The events at Patisserie (CAKE) have been well covered in both the national media and financial press so I won’t repeat them here. This article will therefore concentrate on how to avoid such companies in the future. The case of Patisserie is very similar to those of Globo in 2015 and Torex Retail in 2007. All three were large AIM companies that went into administration after fraud was discovered. These were not just cases of over-optimistic or misleading financial accounts, but deliberate false accounting. Executives of Torex Retail received jail terms and Globo is still being investigated. Note that such criminal cases take years to come to a conclusion. Both Globo and Patisserie were audited by the same firm (Grant Thornton). Such cases can happen not just in relatively small AIM companies, but also large ones – for example Polly Peck.
Ordinary shareholders received zero from the administration of Torex Retail and Globo and it is very likely it will be the same from Patisserie. The only glimmer of light is that it does look as though a normal sale process is being followed by the administrators and there is at least one enthusiastic bidder for the remaining stores. There is also the prospect of a tax refund from HMRC because it is clear the fraud has been running for some years so Patisserie has been paying tax on imaginary profits. But the bank overdrafts/loans need paying, loans from Luke Johnson need repaying (which incredibly seem to rank ahead of the banks), trade creditors need paying, staff need paying, HMRC needs paying and the administrators will run up the usual enormous bills no doubt so I doubt there will be much, if anything, left after those distributions. There usually is not.
Legal action against the former directors who were culpable in these events by regulatory authorities is highly likely. For example, it is a crime (market abuse) to publish false accounts under the Financial Services and Markets Act so that would be one basis. Investors who invested in the company on the basis of those false accounts should submit a complaint to the Financial Conduct Authority (FCA) and encourage them to take such action.
Are there possible legal actions by investors to recover their losses? Perhaps and I know at least two people who are talking to solicitors about that. But such legal actions are very expensive and depend on a) Identifying defendants with sufficient assets to meet both the claim and legal costs; b) Having sufficient standing to do so. Unfortunately shareholders would probably have to do it via a “derivative action” which means applying to the court to force the administrator to pursue such a claim. Bearing in mind administrations are often relatively short term, and it will take years to conclude regulatory investigations and actions, there might be a problem there.
Who could be targeted? The auditors possibly although they will probably say they were misled by the company directors (bank accounts not disclosed, etc). Luke Johnson perhaps although he clearly denies previous knowledge of the fraud and pursuing him for breach of his responsibilities as a director might be difficult – however he does have the assets having taken well over £20 million out of the company in share sales over the years. Former finance director Chris Marsh sold shares worth £8.42 million in 2018 while former CEO Paul May sold shares worth £14.34 million in that year it is worth noting. They both appear to have been near the centre of the fraud but culpability clearly will need to be proved. They have yet to comment in public on the matter.
Were the share sales by those two executive directors a sign that all was not well at the company? Perhaps but Luke Johnson was not selling in 2018 and these sales were the result of share option exercises from LTIPs which executives often sell, partly to meet tax demands.
So how to avoid such fraudulent companies from damaging your wealth in future? From experience I can offer the following advice, and you will see why Patisserie side-stepped all the warning signs:
- Try to invest in directors who you feel you can trust. Luke Johnson had a very public reputation in the investment world which he was no doubt keen to protect. Indeed his actions to try and bail-out the business when the fraud was discovered shows exactly that, although institutional investors who took up the rescue rights issue will be none too happy. His fellow executive directors were a long-established team and hence should have been trustworthy. Make sure you take opportunities to meet the management.
- Do the financial analysis. Read the book “The Signs Were There” which I have covered in a previous article – it tells you where to look. For example, do the profits turn into cash? But if the cash on the balance sheet is a lie, as at both Patisserie and Globo, it does not help. Does the company not pay dividends when it could, or make decisions to raise more debt when it does not apparently need it or provide good justification? That was the what crystalised my views on Globo.
- Look at who else is investing or commenting on the company, e.g. Chris Boxall of Fundamental Asset Management, a very experienced small cap investor, or Paul Scott of Stockopedia who recently said “Quindell, Globo and Carillion were easy to spot a mile off – indeed we warned investors of all 3 long before they blew up. Patisserie Valerie however, appeared to be a wonderful, cash generative business”. Because I follow what others are saying and pay attention, I never invested in Torex Retail and I did not lose money on Globo despite holding some shares until the end. But Patisserie fooled pretty well everyone.
- Research the product or service offering. Some people say they were wary because when they visited the shops, they were not busy and did not like the cakes. That was not my experience after a number of visits to different locations.
- Read the IPO prospectus for AIM companies. It tells you a lot more than you can read in the Annual Reports and is legally required under AIM rules to be available on their web site.
- Invest in steps and not at the IPO so you can build confidence in the company. Private investors have the advantage of being able to do that. After all it’s unusual for frauds to run for years without being discovered by someone – rarely by auditors though. I first invested in Patisserie in 2017 and built up a small holding in stages following the share price momentum. But this was only limited protection and it appears the fraud had been going on for many years at Patisserie.
- Have a diversified portfolio so one company can go bust and it does not undermine your overall returns. If you invest in large cap companies which may be less risky, perhaps 10 to 20 shares are sufficient diversification. Throwing in a few investment trusts or other funds will help as they are intrinsically diversified. But if you are investing in AIM shares you need a lot more. By having a large portfolio of shares in terms of numbers of holdings the damage to my portfolio from the administration has been a loss of 0.9% of my portfolio value. That’s less than the portfolio varies from day to day on some days. I have spoken to a number of investors who bet their houses or life savings on one share, e.g. Northern Rock or the Royal Bank of Scotland rights issue. One at least went bankrupt. Don’t be so daft.
- Monitor news flow on a company and unusual share price movements. But at Patisserie there was really nothing unusual until the date the shares were suspended.
I hope the above comments help investors to avoid the dogs and complete frauds of the investment world. Some of these avoidance techniques help you to avoid not just outright frauds but general financial mismanagement by company directors.
Roger Lawson (Twitter: https://twitter.com/RogerWLawson )
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Postscript: Tom Winnifrith has pointed out that in his ShareProphets blog there were several articles that queried how Luke Johnson was bucking the trends on the High Street. He suggested shorting/selling the shares in 29 October 2017 but on the 27th November (after a results announcement) he mentioned he was surprised at the good results and said “Luke Johnson is a complete and utter genius”. But he also said “something is not right here”. On the 29th December he said he was “amazed and I take my hat off to Luke Johnson” and repeated his comment that Luke Johnson was a total genius. On the 12th August his co-writer Chris Bailey said he “really likes the model of this company”. He compared the roll-out story to Costa’s and was clearly thinking of buying the shares.
Perhaps we should all have paid more attention to what Tom was saying but what should we have believed – Tom’s analysis of the problems on the high street and how it might affect Patisserie or the published accounts? Or should we have accepted Tom’s evaluation of the capabilities of Luke Johnson as enabling him to overcome those problems? A difficult conundrum. But perhaps Mr Johnson’s fellow directors and the company’s auditors should have paid attention to the issues he raised though.