Has the UK Corporate Governance Code let Tesco Shareholders Down?

Five months have passed since we first heard of Tesco overstating its profits by £263 million and still the story continues to appear in the press on a frequent, if not weekly basis.  Recently, Tesco announced that it had agreed to pay £1.22m liquidated damages contractually owing to Philip Clarke, its former CEO and £970,800 due to Laurie McIlwee, its former Finance Director, despite the fact that findings of an investigation by the Serious Fraud Office into the profit overstatement are still to be released. (Quinn, 2015).This investigation could possibly reach adverse findings against the former executives negligent for the overstatement of profits.

This has once again raised the question whether or not the board of Tesco has acted in the best interests of its shareholders.  Some shareholders may question why Tesco is paying compensation to these senior executives who may have been liable for the recent overstatement of profits.  It may be seen as ‘rewarding’ these former executives rather than punishment. Another point of view may find it commercially beneficial for the company to pay the former executives now rather than later in order to avoid an expensive legal battle in the future, particularly when the compensation for loss of office is contractually owing.  In fact, in its announcement Tesco stated, ‘defending costly claims would not be in the company’s best interests’ (Treanor, 2015).  This point along with the fact that the findings of the Serious Fraud Office’s Investigation are still to be released may justify Tesco’s decision to make these compensation payments now, rather than later.

When news of the accounting scandal first surfaced in October 2014, the need for strong Corporate Governance was highlighted once again, with questions asking why Tesco has not learned from the examples of Enron and the collapses of banking institutions during the financial crisis as a result of poor Corporate Governance.  The Tesco executives may have overstated profits in order to cover up its poor performance in the months prior to the overstatement, with the company facing intense competition from Aldi and Lidl which resulted in Tesco losing market share (BBC News, 2014).  The Executives may have been thinking about their own job security and potential performance related payments if they intentionally meant to overstate the profits, therefore putting the reputation of the company at risk.  If this was the case, it supports the Agency Theory proposed by Jenson and Meckling (1976) who stated that managers engage in their own interests for their own benefit rather than that of the firm’s shareholders.

At the time of the scandal, the Financial Times (2015) offered a possible explanation for the overstatement of profits, suggesting that supermarkets have a complex relationship with suppliers which can add a degree of subjectivity to profits.  The article also argued that a flaw in the UK Corporate Governance Code could be a contributor to the scandal – with the ‘comply’ or ‘explain’ approach being of strong significance.  Within the Code it states: ‘an alternative to following a provision may be justified in particular circumstances if good governance can be achieved by other means’ (Frc.org.uk, 2015).  PwC, as auditors may have fulfilled its role by flagging concern to directors who then dismissed it.  This had the result of potentially misleading  investors.

While the accounting scandal and the recent subsequent announcement of paying compensation to former executives have raised questions about Tesco acting in the best interests of shareholders, I think the scandal would not have occurred if the UK Corporate Governance Code did not have the ‘comply’ or ‘explain’ approach.  The overstatement could have been dealt with internally between Tesco and PwC before it reached the public domain if the UK Corporate Governance Code was mandatory and did not permit non-compliance.  Tesco’s shareholders were therefore prejudiced by the weakness in the Code.  I think this is a key issue which the Financial Reporting Council needs to address.  If the UK Corporate Governance Code was a more ‘rule-based’ instead of ‘principle-based’ set of guidance companies would not have the opportunity to exploit the gaps a ‘principle-based’ set of guidance provides.

Financial Times,. (2015). Picking up the pieces after Tesco’s stock affair - FT.com. Retrieved 3 February 2015, from http://www.ft.com/cms/s/0/341f1c2a-5b75-11e4-a674-00144feab7de.html#axzz3QgQAQJvM

Jensen, M., & Meckling, W. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal Of Financial Economics, 3(4), 305-360. doi:10.1016/0304-405x(76)90026-x

Treanor, J. (2015). Tesco to spend £2m in payouts to former executives. the Guardian. Retrieved 3 February 2015, from http://www.theguardian.com/business/2015/feb/03/tesco-2m-payments-executives-supermarket-accounting-scandal

Quinn, J. (2015). Tesco u-turn on £2.1m pay for former bosses - Telegraph. Telegraph.co.uk. Retrieved 3 February 2015, from http://www.telegraph.co.uk/finance/newsbysector/epic/tsco/11386304/Tesco-u-turn-on-2.1m-pay-for-former-bosses.html