We first became aware of problems at Tesco Plc (Tesco) and its subsidiary Tesco Stores Limited (Tesco Stores), on 22 September 2014 when Tesco announced that it had overstated its expected profits for the half year to 23 August 2014 by an estimated £250m.
Two years after the misstatement came to light, three senior ex-employees of Tesco Stores, (Carl Rogberg, Chris Bush and John Scouler (The Tesco Three)), were charged with fraud by abuse of position and false accounting.
In April 2017, a few months after the Tesco Three were charged, Tesco Stores entered a Deferred Prosecution Agreement (DPA) and associated Statement of Facts (Statement) with the SFO in which the Tesco Three were identified as individuals who had dishonestly perpetuated the misstatement. The fact of the DPA has been known since the provisional hearing in March 2017. However the document and therefore its precise terms were not published until after the trials of the Tesco Three were concluded.
The trials of the Tesco Three have now collapsed on grounds of insufficient evidence.
So, what went wrong? Why did the case against the Tesco Three collapse? How was it that Tesco Stores and the SFO were able to conclude a DPA based on a Statement that identified the Tesco Three and stated that they had dishonestly perpetuated the misstatement? On what basis did the Court approve such a DPA? The collapse of the trial of the Tesco Three leaves many questions for companies, the SFO and the Court.
Background
The issue which led to the financial misstatement by Tesco was the accounting treatment of commercial income, primarily in Tesco’s UK food business that was operated by its subsidiary Tesco Stores. Commercial income arises in a number of ways, including discounts or rebates that suppliers agree to pay Tesco Stores based on the volume of sales achieved and contributions to product promotion expenses from suppliers.
In September 2014, an internal whistleblower brought information to the attention of Tesco’s Board that the recognition of UK commercial income was being accelerated and the accrual of costs was being delayed. The company and its auditors, PwC, reviewed the situation and concluded that a misstatement of approximately £250m had occurred.
Since the re-statement of profits was announced, the Tesco Group has been the subject of an investigation by the Serious Fraud Office into its accounting practices (opened in October 2014), an investigation by the Financial Conduct Authority into alleged market abuse, an investigation by the Groceries Code Adjudicator for regulatory breaches, civil claims in England for compensation from 112 of its shareholders who claim to have suffered loss as a result of the company's misleading financial statements (s90A FSMA) and claims from shareholders in the US. All of these proceedings were an inevitable consequence of the correction of the misstatement.
It is understandable that a company under this level of scrutiny would be keen to bring criminal proceedings to an end as quickly as possible and this is what Tesco resolved to do. Tesco's board "committed to a course of full cooperation with the SFO from the outset of its dealings with it" and that this cooperation included self-reporting to the SFO and complying with the authorities' request "not to interview the witnesses to the conduct which is the subject of the indictment".
This decision to cooperate with the SFO unlocked the potential for a settlement of the criminal proceedings. The DPA reached by Tesco Stores related to an indictment of false accounting. As part of the DPA, Tesco Stores agreed to pay a financial penalty of £129m and costs of £3m. It agreed to implement a detailed compliance programme under the direction of its new auditors, Deloitte. The Court recognised that Tesco had agreed with the FCA to pay £84.4m to shareholders under a statutory scheme to compensate holders of its securities and concluded that no further restitution by Tesco Stores was required. Tesco Stores also agreed to cooperate fully with the prosecution of the Tesco Three.
The Tesco Three
The Tesco Three were charged with fraud by abuse of position and false accounting. A crucial element of each of these offences is that the act or omission of the defendant was dishonest. To charge the individuals, the SFO needed sufficient evidence of their dishonesty to satisfy the evidence stage of the Full Code Test set out in the Code for Crown Prosecutors, which provides that "Prosecutors must be satisfied that there is sufficient evidence to provide a realistic prospect of conviction against each suspect on each charge."
However in November 2018, over four years after the charges were originally brought, the trial of Chris Bush and John Scouler collapsed. His Honour Sir John Royce ruled that the defendants had "no case to answer", describing the evidence against them as "weak". The Court of Appeal upheld that decision. Carl Rogburg was not part of that retrial because he was recovering from a quadruple heart bypass. However, the case against him also collapsed on 23 January 2019 when the SFO offered no evidence against him.
Dishonesty
It seems that the Defendants did not deny that accounting practices which led to the financial misstatements took place. However the trial collapsed because the prosecutor failed to provide sufficient evidence that the individual directors acted dishonestly.
It is therefore concerning that Tesco Stores agreed a Statement and for the Courts to endorse a DPA based on that Statement which confirms the dishonesty of these individuals. The Statement executed by Tesco Stores in April 2017, states:
"Members of Tesco Stores' senior leadership team who were aware of and dishonestly perpetuated the misstatement leading up to the trading update on 29 August 2014 and up until the correction on 22 September 2014, thereby falsifying or concurring in the falsification of accounts or records made for an accounting purpose were [individuals named]."
In the DPA, Tesco Stores also affirmed that the Statement was "true and accurate to the best of Tesco Stores' knowledge and belief". It is possible that this belief was predominantly based on the decision of the SFO to charge the individuals after interviewing them. Nevertheless there seems to have been insufficient scrutiny of the evidence by the SFO, the company and the Court approving the DPA to establish the allegation of dishonesty.
The Judgment of Sir Justice Leveson approving the DPA referred to material before the Court which made clear that members of the senior management team at Tesco Stores were aware of the accounting practices in question and did not raise a red flag in relation to the treatment of commercial income. However, no one appeared to test against the evidence the possibility that the individuals did not know that what they were doing was improper.
There is no reference in the Statement or the DPA to evidence that the individuals were dishonest. In fact, the evidence referred to shows that the accounting treatment of commercial income was dealt with by the Tesco Three in an open manner, consistent with their account that they did not know that what they were doing was wrong.
The company's internal and external auditors appeared to provide some comfort in this regard.
The company's external auditors PwC took a detailed look at the treatment of commercial income in early 2014 and warned there was a “risk of manipulation”. However, on the basis of the information available to them, Tesco’s accounts were given a clean bill of health.
In addition, Tesco's annual report in 2014 noted that the risks related to commercial income were flagged both in the audit report and in the audit committee report (the latter almost by exception: stating that it wasn’t in fact a risk):
“The committee notes that commercial income was an area of focus for the external auditors based on their assessment of gross risks. It is the Committee’s view that whilst commercial income is a significant income for the Group and involves an element of judgement, management operates an appropriate control environment which minimises risks in this area. As a result, the Committee does not consider that this is a significant issue for disclosure in its report.”
DPA – good or bad decision?
The DPA had many advantages for Tesco. It appears that in the circumstances the authorities would have launched an investigation into Tesco's accounting practices following the re-statement of profits. It is therefore understandable that Tesco decided to self- report to the SFO providing them the opportunity to enter into negotiations for a DPA. As a result of the DPA, the criminal charges against Tesco Stores have been deferred and provided it complies with the terms of the DPA, the charges will be discontinued. Further, it received a 50% discount on the financial penalty that the Court would otherwise have imposed for the offence of false accounting.
The DPA had significant and wide ranging benefits for Tesco outside the criminal process. The company was able to move on from the scandal and regain the trust of the public and the markets. The company was able to apply its resources to operating the business rather than fighting a prosecution. The DPA also helped bring the FCA investigation to a satisfactory conclusion. When the SFO announced the DPA, the FCA said it would not impose a financial penalty on Tesco. Tesco admitted market abuse and agreed to pay compensation to investors who purchased Tesco securities on or after the original profit statement was made on 29 August 2014 and who still held those securities when the statement was corrected on 22 September 2014. This brought the FCA investigation to an end.
However, it is not all good news. Despite all of the advantages, questions still remain as to whether it was in Tesco's best interest to enter into the DPA when there appears to be very little evidence of dishonesty. The DPA involved a very substantial fine for Tesco Stores – albeit a lower fine than would have been imposed if the SFO had succeeded in securing a conviction of the company. Tesco shareholders may well bring actions against Tesco's directors on the grounds that they did not act in the shareholders' best interests in agreeing to the DPA. Following the collapse of the trial of the Tesco Three, Tesco Stores may now face claims by those ex-employees. Of course, the failure to secure a conviction of the Tesco Three does not necessarily mean that Tesco Stores were innocent. It may be the case that the SFO investigation was flawed in some way and/or that they charged the wrong people.
In our view the key mistake of Tesco may not have been agreeing to the DPA but agreeing to name the individuals who they said acted dishonestly in a document that would ultimately become public. The accounting functions that the employees were carrying out involved an element of judgement. In those circumstances, the question of the wrongdoer's state of mind ought to be judged by a Court by reference to all of the available evidence.
Conclusion
These events have left the corporate world pondering the dangers of relinquishing control of the investigative process to the SFO, naming individuals in a DPA and making allegations in a DPA that have not been tested against the evidence.
The Tesco DPA was approved by a judge at an early stage, arguably prematurely and before the SFO had completed its investigation. It is now clear that the SFO had not properly made out its case. There is a strong argument that judges should take a more proactive role in supervising the DPA process and analyse the evidence more closely to check that it is sufficient to support the case that the SFO is trying to make. If it does not, the prosecutor should be sent back to the drawing board. A company facing criminal charges and offered a DPA cannot be expected to scrutinize the strength of the SFO's case against individuals. It is arguable that when the Court considers whether the terms of the DPA are fair, reasonable and proportionate, it should consider whether the SFO has met the evidential stage of the Full Code Test set out in the Code for Crown Prosecutors both for its indictment of the company and any individuals accused of wrongdoing.
For the company seeking a DPA, careful thought should be given to the terms of any agreement to relinquish control of the investigative process. If witnesses are to be interviewed by the prosecutor, there is an argument that the company should be permitted to have some input and knowledge of the investigation so they can properly assess their position.
Finally, the company and its legal advisers should take great care before agreeing to the wording of a DPA and its associated Statement. The company should be permitted to accept responsibility for an alleged crime without specifically naming individuals who have not yet been convicted of any criminal wrongdoing. Naming an alleged wrongdoer in a Statement or DPA seriously impinges on the character of the individual. There is a strong argument that if an accused person is referred to in a DPA or Statement, they should be given the opportunity to provide input, through their solicitor, into what is agreed, especially when the person is named. It seems to us that the SFO has had too much control when deciding the terms of a DPA and companies and the Court must be given a greater say in the process.
This article was first published in Fraud Intelligence (www.counter-fraud.com)