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How does Tesco climb the mountain?

Tesco has been rocked by controversy. What issues of corporate governance does this raise and how should they be handled? Mark Lane investigates

How are the mighty fallen – or, in Tesco’s case – in the process of falling.

It was only just over five years ago that the UK’s biggest retailer dominated the grocery world with £1 out of every £7 spent in British shops ringing through its tills.

That was then, this is now. Today, not only is Tesco’s market share falling and its half-year profits down by 92%, the group is mired in a scandal which seems to grow steadily worse and which raises profound corporate governance issues.

Now, following the revelation of a £263m profit overstatement, the Serious Fraud Office has launched a formal criminal investigation into accounting practices at the group.

This supercedes an investigation by the Financial Conduct Authority, the City regulator, and comes in the wake of eight senior executives being suspended.

What went wrong and why is a question for the investigation and for Tesco’s own review. But, in the meantime, what will be exercising the mind of Tesco chief executive Dave Lewis is what to do now to revive the fortunes of the ailing giant and how to address the corporate governance issues raised.

Ken Odeluga, market analyst at spread betting broker City Index, says that Tesco’s own review must go ahead and be rigorous.

He says: “There’s no suggestion there’s going to be back-pedalling on the review, which is meant to be a root and branch, no-holds-barred review of everything that’s going on in Tesco and everything that it was doing and everything that it had planned to do. That needs to be allowed to run its course.’’

The truth has to come out and investors and customers need to be satisfied it has come out, without any attempt to put a gloss on it.

Jim Prior, chief executive of WPP branding and design agency The Partners, says: “They are doing the right thing so far, which is to get the issue in hand. He [Lewis] has to be seen to be decisive in dealing with that and be seen to be ready to address that as immediately as possible. There’s nothing more they can do other than act as quickly as possible and get to the bottom of it and the last thing they want to do is to try to put a positive spin on that story. This is not a time for spin, this is a time for sorting it out.’’

With all the usual caveats about pre-empting the findings of any inquiries, these will take time and more urgent action is called for. Observers are already making certain assumptions.

Mike Dennis, food and general retail managing director with Cantor Fitzgerald Europe, believes that while the actual figures may have been a surprise, the issue lying behind them – that of Tesco pulling forward supplier rebate payments – must have been known about.

He says: “Hundreds of suppliers were going through this situation with Tesco going back two years.

“It originated out of a senior management being incentivised very heavily on sustaining the UK margin of 5.2% and holding the UK trading profit at virtually any cost and that incentivisation of a very senior board director – 70% of their total pay-out was based on those key metrics – would have filtered down to all the trading groups, all the retail groups, all the cost saving operations within the business and all the distribution people and that would have modified their behaviour to not act in chasing sales but act in chasing margin and lowering costs and trying to get as much as possible out of suppliers.’’

Odeluga agrees. “The suggestion is that certain practices became established over a period of time between two and four years and they were not challenged initially for whatever reason but eventually they became such that they were no longer questioned and these things became almost routine.’’

That raises obvious corporate governance and cultural issues for Lewis to address but it also begs questions of the group’s auditors, PwC, who had been signing off the accounts for more than 30 years. It is worth remembering, as Odeluga points out, that, as long as four years ago, Tesco’s policy on revenue recognitions was challenged as being “more aggressive than its competitors’’ by an analyst with US investment bank Citigroup.

Third parties are beyond the control of Lewis but there are things he can do in his own organisation. Heads must roll.

“The senior managers within the finance unit are officially still suspended,’’ says Odeluga. “I don’t think there’s any other option but for them to go, I think that’s pretty clear.’’

It is usually suggested at times such as this that there should be more oversight of boards to ensure good corporate governance, with board members specifically charged with ensuring that playing by the rules trumps playing hardball with suppliers or anyone else.

Odeluga is not convinced that such independent voices on the board would necessarily have a material effect on standards of corporate governance at Tesco or other companies. He points out that in many companies where the roles of chairman and chief executive are combined are effectively and ethically run.

On a more basic level Lewis can immediately put a stop to some of the practices which may have led to Tesco’s current problems. Dennis says that many of the agreements with suppliers were made verbally.

“That’s been an industry factor for ages. There’s nothing wrong with a tough negotiation but where Tesco were going wrong was that they were taking money, expecting the supplier to phone up and say where’s our money and then start a negotiation.’’

Tesco also needs to raise funds, which it can do, Odeluga believes, by selling off property or with sale and lease backs, selling its video streaming service Blinkbox, the restaurant chain Giraffe, and elements of its Club Card.

Prior argues that Tesco must then launch a radical overhaul of its whole brand.

“If you have an organisation that isn’t paying proper attention to its corporate governance, then it’s probably not paying proper attention to its brand either and vice versa,’’ he says. “This all suggests an organisation that had really lost its way at a senior level in terms of how it set its strategy. When you get incredibly tactical at the brand level and the operational level, that’s when these mistakes happen. Tesco needs a differentiated strategy but they cannot afford to get the brand right and get the corporate governance wrong.’’

Tesco is a large and highly complex organisation and it is hard for any single figure to have a handle on what goes on in every part. For this, senior management has increasingly to rely on sophisticated management information tools and software.

Piyush Pant, vice president of strategic markets at MetricStream explains: “Over the past 10 years a number of corporate governance practices and risk practices and assurance practices have had a large element of manual participation. As the speed and the amount of information that they have to deal with has increased they have needed a level of automation so they can have consistent, reliable processes. Software allows the consistency of processes in risk assessment and risk management.’’

Is there a danger that with future failings of corporate governance, the management will simply blame the software?

Pant says: “Software that automates the process of risk management doesn’t allow abdication of responsibility. The actual actions that a business takes once it has understood the risks still needs leadership, judgement and speedy decision making.’’

Over to you Mr Lewis.

This was posted in Bdaily's Members' News section by Mark Lane .