In September 2014, Tesco PLC (“Tesco”) admitted to an estimated £250 million profit black-hole in its books after a whistle-blower exposed the issue. Further independent investigations by Deloitte raised the misstatement to £263 million, uncovering past years’ manipulations of commercial income, a subjective area of accounting in the grocery retail industry. The objective of this case is to allow discussion of issues such as board composition, particularly the skills, knowledge and competencies of the board; the governance role of the board; the role of regulators; shareholder litigation; and accounting for commercial income in the grocery industry.

Warren Buffett’s £427 million grocery bill

There he sat, arguably the world’s most famous investment guru, reflecting on his decision to invest in Tesco. Seated across the interviewer in the CNBC building, the third-largest shareholder of Tesco admitted his “huge mistake”.¹ This came in light of the eruption of the accounting scandal the previous Monday. Tesco had admitted to unaccounted profits estimated at a whopping £250 million, sending shockwaves through the stock market. The share price plunged, wiping £1.1 billion off the retailer’s market value.² Later that month, Buffett dumped 245 million shares, effectively halving his stake in the retail giant. In the process, he suffered a loss of £427.2 million.

Tesco PLC

Prided as a British national asset, Tesco PLC is a British multinational grocery and merchandise retailer listed on the London Stock Exchange (LSE). It is also a constituent of the FTSE 100 Index. Tesco is Britain’s largest retailer and the second-largest retailer in the world by revenue.³ Founded in 1919 by Jack Cohen, Tesco began growing rapidly in the 1950s through expansion and acquisitions. Tesco has since engaged in geographical and product diversification. Its products include books, clothing, electronics, financial services, telecommunications and internet services.

The space race

For the past decade, Britain’s ‘big four’ supermarkets – Tesco, Asda, J Sainsbury and Wm Morrison – had been undertaking an aggressive expansion strategy, opening an unprecedented number of new stores⁴ against the background of a sharply declining supermarket industry. Factors contributing to the industry’s decline included a raging price war, the falling cost of food commodities, stiff competition from growing discounters Aldi and Lidl and up-market grocer Waitrose, and the growth of online and high street convenience stores.⁵ Other factors included the advent of online retailers and consumers’ lifestyle preference for low-cost products.⁶ As such, supermarkets struggled to maintain profit margins in the weak market.

Board composition

In 2014, Tesco had a board consisting of 12 directors, including two executive directors – Chief Executive Officer (CEO) Philip Clarke and Chief Finance Officer (CFO) Laurie McIlwee, who were also the only individuals on the board with a background in the retail industry. The other 10 board members, including Chairman Richard Broadbent – who had worked previously at HM Treasury, Schroders and HM Customs and Excise before joining Tesco in 2011 – had no prior experience in retail. Three board members had a background in banking and finance, one in telecommunications, one in glass manufacturing, and two in the government.⁷ There were also two board members with a background in audit – Ken Hanna, a non-executive director and the Chairman of the audit committee, who was previously the CFO of Cadbury⁸, and Mark Armour, another nonexecutive director, a former partner at PricewaterhouseCoopers (PwC). Among the nonexecutive directors, only Hanna and Patrick Cescau had a ‘consumer bent’.⁹ The shortage of retail experts on the retail giant’s board of directors led to concerns regarding the lack of knowledge and skills on the board relating to the grocery retail industry.¹⁰

Early warning signs

Tesco issued a series of profit warnings in 2014. Its first profit warning came on 9 January, 2014 due to poor Christmas sales, with an announcement that projected profits might be up to £150 million below expectations.¹¹ Deterioration of sales continued into April, despite Clarke’s efforts to revive the business. On 5 April, 2014, McIlwee, who did not see eye-to-eye with Clarke, resigned.¹² Consequently, Clarke was the only remaining executive director on the board, and the only director with retail experience.¹³ McIlwee assumed the role of CFO emeritus for the following six months to help with “transition activities” while Tesco searches for his successor. During this period, he continued to receive his salary of £886,420 and a potential bonus valued at twofold of his remuneration for the half-year period. Upon his departure from Tesco in October 2014, McIlwee received a £970,800 golden goodbye.¹⁴
In May 2014, PwC, Tesco’s auditor for 30 years since 1983¹⁵, informed Tesco in its latest audit report about its concern regarding how income from commercial deals with suppliers had been recognised.¹⁶ Citing the “judgment required in accounting for the commercial income” and the “risk of manipulation of these balances”, PwC noted the issue as a specific area of focus.¹⁷ In response, Tesco’s audit committee said it did not consider it a “significant area for disclosure in its report.”¹⁸ Nevertheless, this did not impact the unqualified opinion of PwC.

The curious case of commercial income

Commercial income is defined as promotional fees, discounts and rebates from suppliers. Suppliers routinely contribute a percentage of the promotional costs. In effect, suppliers pay retailers back a portion of their lost income. Such negotiations between retailers and suppliers usually take place a year in advance; hence cash is often received much earlier than when actual sales are made.¹⁹ This time lag results in room for interpretation with regards to the timeliness of the booking of relevant profits and costs. While Generally Accepted Accounting Principles (GAAP) advocate the matching of revenues and costs, profit accruals may be recognised earlier while cost accruals may be delayed, effectively overstating profit for the period.²⁰ In reality, such grey areas are prevalent in the accounting of many retailers, including Tesco.
There is difficulty in estimating exactly when retailers would reach the sales target triggering the rebate; hence the ambiguous timing on the booking of rebates that were earlier received.²¹ While there had been no clear guidance on the matter, the sheer size of Tesco’s accounting misstatement and persistence of profit warnings, coupled with PwC’s earlier warning, indicate a lack of sustainability of early profits stemming from Tesco’s earnings management.

Profit warnings continue

On 21 July, 2014, Tesco issued a second profit warning, stating that sales and trading profits would be lower than previously expected, which contributed to brewing negative sentiments among shareholders against Clarke and Broadbent. This prompted Cescau, Chairman of Tesco’s nominating committee, to succumb to shareholder pressure and oust Clarke on the basis of a lack of improvement in financial performance.²² Subsequently, Dave Lewis was appointed as his successor and he was expected to join the retail giant’s board in October that same year.²³ In response to this management change, Tesco’s share price rose by 2.8% to 292.80p within the first hour of trading, despite the profit warning.²⁴
On 29 August, 2014, Tesco issued yet another profit warning – its first-half year profits were to be £400 million less than expected.²⁵ This triggered a more than £1.3 billion decline in Tesco’s value, as its shares dived nearly seven percent to 230p, its lowest level in 11 years.²⁶
On 1 September, 2014, incoming CEO Dave Lewis started his job at Tesco one month earlier than had been arranged for, amidst doubts of his capability.²⁷ In early trading hours on the same day, Tesco shares fell by 1.9% to 225p.²⁸

Whistleblowing

On 22 September, 2014, Lewis revealed that Tesco has uncovered issues with its accounts that had boosted profits by £250 million in the first half of the year.²⁹ The problem had been brought to the attention of the general counsel in Tesco by a whistleblower, who had approached Lewis with a report. This immediately triggered an investigation.³⁰ It was alleged that the same whistleblower had earlier in July 2014 attempted to alert Carl Rogberg, the UK finance director of Tesco, regarding the accounting error but was ignored for months.³¹ The news raised questions about the effectiveness of Tesco’s board in its oversight role.³² Broadbent later commented that he could not be sure that £250 million was the limit of the overstatement.³³ Tesco further admitted that they had had a vacant CFO position for five months leading up to the scandal. The shares tumbled 11.3% to 203.5p – a new 11-year low – in early Monday trading on 22 September, 2015, in response to the revelation.³⁴ Broadbent said that he would not resign in the wake of the profit accounting scandal, but will “always listen to shareholders”.³⁵ Tesco also suspended four executives immediately after the discovery of the profit misstatement.

Here comes another: The series of investigations

Pursuant to the announcement of the accounting misstatement, Lewis concurrently alerted the Financial Conduct Authority (FCA), the City regulator of UK, and appointed audit firm Deloitte and law firm Freshfields for an internal review concerning the accounting misstatements.³⁶ This led to a gruelling series of investigations into Tesco’s inflated commercial income. On 23 September, 2014, a new finance director, Alan Stewart, was brought in two months ahead of schedule to help a team of external investigators to get to the bottom of the profit misstatement.
On 1 October, 2014, the FCA launched an investigation to examine whether Tesco had breached financial disclosure rules and released misleading statements to the stock exchange.³⁷ At this point, Tesco’s shares had lost half of its value from the previous year.³⁸ Just three weeks later, on 23 October, 2014, Deloitte’s inquiry pointed to a shocking overstatement of £118 million in Tesco’s 2014 financial half-year, £70 million in the 2013/14 financial year, and £75 million in the prior year³⁹, effectively extending the period and the amount of misreported profits. In response to Deloitte’s report, Broadbent announced his departure from the board so as to draw a line under the entire affair.⁴⁰
On 29 October, 2014, an investigation commissioned by the Serious Fraud Office
(SFO) – the organisation which “probes the gravest of financial crimes”⁴¹ – took over the ongoing investigation by the FCA. The wide scope of investigations uncovered unfair payments and complex transactions underlying supplier-retailer relationships.
With the largest drop in sales in four decades, the fifth profit warning of the year was issued on 9 December, 2014. Lewis announced that annual profits would not exceed £1.4 billion, down from the earlier consensus of £1.94 billion. In response, Tesco’s share price plunged by 16% to 156p, reducing Tesco’s market value by another £2 billion.⁴² By 18 December, 2014, a total of nine executives were suspended.⁴³ Meanwhile, the Financial Reporting Council joined the ongoing investigation on 22 December, 2014 to investigate the conduct of Tesco’s auditor, PwC.⁴⁴
Two months later, on 5 February, 2015, the Groceries Code Adjudicator (GCA) also joined the investigations, based on “reasonable suspicion” that Tesco had breached the Groceries Supply Code of Practice. Critics, however, argued that the GCA alone was not strong enough to force supermarkets like Tesco to change their ways due to its lack of legal powers to impose penalties.⁴⁵ This prompted drastic changes to be implemented in the UK grocery retail scene. On 4 February, 2015, the UK government submitted new rules to Parliament to hand powers to the GCA to fine supermarkets for poor treatment of suppliers.⁴⁶ The new legislation was approved, allowing the GCA to impose penalties on large supermarkets of up to one percent of their total annual turnover.⁴⁷ However, the new powers were only limited to breaches from 6 April 2015. As a result, Tesco would not be affected by the change in legislation.

We want our share: Shareholders’ reaction

The accounting scandal sent a ripple of rage through its shareholders with its £263 million black hole in profits. With the majority of Tesco being owned by large pension funds and institutional investors, Tesco had to brace itself for a series of long legal battles by angry investors chasing compensation. On 9 November, 2014, numerous US law firms such as Scott and Scott LLP, were in talks with European institutional investors over the filing of legal claims.⁴⁸ Subsequently, a class-action lawsuit was filed in the US by Tesco’s shareholders. On 25 November, 2014, Stewarts Law attempted to bring together major shareholders who owned at least 10,000 shares with a value of more than £20,000, to launch a lawsuit in the UK, where there exists no legal provision allowing for thousands to come together to file one big claim.⁴⁹ The claim, which was funded by Bentham
Ventures B.V., was premised on the argument that Tesco’s directors and senior management “knew or were reckless as to whether Tesco’s statements to the market were untrue or misleading”, which was in breach of the UK Financial Services and Markets Act.⁵⁰ The Tesco Shareholder Claims, a non-profit group funded by Scott+Scott, was also set up in the US on 25 March, 2015, to rally institutional shareholders’ support to bring an action against Tesco.⁵¹ The group was also determined to extend the claims to institutional investors in the UK through representation by McGuire Woods. With the group’s argument that Tesco’s shares had lost between 50p and 70p of their value per share, Tesco was thus set to face a claim of £5.6 billion with its eight billion outstanding shares.⁵² On top of hefty legal claims, Tesco’s CEO, Lewis, had to grapple with a loss in shareholder’s confidence as Tesco’s shares hit a 14-year low during the series of investigations.⁵³
Unlike in the US, there are currently no legal provisions in the UK for class-action lawsuits, and the use of the Financial Services and Markets Act by investors to lodge civil claims in the UK is relatively rare.⁵⁴ Hence, the Tesco scandal marks one of the rare recent cases of shareholder class action in the UK and may set the tone for future shareholder action against irresponsible large corporations.⁵⁵ On 8 January, 2015, Lewis announced a turnaround plan for Tesco in a bid to regain its competitiveness in the market and to cut costs significantly to save £250 million a year.⁵⁶ As part of the cost-cutting measures, Lewis abolished dividends for the second half of 2014. Tesco’s share price surged by more than 15% after the announcement, closing at 209.25p at end of the day.⁵⁷
Too little, too late?
Since the commencement of the investigations, Tesco’s board has experienced major restructuring in response to criticisms of its board composition. On 1 November, 2014, the board was joined by two non-executives with retail experience: Mikael Ohlsson, the former chief executive of Ikea, and Richard Cousins, the former chief executive of food services firm, Compass Group.
Two female non-executive directors, Olivia Garfield and Jacqueline Tammenoms Bakker, resigned on 26 February, 2015, leaving only one female director remaining on the board. This left Tesco far short of the government’s recommendation on female board representation. New Chairman John Allan mentioned that “we are committed to a balanced, representative board and the composition of that board continues to evolve”.⁵⁸ On 5 March and 7 April, 2015 respectively, Gareth Bullock and Patrick Cescau retired from the board.⁵⁹ Gareth Bullock still remained on the board of Tesco Bank. Tesco’s board was joined by Byron Grote, a former BP chief financial officer, on 1 May, 2015.⁶⁰
As investigations proceed, only time will tell whether the future of Tesco will improve with board changes and turnaround plans.

Discussion questions

1. Comment on the composition of the Tesco Board before the accounting scandal. Discuss how this has changed throughout the accounting scandal.
2. Discuss the key similarities and differences in board composition recommendations in the UK and Singapore corporate governance codes.
Which do you think provide for better standards of board composition?
3. CFO Laurie McIlwee left right before the accounting scandal blew up, leaving with a golden parachute. What do you think about this remuneration policy? Are there any other noticeable deficiencies in Tesco’s succession planning?
4. Evaluate the effectiveness of the regulators in dealing with the scandal and in protecting the interests of minority stakeholders.
5. Compare the legal system in the US and UK with respect to shareholder litigation. Which system do you prefer? Explain.