports were plain wrong. The CEO was very surprised but it had never occurred to him to challenge them.
Now the lid is being raised on a wider range of Tesco’s accounting practices and attention has been drawn to its treatment of debt. Apparently between 2009 and 2013, as part of its sale and leaseback plan, Tesco used a series of six special purpose vehicles to issue nearly £4bn worth of property bonds, structured with the help of Goldman Sachs. The suggestion is that the effect of this off-balance sheet financing has been to artificially reduce Tesco’s net debt by around £2bn and raises the question why they should want to move the debt off the balance sheet when they appear still to be ultimately responsible for the liabilities. It would, presumably reduce capital employed and boost the return on capital, benefiting published results and related management bonuses. But special purpose vehicles have uncomfortable echoes of Enron, and we know how that story ended.
So we know in broad terms what has happened and the why appears to relate to pressures on management which caused people to cross the line into unacceptable valuations of revenue. But what are the lessons?
The new CEO, Dave Lewis has apparently emailed staff saying Tesco must be “open, transparent, fair and honest”. Which is fair enough, but no-one is ever going to actively promote the philosophy of a culture which is secretive, opaque, unfair and dishonest. So how should Tesco put in place a system which makes whistleblowing unnecessary?
The answer, we believe, lies in our Applied Corporate Governance approach with its set of five Golden Rules of Good Corporate Governance and use of regular targeted surveys of key stakeholder groups to flush out deficiencies.
Three of the major stakeholders in the Tesco case would have made it perfectly clear to the board through an independent survey that something was going seriously wrong in the area of supplier relationships. The City analysts, representing the investing community, had already flagged up their concerns. Indeed, a broad survey would surely have brought sufficient evidence of concern that the board would have listened rather than threatened. The suppliers would have been able to express views in a confidential survey which they would never have felt able to do publicly and these would have drawn attention to the vulnerabilities to which PwC’s report had alluded. Finally, a confidential staff survey would have made it unnecessary for the whistleblower to go to the company’s general counsel, when the CEO, or his office, declined to take him seriously.
It took a new broom to sweep the office clean. But preventive maintenance is what is practiced by airlines to prevent their aeroplanes falling out of the sky when something breaks. That is what our regular survey approach provides.