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Patisserie Valerie and Corporate Governance

by AppliedCG

Recently, one of the darlings of the UK’s AIM market blew up spectacularly. Patisserie Valerie is a chain of high street cake shops, which had been expanded from eight shops in 2006 to over 200 in 2018. It was acquired by well-known entrepreneur, Luke Johnson, in 2006 and he took the role of executive chairman, recruiting a CEO and CFO with whom he had worked before in earlier ventures. and taking its value from the £8m he paid for it to nearly £450m before the disaster.

Hubris to Nemesis?

As the business grew, so did Mr Johnson’s reputation, and he felt able to dispense his advice in a number of other roles, from journalism, writing a column for the Financial Times, and later the Sunday Times, to several non-executive directorships, while running his own company, Risk Capital Partners. He clearly had total confidence in his management team, and presumably, therefore, limited the executive element in his chairmanship duties at Valerie Patisserie.

One morning, however, he came into his office for a briefing by his CEO, to be given the horrifying news that the company was on the verge of being wound up, having discovered a £20m hole in its accounts. The CEO reported that the Tax Authorities had grown tired of pursuing a claim for over £1m, and some weeks earlier had applied for a winding up order. Additionally, and catastrophically, instead of the company having, as they thought, nearly £30m in the bank, there were two undeclared overdrafts amounting to nearly £10m. And, as it later emerged, the rent on a number of shops was outstanding, and when the company had to go public with the news about its finances, these shops were immediately repossessed by the respective landlords.

Being an honourable person, and having a substantial portion of his personal wealth tied up in his 37% shareholding, Mr Johnson immediately took steps to try to save the company. In the next few days, he pledged £20m in short term loans from his own resources, and rapidly raised nearly £16m in pledges from various investors to subscribe to an emergency share issue at a very deep discount. So the company was saved, at least for the immediate future, but the CFO was suspended, arrested and released on bail, then later resigned. The auditors, Grant Thornton, have egg on their face, and Mr Johnson has called in PwC to investigate.

What were the corporate governance failings?

In our holistic approach to corporate governance, we define the five principles of good governance of a company as being an ethical approach, a common goal for the main stakeholders, effective strategic management, an organisation structured and resourced to deliver and a culture of transparency and accountability. In our forthcoming book, we also point to the obligations of the stakeholders and the role of the board in supervising the company, and the part played by the regulatory bodies and the auditors in checking what the company is doing. So how well do these various parties come out of an examination of what went wrong here?

Bear in mind that, at this stage, we don’t know exactly what happened, let alone why, but as far as the company itself is concerned, the obvious failing is in the concealing of the financial state of the business. And this must reflect on that part of the management team which is relied upon to look after the numbers. Which is why the finger is being pointed at the CFO, and why he has felt it appropriate to resign. In turn, the organisation was clearly structured in such a way that failings in this area appear to have gone undiscovered until the roof fell in. So the internal controls must have been seriously deficient, and that is conventionally the responsibility of the Finance and Administration function.

Which leads us on to the supervisory function exercised by the Board of Directors. To be caught out by such a dramatic misunderstanding of the financial position implies a major lack of attention, and a lack of efforts to check the figures presented to them on a regular basis. And for the chairman to describe his role as “executive” implies an intention to participate in the running of the business. It is often criticised for the chairman to take an executive role since the chairman ought to be managing the board and ensuring that it carries out its duties in ensuring that the executive is running the business properly. Arguably, that cannot be done properly if the chairman doesn’t have an arms’ length relationship with the executive. And for Mr Johnson, who has made a point (and a living) out of telling other directors how to do their jobs, it must be very embarrassing indeed to be criticised for distracting himself with his outside activities and failing to spot a catastrophic failing under his nose.

Then we look at the bodies which are supposed to provide an outside check that the company is being run properly. What on earth were Grant Thornton doing in their audit that they failed to pick up this major discrepancy between the declared cash position and the actual? At this point, we don’t know over what period the shortfall developed, or the time that elapsed from the last audit to the financial crisis. But the difference between £30m in the bank and £10m overdrawn seems unlikely to have happened overnight in a business with a mere £130m turnover. The auditor must now be checking its professional indemnity insurance as the lawyers line up to bring a possible shareholder’s action.

How the disaster might have been avoided

So what could have been done to spot these problems earlier? Here we would point to our belief in the need to maintain a permanently open channel to the main stakeholders, and the importance of this channel being maintained outside the company’s internal structures and reporting in at the highest level to the chairman and board, canvassing stakeholders’ views about the company and its business practices. Now two of the important stakeholders are the sources of finance (the banks) and the creditors (in this case, the landlords). The Tax Authorities are another stakeholder whose opinion of the company’s behaviour can be critical to its well-being (as has been shown in this case). An open channel and regular engagement would undoubtedly have brought to the attention of the chairman and the board that several landlords were concerned about rent arrears, that the two banks had been approached to set up new finance and now were about to stop providing further overdraft finance. And finally, the Inland Revenue’s court action would surely have been notified through this channel by the tax inspector concerned with the case.

So, once again, a company which appears to be well-run and to comply with all the regulations and pass its audit tests, has proved to be an object lesson in poor governance. Another candidate for our Applied Corporate Governance approach.

Read our update on Patisserie Valerie corporate governance here

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