SFO charges three Tesco execs

It has been a difficult couple of years for retail giant Tesco, but at least one of its former senior executives can breathe a sigh of relief.

The United Kingdom’s corporate governance regulator, the Financial Reporting Council (FRC), closed its investigation into Tesco’s former chief financial officer Laurie McIlwee on 31 August, saying that it did not have a “realistic prospect that a tribunal would make an adverse finding” in relation to his professional conduct.

However, while the former CFO of the United Kingdom’s largest supermarket may have escaped further investigation into his role into the company’s accounting scandal, others have not been so lucky. On 9 September the Serious Fraud Office (SFO)—the United Kingdom’s enforcement agency—charged U.K. finance director Carl Rogberg, U.K. managing director Christopher Bush, and U.K. food commercial director John Scouler each with one count of fraud by abuse of position and one count of false accounting between February 2014 and September 2014.

The three will appear at Westminster Magistrates’ Court on 22 September 2016. Each faces up to 10 years in prison if convicted. Experts say that while they are aware of the stiff penalties that U.K. courts can impose for these offences, none can readily recall when the maximum terms were ever given out.

Crawford Spence, professor of accounting at Warwick Business School, says that “custodial sentences are possible, but being disbarred from holding directorships is more likely, as is being fined.” He adds that “there is no suggestion that the individuals here enriched themselves personally as a result of their activities so any financial penalties would likely be insignificant as they would be levied on individuals rather than the company.”

The SFO investigation into Tesco is ongoing, as is the FRC’s investigation into PwC, which until last year acted as the company’s external auditor for 32 years. The accounting scandal has led to Tesco reporting its biggest ever loss of £6.4bn for the year to February 2015.

It is now two years since Tesco first issued news of the holes in its accounts. The supermarket’s initial estimate of the accounting mis-statement was issued to the stock exchange in September 2014 and was believed to be around £250m spanning three accounting periods. After review by auditors Deloitte and law firm Freshfields, the mis-statement was “confirmed” as £263m in October 2014.

“Accounting mis-statements are fiendishly complicated and difficult to identify in advance. From what I have seen of the cases that the SFO investigates, such investigation is always ‘after the event’ of either formal insolvency of the corporate or the corporate self-reporting, either in isolation or after a take-over.”
Duncan Swift, Partner, Moore Stephens

However, in April 2015 Tesco restated the amounts for two of the three accounting periods upwards by a cumulative £63m and has since confirmed the actual mis-statement was £326m.

Duncan Swift, partner and head of the food advisory group at accountancy firm Moore Stephens, says that the revisions are important as the figure of £263m—when broken down across the three accounting periods—appeared to be below the audit materiality threshold (5 percent of profit before tax), which is the point whereby the auditor would be expected to have spotted it and to make shareholders aware. However, “at £326m the materiality threshold is breached in one of the three accounting periods,” he says.

There has been evidence of Tesco engaging in sharp practices with regards to the treatment of suppliers for years (as there has been of the other top 10 U.K. supermarkets as well). The Groceries Market Review in 2008, carried out by the Competition Commission, the United Kingdom’s competition regulator, highlighted how the supermarkets were using suppliers’ income to conduct their own business. In January this year Tesco was formally criticized in a 60-page report by U.K. regulatory body the Groceries Code Adjudicator (GCA) for its “widespread” practice of encouraging suppliers to give it extra cash in return for more control over where products appeared on shelves, as well as for deliberately and repeatedly withholding money owed to suppliers to artificially boost the supermarket’s sales performance.

SFO and DPAs

Below author Neil Hodge discusses the inner workings of the SFO in how it uses deferred prosecution agreements.
The introduction of deferred prosecution agreements (DPAs), which allow a prosecution to be suspended for a defined period while the company is monitored and bound to meet certain conditions, shows that the SFO can be pragmatic in how it pursues prosecutions, say lawyers.
The enforcement agency has so far been able to have two DPAs gain court approval—the first with Standard Bank last November, and the second in July this year with an unnamed organisation (a SME referred to as “XYZ”).
Furthermore, a DPA may allow for a reduced fine. In the July settlement, the DPA extended the 30 percent discount normally given to companies that self-report to 50 percent as the admissions were made “far in advance of the first reasonable opportunity” after charge. This means that the businesses may in future secure a more advantageous outcome through a DPA than a guilty plea (which can only take place after charge).
—Neil Hodge

However, the means by which a supermarket extracts so-called “commercial income” from suppliers is separate from the matter of how the supermarket—as a listed entity—records that income in its accounts and attributes it to the accounting periods in which it is earned together with any cost obligations. It is only the revenue/costs accounting treatment that the SFO are looking into—not the revenue source.

“Accounting mis-statements are fiendishly complicated and difficult to identify in advance,” says Swift. “From what I have seen of the cases that the SFO investigates, such investigation is always ‘after the event’ of either formal insolvency of the corporate or the corporate self-reporting, either in isolation or after a take-over.”

As a response to Tesco’s accounting scandal, in December 2014 the FRC issued a notice calling on boards of retailers, suppliers and other businesses to provide investors with more information on their accounting policies, judgements and estimates arising from their complex supplier arrangements. Such disclosure is made on a “comply or explain” basis, but companies may be investigated if their explanations (and disclosures) are inadequate.

Richard Fleck, then chairman of the FRC’s Financial Reporting Review Panel, said that “complex supplier arrangements such as fees and discounts may have a significant impact on the reported margins and other results of a company and on investors’ views of its performance. Where this is the case, it is essential that investors are able to understand the basis and extent of judgement and estimation involved and the potential uncertainties affecting the accounts and future prospects.”

The FRC hoped that the top four U.K. supermarkets—Tesco, Asda, Morrisons, and Sainsbury’s—would make full disclosure in their future accounts of the amounts of commercial income earned from suppliers in the period and the amount of income (and associated costs) recognised on the balance sheet as attributable to future years. However, to date only Morrisons has fully complied: Tesco and Asda have partially complied, while Sainsbury’s has chosen not to comply—risking regulatory action.

The regulator has written to Sainsbury’s to ask why it has not disclosed the information in its financial reports. According to sources, the supermarket has said that the information is “immaterial”, “commercially sensitive”, and is difficult to provide since there is not yet a fixed regulation in place detailing how the calculations should be made. The FRC has not commented on what further steps it may take to “encourage” companies to disclose the information.

While Tesco may be still grappling to rebuild its damaged reputation—and share price—experts have broadly welcomed how it has coped with the crisis. Several lawyers note that Tesco has co-operated “very well” with the SFO and suggest that the case is proceeding more quickly than others that the agency is investigating. Swift says the supermarket has been “exemplary” in corporate governance terms in disclosing and tackling the root-causes of the accounting mis-statement. “Within the space of two years, the company has self-reported the accounting irregularities; it has retained and protected the whistleblower that helped bring the case to light; and it has given the SFO all the information it needs to bring individual prosecutions. All of this should be applauded,” he says.

Some have also commended the SFO’s new regime of encouraging companies to self-report in exchange for potentially more lenient penalties and quicker case turnarounds. Spence says that the SFO may need to be as pragmatic as possible due to a sustained lack of funding.

“Although the SFO’s core funding increases incrementally each year, it generally receives up to 50 percent additional funding from the government. That additional funding has been sharply cut in recent years. For example, its gross budget for 16/17 will only be three quarters of what it was in 15/16,” says Spence.

Michael Dean, partner and head of the European Union, competition & regulatory practice at U.K. commercial law firm Maclay Murray & Spens, also believes that self-reporting and co-operating with the SFO may result in more lenient outcomes, but warns that it is not necessarily an easy road. For example, engine-maker Rolls-Royce self-reported allegations of bribery and corruption to the SFO in 2012, was informed of an investigation in 2013, and is still waiting for the outcome four years later.

One of the key inducements for companies to self-report is the recent introduction of deferred prosecution agreements (DPAs). These are particularly useful to the SFO as they avoid the need for costly jury trials (which can deliver a verdict either way) and avoid the difficulties of meeting a higher burden of proof, especially when seeking to pursue and pinpoint individual guilt.

However, finalising DPAs can also take a significant amount of time to arrange. DPAs require a judge to approve them and they generally involve paying a penalty, paying compensation, and cooperating with future prosecutions of individuals. If the company does not honour the conditions, the prosecution may resume. The SFO has so far concluded two of them.

“No agency has the resources to investigate every complaint or lead, and indeed many would not warrant prosecution anyway,” says Dean. “DPAs allow a more efficient use of the SFO’s resources. But that is not to say the SFO won’t prosecute a company either: The Sweett Group being convicted of failing to prevent bribery by an associated person in the UAE is a good example,” he adds.