How Tesco are affected by company law and governance

What do the problems at Tesco tell us about company law, the modern company and corporate governance?

Question

What do the problems at Tesco tell us about company law, the modern company and corporate governance?

This should be based on UK Company Law. Please include the Companies Act (2006) and The Corporation Tax Act (2009) if relevant and any European Law or directives which are relevant.

Introduction

Corporate scams, from Enron, Worldcom, Tyco, and Lehman in the US, Parmalat in Italy, and Satyam in India, are rampant. This seems ironic, given that the domain of corporate law has evolved, presumably, towards better rules, enforcement, regulation and overall governance. So, what actually leads to such recurring menace of corporate scandals?

The most recent addition to this list of erring companies is Tesco- the UK based retail giant, coming under the regulatory scanner in 2014 after the discovery of whopping overstated profits of around £263 million.¹ A closer look into the various company aspects of Tesco over a period of one-two years until the emergence of the accounting gap perhaps hints at the ignored missing links.

Accounting and Audit

A historical investigation into the corporate scams to date reveals a common trait of the “expectations-gap”.² To explain, when the corporate watch-dogs, namely the board of directors, auditors, analysts, lawyers, and consultants fall short of the performance levels perceived or expected from them by investors/stakeholders, such a gap is created. For instance, the Parmalat episode can be attributed to audit failure by Grant Thornton and Deloitte, who was responsible for the company’s audit function since decades. Notwithstanding such long tenure of association, the auditor overlooked certain fictitious bank accounts used to channel funds to controlling shareholders.³ Similarly, PriceWater House Coopers- PwC had been engaged with the external audit of Tesco for several years at a stretch. Likewise, Enron managed to keep huge debt off its balance sheet with the aid of its auditor – Arthur Andersen is alleged to have disguised excess executive remuneration and manipulated fudged the company accounts.⁴ More recently in 2009, the Satyam debacle in India exposed gross inflation of revenue and assets by the company promoters, once again calling into question the veracity of the company’s audit function.⁵ All of these examples, inter alia, reveal that auditors, in order to protect clientele, tend to rely on information and sign off on accounts supplied by insiders, akin to the Hollinger scandal.⁶ Thus, auditors, as corporate gatekeepers, have triggered massive corporate scams across the globe.⁷

One of the precautionary measures to avoid such corporate debacles implemented by the UK Corporate Governance Code of 2014 (“Code”) is the rotation of auditors every ten years so as to avoid any dominance, subjectivity or any bias.⁸ Such rotation is also reiterated in the European Union Regulation on Statutory Audit of 2014.⁹ However, given that this provision works on a “comply or explain” basis, the requirement is not absolute and may be surpassed, as evidenced with Tesco’s links with PwC for more around three decades.¹⁰ Such long stretches of engagement call into question the independence of such external audits, and potential threats of familiarity, conflict of interest and board influence on the audit function. Moreover, given that many of the Tesco executives had prior connections with PwC, including the chair of audit committee, the independence of external audit raises concerns.¹¹

Alongside the external audit, Tesco’s faulty accounting also highlights the inefficacy of the company’s internal control and audit committee, which failed to question such manipulated profits, despite the external auditor’s qualification mentioning “risk of manipulation” to the audit report of 2014.¹² While the Code and the EU Audit Directive¹³ lay strong impetus on internal control¹⁴ and the constitution and role of the audit committee,¹⁵ including in terms of reporting the significant issues relating to the financial statements, Tesco’s audit committee proved to lack proactiveness in this regard.¹⁶ The audit committee, expected to discharge its function of ensuring a fair and true reflection of the company’s finances in the annual report to shareholders, clearly defaulted in its duty by not reporting or flagging the inflated revenue.

Governance and Board of Directors

“The history of the twentieth century was dominated by the struggle against totalitarian systems of State power. The twenty-first will no doubt be marked by a struggle to curtail excessive corporate power.”¹⁷ The above statement aptly describes the growing impetus on the need to harmonise the conflicting interests of company, its owners and controllers, the stakeholders, vis-à-vis the society. In other words, it highlights the significance of governance and corporate responsibility, in which the board of directors (being the steering group) has a pivotal role to play.

Accordingly, detailed provisions are found in the Companies Act of 2006 (“Act”), codifying directors’ duties of care, diligence, skills, disclosures, independent judgment, promoting the company’s success, and for avoiding conflict of interest situations.¹⁸ Likewise, extensive deliberations are found on independent directors, balancing the board composition with executive and non-executive directors, and promoting board diversity.¹⁹ These aspects were time and again also emphasised upon in expert committee reports and recommendations, such as the Cadbury Committee²⁰ and the Higgs Report.²¹

However, from a practical standpoint (as revealed in the corporate scams described above), the board and its committees are most often found to be in conflicting situations failing to provide an effective leadership, monitoring and supervision, resulting in the expectations-gap.²² For instance, although well constituted with both- insider and outsider directors, boards are often found short of directors truly “independent” in terms of function and judgement, as was the case in Parmalat, and also in Enron which otherwise boasted of a fifteen members’ perfect on-paper legally compliant board.²³ The latter further highlights shortcomings emanating from the excess load of multiple directorships in detecting systemic flaws.²⁴

Similar conditions as above applied to the Tesco board, where the institution of independent directors and critical assessment of board decisions have been brought into question. This was because, despite being duly constituted and gender diverse, Tesco’s board failed to raise a critical voice against the prevalent irregularities, more particularly in terms of revenue recognition. It seemed that the non-executive directors succumbed to the notion of “group-think”, peer pressure and executive dominance.²⁵

In terms of director liabilities, while the Company Directors Disqualification Act of 1986 enables disqualification of directors in default, and section 178 of the Act provides for civil consequences of breach of directors’ duties, not much of these are relevant for Tesco. This is because the responsible directors, namely the chief executive officer (Philip Clarke), the chief financial officer (Laurie McIlwee), and the chairman (Richard Broadbent) have resigned from their respective positions prior to the conclusion of investigations into the matter.

Reliefs

As is evident from the above discussions, although much progress has been made in the substantive laws of nations,²⁶ including in the UK, gaps continue to exist in respect of the implementation and enforcement of such laws. Hence, the solution needs to sorted by way of stronger enforcement of the enacted laws.

As such, although UK company law provides for civil consequences, there is much uncertainty infused by conflicting court rulings.²⁷ For instance, while the cases of Caparo,²⁸ Hercules²⁹ and Stone & Rolls³⁰ negate any auditor’s prima facie duty of care towards shareholders, others like Kripps v Touche Ross³¹ and Morgan Crucible Co. v Hill Samuel Bank³² favour such liability. In view of these ambiguities, newer reliefs such as private enforcement actions (class-actions and derivative suits)³³ may be more relevant. Not surprisingly, these remedies have, thus, been codified in the contemporary company law provisions of the US³⁴ and UK.³⁵ For instance, given that Satyam was listed on US stock exchange, the US investors resorted to class-action in US courts to seek redress of their losses.³⁶ Needless to state, similar paths can be invoked in the Tesco instance too.

Parallel to regulatory and law mechanisms, industry initiatives may go a long way in preventing and curing such menace. A potential method being an efficient nomination and recruiting policy which imbibes an optimum balance of skills, experience, independence and knowledge to boost gatekeeper functions.³⁷ The aftermath of the Tesco scam highlights two of such initiatives, namely (i) removal of PwC as the external auditor, and its replacement with Deloitte; and (ii) recovery of certain hefty severance amounts paid to the executive directors responsible for the company management at the time when the reported irregularities were alleged to have been commissioned.³⁸

Short-term Focus

It is condemned that the Tesco accounting errors and manipulated profits were aimed at enhancing stock prices and short-term returns to the investors, at the cost of long-term interests of the company.³⁹ This is further corroborated by Tesco’s recent overhaul of its executive bonus plan to prioritise sales growth, customer relations and long term vision over and above short-term profits.⁴⁰ It is worthwhile to note here that the overall long term success of the company is a deep-rooted principle of the Code (reiterated in various sections),⁴¹ and thus, Tesco’s conduct of profit inflation goes much against this germane philosophy of UK corporate governance.

Convergence

In the globalised market with reduced trade and investment barriers, and a crowd of market participants, increase in competition and resultant tapping of foreign markets is a commonplace. Regardless of the form of the presence in such foreign markets (whether by incorporating a subsidiary, an offshore office, franchise, agency or other contractual arrangements), the burden of legal compliances increases manifold. This is because the company no longer remains confined to the laws of a single country.⁴² In addition, such multi-jurisdictional exposure brings the company under the scanner of multiple regulators/enforcement authorities, with the result being a paradox of conflicting laws and regulatory overlap.⁴³ Cross-listing is such an instance where a company trading its securities on any foreign exchange is subject to the laws of such country,⁴⁴ which adds to the volume of its legal obligations, associated costs, and risks.

Aside to the national governance codes and expert committees⁴⁵ which inspire the corporate agenda, multi-national companies like Tesco must also be cognizant of similar norms at the international level prescribed by organisations like the Organisation for Economic Co-operation and Development (OECD)⁴⁶ and the International Organisation of Securities Commissions (IOSCO).⁴⁷ This overlap further aggravates in complex corporate structures driven by, aside to strategic objectives, tax and regulatory arbitrage purposes.⁴⁸

A potential solution may be found in the converging trends of corporate compliances and governance norms. Convergence, in other words, seeks to attain a consensus on standardised or uniform rules across jurisdictions so as to reduce the friction of laws and procedures. While certain commonality is evident in the emerging governance features such as independent directors, board committees, succession planning, diversity, and audit/accounting and disclosure/reporting standards,⁴⁹ divergences are inherent. Thus, convergence is a limited concept, and its journey has so far been slow-paced and seems far from attaining any universal uniform code.⁵⁰ The difficulty further mystifies with the ever expanding contours of corporate law extending to social responsibility, democratisation, corporate citizenship, running into an indefinite list.⁵¹

Tesco, as a multi-national company with extended outreach in foreign markets, is thus not exempted from this challenge of legal and regulatory overlap, and consequent enhanced compliance costs. While on one hand, the company had been aggressively expanding its market, its legally constituted board on the other hand omitted to pay attention to the most fundamental errors- thereby highlighting flaw at the very basic level.⁵² Needless to mention, allocation of corporate resources to such variant cross-country measures tends to deviate the corporate focus from more meaningful governance concerns like audit and board accountability to on-paper and tick-the-box compliances.

Whistle-blower

The Tesco episode once again stressed upon the merits of the much acclaimed whistle-blower mechanism, as the accounting disguise was unmasked and flagged to the senior officers by a whistle-blower employee.⁵³ A whistleblower is one who raises, whether internally or externally, any concern regarding a risk, malpractice, danger, manipulation or wrong within an organisation. Although such anonymity based policy was put to use in the case of Tesco, criticisms surround its efficiency, considering that the revelation was ignored for months before any action was pursued.⁵⁴

Whistle-blower policy has become a pivotal component of the corporate governance framework, as envisaged in C.3.5 of the Code. Accordingly, it is the responsibility of the audit committee to ensure adequate arrangements to enable reporting in confidence of concerns relating to the company finances. This reiterates the Institute of Chartered Accountants in England and Wales’s Guidance for Audit Committees: Whistleblowing arrangements, promulgated in March 2004. Moreover, whistle-blower has been acknowledged as a favoured practice in other corporate disciplines too, like the UK Bribery Act of 2010, which addresses the issue of corrupt payments made by UK companies.⁵⁵

Conclusion

It appears that the problem, as revealed in the Tesco scam, has more to do with the enforcement gaps than with any legal lacunae. This is because the Tesco board was legally compliant with all requisite composition rules, the company had a whistle-blower policy in place, and its annual report contained all necessary items in terms of directors’ report, audit report and committee remarks, as envisaged by the Act.⁵⁶ Nonetheless, the profit inflation did occur and has emerged to be a major faux in the UK retail sector, necessitating review and reforms at the enforcement stage.

This, however, does not undermine the necessity of laws to consistently evolve in keeping with contemporary corporate needs.⁵⁷ Such progression must also be on the converging roadmap so as to simplify compliances for multinationals like Tesco. Having said that, such reforms must not be ignorant to the variances warranted by the local country-specific conditions.

Further, the remedy will remain incomplete unless these formal laws are backed up by active surveillance by professional bodies like the Recognised Supervisory Bodies for auditors.⁵⁸ All in all, “corporate gatekeepers”- although a term not formally defined,⁵⁹ assumes a central role in building a strong governance system, and a robust corporate and investor protection culture.⁶⁰ This has been confirmed through recurring scams blotting the corporate map globally.

Footnotes

¹ Graham Ruddick, ‘The unanswered questions in Tesco’s accounting scandal’ (The Telegraph, 6 November 2014) Read the article here accessed 14 September 2015.

² Iris H-Y Chiu, ‘The role and liabilities of auditors in financial regulation: addressing the expectations gap’ (2012) 5 I.B.L.J. 545.

³ G.A. Ferrarini & P. Giudici, ‘Financial Scandals and the Role of Private Enforcement: The Parmalat Case’ (2005) European Corporate Governance Institute Law Working Paper No. 40/2005 Read the article here accessed 24 June 2015.

⁴ J. C. Coffee, ‘A Theory of Corporate Scandals: Why the United States and Europe Differ’ (2004-05) 7 Stud. Int’l Fin. Econ. & Tech. L. 3.

⁵ Floyd Norris, ‘Indian Accounting Firm is Fined $7.5 Million over Fraud at Satyam’ The New York Times (5 April 2011).

⁶ J.C. Coffee (n 4).

⁷ Fox, ‘Gatekeeper Failures’ (2008) 106 Michigan Law Review 1089. See also, J.C. Coffee, ‘Understanding Enron: Its About the Gatekeepers, Stupid’ (2002) 57 Business Lawyer 1403.

⁸ C.3.7 of the UK Corporate Governance Code, 2012.

⁹ Regulation (EU) No 537/2014 of the European Parliament and of the Council, on specific requirements regarding statutory audit of public-interest entities and repealing Commission Decision 2005/909/EC, dated 16 April 2014- art 17.

¹⁰ ‘The Guardian view on Tesco’s auditing debacle: a systemic shambles?’ (The Guardian, 23 October 2014) Read the article here accessed 14 September 2015.

¹¹ Ibid.

¹² Tesco PLC Annual Report and Financial Statements 2014 Read the article here accessed 13 January 2015.

¹³ Directive 2014/56/EO of the European Parliament and of the Council, amending Directive 2006/43/EC on statutory audits of annual accounts and consolidated accounts, dated 16 April 2014.

¹⁴ C.2 of the UK Corporate Governance Code, 2014.

¹⁵ C.3 of the UK Corporate Governance Code, 2014.

¹⁶ C.3.8 of the UK Corporate Governance Code, 2014.

¹⁷ Eric Schlosser, Fast Food Nation: The Dark Side of the All-American Meal (Mariner Books 2012) 261.

¹⁸ Chapter 2 of the Companies Act, 2006.

¹⁹ B.1 and B.2 of the UK Corporate Governance Code, 2014.

²⁰ The Cadbury Committee Report on Financial Aspects of Corporate Governance, 1992.

²¹ The Higgs Report on Independent Review of Non-Executive Directors, 2003.

²² Iris H-Y Chiu (n 2).

²³ Jeffrey N. Gordon, ‘What Enron Means for the Management and Control of the Modern Business Corporation: Some Initial Reflections’ (2002) 69 U. Chi. L. Rev. 1233. See also, Committee of Governmental Affairs, Report on the Role of the Board of Directors in Enron’s Collapse, United States Senate (8 July 2002).

²⁴ J. Welch & S. Welch, ‘Of Boards and Blame’ (26 January – 2 February 2009) Business Week 102.

²⁵ S Nielsen, ‘Top Management Team Diversity: A Review of Theories and Methodologies’ (2010) 12 International Journal of Management Reviews 301. See also, IL Janis, Victims of Groupthink: A psychological study of foreign-policy decisions and fiascos (Houghton Mifflin Company 1972).

²⁶ For instance US’ Securities Exchange Act of 1934, the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. See also, UK’s Companies Act, 2006, read with Financial Reporting Council, The UK Corporate Governance Code (September 2014).

²⁷ Anita Anand & Niamh Moloney, ‘Reform of the audit process and the role of shareholder voice: transatlantic perspectives’ (2004) 5(2) E.B.O.R. 223.

²⁸ Caparo Industries plc v Dickman ¹⁹⁹⁰ 2 AC 605.

²⁹ Hercules Management Ltd. v Ernst & Young ¹⁹⁹⁷ 2 S.C.R. 165.

³⁰ Stone & Rolls v Moore Stephens ²⁰⁰⁹ 1 AC 1391.

^{31 1997} 6 W.W.R. 421, 33 B.C.L.R. (39) 254 (CA).

^{32 1991} Ch. 2995.

³³ Luca Enriques, ‘Corporate governance reforms in Italy: what has been done and what is left to do’ (2009) 10(4) E.B.O.R. 477.

³⁴ Hawes v City of Oakland 104 U.S. 450, 455 (1881); and Cohen v Beneficial Indus. Loan Corp., (1949) 337 U.S. 541. See also, Thomas P. Kinney, ‘Stockholder Derivative Suits: Demand and Futility Where the Board Fails to Stop Wrongdoers’ (1994) 78 Marq. L. Rev. 172.

³⁵ Part 11 of UK’s Companies Act 2006. See also, Langley Ward Ltd v Trevor ²⁰¹¹ EWHC 1893 (Ch) 61; and Kiani v Cooper ²⁰¹⁰ EWHC 577 (Ch).

³⁶ Press Trust of India, ‘Mahindra Satyam agrees to settle class action suit’ (The Hindu 17 February 2011) Read the article here accessed 12 July 2015.

³⁷ Roman Tomasic and Folarin Akinbami, ‘Towards a new corporate governance after the global financial crisis’ (2011) 22(8) I.C.C.L.R. 237. See also, Matthew Saunders, ‘Corruption and the auditor’ (2004) 36 Euro. Law. 20.

³⁸ Paul Jarvis & Sam Chambers, ‘Tesco Overhauls Executive Pay in Wake of Accounting Scandal’ (Bloomberg, 21 May 2015) Read the article here accessed 13 September 2015.

³⁹ Alex Miller, ‘Tesco Scandal- The Perils of Aggressive Accounting’ Read the article here accessed 13 September 2015.

⁴⁰ Paul Jarvis & Sam Chambers (n 38).

⁴¹ Para 1 of the the UK Corporate Governance Code, 2014.

⁴² Viet D. Dinh, ‘Codetermination and Corporate Governance in a Multinational Business Enterprise’ (1998-99) 24 J. Corp. L. 975.

⁴³ Loukas A. Mistelis, ‘Regulatory Aspects: Globalization, Harmonization, Legal Transplants, and Law Reform-Some Fundamental Observations’ (2000) 34 Int’l L. 1055.

⁴⁴ Mark J. Roe, ‘Legal Origins, Politics, and Modern Stock Markets’ (2006-07) 120 Harv. L. Rev. 460.

⁴⁵ For instance, the Cadbury Committee Report on Financial Aspects of Corporate Governance, 1992; the Greenbury Report on Director’s Remuneration, 1995; the Higgs Report on Independent Review of Non-Executive Directors, 2003; and the Smith Report on Audit Commitees, 2003.

⁴⁶ OECD Declaration and Decisions on International Investment and Multinational Enterprises, 1976.

⁴⁷ IOSCO, ‘Corporate Governance Practices in Emerging Markets Report’ (Emerging Markets Committee 2007).

⁴⁸ Kenneth A. Grady, ‘Income Tax Treaty Shopping: An Overview of Prevention Techniques’ (1983-84) 5 Nw. J. Int’l L. & Bus. 626. See also, Roeline Knottnerus & Roos van Os, ‘The Netherlands: A Gateway to ‘Treaty Shopping’ for Investment Protection’ (International Institute for Sustainable Development 12 January 2012) Read the article here accessed 13 July 2015.

⁴⁹ G. Markarian, ‘The Convergence of Disclosure and Governance Practices in the World’s Largest Firms’ (2007) 15(2) Corporate Governance 294. See also, Tobias H. Troger, ‘Corporate Governance in a Viable Market for Secondary Listings’ (2007-08)10 U. Pa. J. Bus. & Emp. L. 89.

⁵⁰ Thomas Clarke, International Corporate Governance: A Comparative Approach (Routledge 2007).

⁵¹ J.N. Gordon & M.J. Roe (eds), Convergence and Persistence in Corporate Governance (Cambridge University Press 2004).

⁵² The Guardian (n 10).

⁵³ Nathalie Thomas, ‘Tesco’s £250m accounting black hole first flagged during Phil Clarke’s reign’ (The Telegraph, 28 September 2014) Read the article here accessed 14 September 2015.

⁵⁴ Ibid.

⁵⁵ The Bribery Act, 2010- Guidance about procedures which relevant commercial organisations can put into place to prevent persons associated with them from bribing (section 9 of the Bribery Act 2010) (Ministry of Justice, March 2011).

⁵⁶ Chapter 5 of the Act.

⁵⁷ John Armour & Joseph A. McCahery, After Enron: Improving Corporate Law and Modernising Securities Regulation in Europe and the US (Hart Publishing 2006).

⁵⁸ For instance, the Financial Reporting Council in the UK, and the Institute of Chartered Accountants of India.

⁵⁹ J.C. Coffee, ‘Gatekeeper Failure and Reform: The Challenge of Fashioning Relevant Reforms’ (2004) 84 Bu. L. Rev. 301.

⁶⁰ S.M. Solaiman, ‘Statutory civil liabilities of corporate gatekeepers for defective prospectuses in Australia, the United States, the United Kingdom and Canada: a comparison’ (2014) 35(4) Comp. Law. 100.