Patisserie Rescue Bid and Closing Accounts

It looks like Luke Johnson’s reputation will not be totally trashed after all after he announced a way for the company to be rescued today. It is proposed to do a placing at a heavily discounted share price of 50p (last price before suspension was 429p). This will raise £15 million from the issue of 30 million shares. The current shares in issue are 104 million so that implies substantial dilution although I have seen worse.

It will take some time to organise the placing as it requires a General Meeting to authorise the full number of shares required. In the meantime Mr Johnson is to loan the company an immediate £10 million on a three year term and interest free (that is generous is it not). In addition he will provide a further immediate bridging loan of £10 million which will be repaid out of the placing.

The directors estimate the current revenue run rate at £120 million per annum with EBITDA of £12 million although that is clearly based on only an initial review so is subject to doubt.

Apart from the usual problem that most placings are not open to private investors, this looks a good deal and much better than the likely alternatives. If this is pulled off, it seems my small holding in the company won’t be totally worthless after all.

There has been much hand wringing among financial commentators about the fact that the fraud was not obvious from the accounts of the company. That’s assuming the cash was not stolen in the last few months which seems unlikely although at this point in time we do not know. But false accounting is often not obvious. It could be many months before we find out what the source of the problem was, and whether the auditors fell down on the job or not, but it’s good to hear that the company’s finance director, Chris Marsh, was arrested by the police. It looks like prompt action by the regulatory authorities is being taken which is often not the case.

Recently I had a call from Cornhill who I am registered with for placings. They wanted to go through a long conversation to confirm my KYC details even though I had only given them very comprehensive information eighteen months ago and I was happy to confirm that nothing had changed. After a lot of pointless debate, I told them to close the account (and the linked account with Jarvis – total cash held £1,600 and no shares). This they refused to do initially unless I provided more evidence of who I was and the bank account I wanted the money sent to (which was the one already known to them). I had to threaten then with a complaint to the FCA and the Financial Ombudsman for wasting my time before they eventually backed down.

This is compliance gone mad. It’s difficult enough to open an account now, but it should not be that difficult to close one.

Anyway I might be missing out on any placing for Patisserie as a result but I feel life is too short to waste time on tedious KYC checks.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Lehman Collapse, Labour’s Employment Plans, Audit Reform Ideas and Oxford Biomedica

There was a highly amusing article in today’s FT by their journalist John Gapper explaining how he caused the financial crisis in 2008 by encouraging Hank Paulson, US Treasury Secretary, to resist the temptation to rescue Lehman Brothers. So now we know the culprit. Even more amusing was the report on the previous day that the administrators (PWC) of the UK subsidiary of Lehman expect to be left with a surplus of £5 billion. All the creditors are being paid in full.

Why did Lehman UK go bust then? They simply ran out of cash, i.e. they were cash flow insolvent at the time and could not settle payments of £3bn due on the day after their US parent collapsed. Just like Northern Rock where the assets were always more than the liabilities as also has been subsequently proven to be the case.

Perhaps it’s less amusing to some of the creditors of Lehman UK because many sold their claims at very large discounts to third parties rather than wait. Those that held on have been paid not just their debts but interest as well. So the moral is “don’t panic”.

Lehman’s administration is in some ways similar to the recent Beaufort case. Both done under special administration rules and requiring court hearings to sort out the mess. PWC were administrators for both and for Lehman’s are likely to collect fees of £1billion while employing 500 staff on the project. It may yet take another 10 ten years to finally wind up. Extraordinary events and extraordinary sums of money involved.

An editorial in the FT today supported reform of employment legislation as advocated by Labour’s John McDonnell recently. He proposed tackling the insecurity of the gig economy by giving normal employment rights to workers. I must say I agree with the FT editor and Mr McDonnell in that I consider that workers do have some rights that should be protected and the pendulum has swung too far towards a laissez-faire environment. This plays into the hands of socialists and those who wish to cause social unrest. Even the Archbishop of Canterbury suggested the gig economy was a “reincarnation of an ancient evil” and that it meant many companies don’t pay a living wage so employees rely on state welfare payments. A flexible workforce may give the country and some companies a competitive advantage but it takes away the security and dignity of employment if taken to extremes. The Conservative Government needs to tackle this problem if they wish to be certain of getting re-elected. If you have views on this debate, please add your comments to this blog.

Mr McDonnell also promoted the idea of paying a proportion of a company’s profits to employees – effectively giving them a share in the dividends paid out. That may be more controversial, particularly among shareholders. But I do not see that is daft either so long as it is not taken to extremes. After all some companies have done that already. For example I believe Boots the Chemists paid staff a bonus out of profits even when a public company.

Another revolutionary idea came from audit firm Grant Thornton. They suggest audit contracts should be awarded by a public body rather than by companies. This they propose would improve audit standards and potentially break the hold of the big four audit firms. I can see a few practical problems with this. What happens if companies don’t judge the quality of the work adequate. Could they veto reappointment for next year? Will companies be happy to pay the fees when they have no control over them. I don’t think nationalisation of the audit profession is a good idea in essence and there are better solutions to the recent audit problems that we have seen. But one Grant Thornton suggestion is worth taking up – namely that auditors should not be able to bid for advisory or consultancy work at the same company to which they provide audit services.

Oxford Biomedica (OXB) issued their interim results this morning (I hold the stock). They made a profit of £11.9 million on an EBITDA basis. OXB are in the gene/cell therapy market. What interests me is that there are some companies in that market, at the real cutting edge of biotechnology with revolutionary treatments for many diseases, that are suddenly making money or are about to do so. That’s often after years of losses. Horizon Discovery (HZD) which I also hold is another example. Investors Chronicle recently did a survey of similar such companies if you wish to research these businesses. It is clear that the long-hailed potential of cell and gene therapy is finally coming to fruition. I look forward with anticipation to having all my defective genes fixed but I suspect there will be other priorities in the short term particularly as the treatments can be enormously expensive at present.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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RIT Capital Partners, Foresight 4 VCT and Sepsis

RIT Capital Partners (RCP) is an investment trust that recently issued its interim report. As one of my longer standing holdings, first purchased in 2003 although I have reduced my holding of late, I read the report with interest. RCP has been a long-standing favourite of private investors having traditionally taken a somewhat defensive investment approach. But the portfolio is now most peculiar. It contains 8.8% of “quoted equities” but many of them are held as “swaps”, 27.7% in “long-only funds”, 19.7% in hedge funds and 0.6% in derivatives. There is 9.1% in direct private investments, 13.2% in private investment funds, 23.1% in “absolute return and credit funds”, 3.0% in “real assets” (which includes gold, silver, corn and soyabean futures) and 2.0% in Government bonds (with more swaps in there also). This is certainly an unusual portfolio to say the least.

Personally when I invest in a fund or an investment trust, I prefer them to invest directly – not pass the buck to some other fund manager. This trust has effectively become a “fund of funds” of late with a large proportion of its investments placed into other funds. Otherwise it appears to be hedging against armageddon.

The Chairman of the company is long-standing Lord Rothschild who is aged 82. When I have attended the AGM of this company I have never been very impressed by the way he handled the meeting or the responses to questions.

The total return net asset value performance in the half year was 3.2%, but 6.2% on share price. The current share price discount to NAV is actually at a premium of 6.8% according to the AIC and the dividend yield is 1.6%. Over ten years the total return (NAV) has been 103% when sector performance was 135%. So it’s not exactly been a great performer. I sold the remainder of my holding after reading the interim report.

Foresight 4 VCT

Another investment trust but of a very different nature is Foresight 4 VCT (FTF) which is of course a venture capital trust. It recently issued its Annual Report for the AGM due on the 11th October. I may attend it although my holding is very small.

The Annual Report does make interesting reading although it fails to mention a past complaint by some shareholders about the over-statement of reserves in the years 2013-2015 which resulted in an illegal dividend allegedly being paid. The auditor, KPMG, who still audits this company make no comment on this and neither do the directors in the Annual Report. But the Audit Committee report does mention that the company has received a letter from the FRC questioning the accounting policy for performance related incentive fees. The company has responded. Both issues are likely to be the subject of questions at the AGM no doubt.

This company has two very large holdings in its portfolio – Datapath and Ixaris. I have been very dubious about the valuations put on the latter company by this and other VCTs as I know quite a lot about the business. I used to be a director and still have a direct holding. This is particularly so after the disclosure by the Ixaris Chairman of the latest business challenges at the recent Oxford Technology VCT meeting.

I will be voting against the reappointment of KPMG as auditors at this company, against the sole director who is standing for re-election (is it not recommended that all directors of fully listed companies stand for re-election?), and against approval of the Report & Accounts.

But FTF did raise some more money this year and is investing in what appear to be interesting companies. One of their new investments has been in Mologic which is a medical diagnostic company. What sparked by particular interest was their product for rapid diagnosis of sepsis which I only narrowly survived a few years ago. Up to 50% of people who develop sepsis die from multiple organ failure, even though it can be treated with antibiotics. It is often misdiagnosed or treatment commenced too late, so a rapid diagnostic tool will be of great use.

Dr Hadiza Bawa-Garba was convicted of gross negligence manslaughter over the death of six-year-old Jack Adcock from sepsis but subsequently challenged being struck of the medical register. She won the latter legal case this week after a big campaign by doctors and a major crowdfunding exercise. Bearing in mind the other contributory factors, and the difficulty in spotting sepsis I consider the original conviction a gross miscarriage of justice. You can feel just slightly under the weather and next minute you are unconscious and in the intensive care unit as I know very well. Jack Adcock had other medical conditions that will not have helped.

There are 44,000 deaths from sepsis every year in the UK, and children are particularly at risk. It appears that cases of sepsis are rapidly rising although that might be due to better diagnosis. Even surviving it can mean life changing injuries. See https://sepsistrust.org/ for more information or if you wish to support a charity that is raising awareness of this deadly disease.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Open Season on Auditors?

I attended a joint ShareSoc/UKSA meeting hosted by PwC yesterday. There was a lively debate as one might expect on the problems of the audit profession where there have been just too many issues with listed company accounts in recent years. The latest is an investigation announced by the FRC into the audit of Conviviality but there have been lots of other problem cases in both large and small companies – Carillion, Interserve, BHS, BT, Rolls-Royce, Mitie, RSM Tenon, Connaught, Autonomy, Quindell, Globo and Blancco Technology are just a few not to mention those in the financial crisis a few years back such as HBOS, RBS, Northern Rock et al. There are simply too many such examples but whenever I go to meetings run by auditors or the FRC I get the distinct impression of complacency. They all think they are doing a great job and the bad apples are exceptions. Yesterdays event was no different.

Reading the London Evening Standard on my way home, there was an article on this topic written by Jim Armitage which was headlined “It’s open season on auditors as others dodge the bullet”. He blamed the incompetent management at Conviviality for the company becoming bust but did the audit report at that company highlight the risks being taken?

Even if it did it seems unlikely from comments from the audience at the PwC meeting that anyone would have noticed them. Only a minority of investors read the audit report part of the annual report because most of it consists of boiler plate text following by the comment “nothing to report”. Indeed it was very clear that auditors will do everything possible to avoid a “qualified” report as that might damage the company and its share price. The result is that a “qualified” report is a rare beast indeed.

There are two ways to improve performance of anyone: the carrot or the stick. Perhaps auditors should be paid more so they can put more time and effort into their audits but company boards might be reluctant to do that. There were a few suggestions raised in the meeting on how to improve matters. One was having auditors appointed by a shareholder committee rather than by the board of directors. But I suspect that would only help if such a committee had the power to approve expenditure of the company’s money. Certainly one problem at present is that auditors are selected to a large degree on price rather than quality.

Another suggestion was to have an independent audit committee (i.e. not made up of board directors), rather like a supervisory board which is used in some European countries. But that would surely add complexity and cost that only the largest companies could justify.

The stick approach would mean more penalties for auditors when they make mistakes. The Financial Reporting Council (FRC) could be tougher and impose higher penalties although they probably need more resources budget-wise to enable them to do that. But one advantageous change would be to reverse the Caparo legal judgement and make auditors liable to shareholders. At present it’s much too difficult for investors to sue auditors while companies rarely want to do so.

As regards the FRC, the Government have recently announced a review of the role of the FRC to be chaired by Sir John Kingman – see https://www.gov.uk/government/news/government-launches-review-of-audit-regulator

Sir John is looking for evidence so if you have some, please send it to him. I will probably be submitting something and ShareSoc/UKSA are likely to do so also. But if you have evidence of individual cases where auditors have fallen down on the job and the FRC have not been helpful then please submit it. The FRC also has responsibility for Corporate Governance so you may like to comment on that also. There may be hope of some change from this review – at least the advisory committee is not full of auditors and accountants.

One idea proposed in the PwC event to help auditors was for a mechanism to enable shareholders to suggest to auditors what they should be looking at in the accounts of a company. That might assist but from my experience of once doing this on a company, it had no impact on a clean audit report – the company subsequently went into administration.

There were some interesting comments on the general quality of accounts with one speaker suggesting that the failure to depreciate goodwill was distorting balance sheets and it was now obvious that investors ignored the statutory accounts and paid attention to the “adjusted” figures for profit or other non-statutory measures. Should not the auditors be auditing the latter and commenting on them? Perhaps we should have alternative measures as part of the statutory accounts?

In conclusion the PwC event was undoubtedly useful as it highlighted many of the current problems and also covered the technological future of auditing (the tools PwC now uses in its audits were covered). One can see that technology might embed the status quo of the four large audit firms as smaller organisations might not have the resources to develop their own equivalent software products.

The more one considers the accounts of companies and the audit profession in the modern world, the more one comes to realise that substantial reform is required.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Quindell and the FRC’s Role

There was a very good article written by Cliff Weight and published on the ShareSoc blog yesterday about the fines on KPMG over the audit of Quindell. Cliff points out the trivial fines imposed on KPMG in that case, the repeated failings in corporate governance at large companies and he does not even cover the common failures in audits at smaller companies. The audit profession thinks they are doing a good job, and the Financial Reporting Council (FRC) which is dominated by ex-auditors and accountants, does not hold them properly to account.

Perhaps they lack the resources to do their job properly. Investigations take too long and the fines and other penalties imposed are not a sufficient deterrent to poor quality audits when auditors are often picked by companies on the basis of who quotes the lowest cost.

Lots of private investors were suckered into investing in Quindell based on its apparent rapid growth in profits. But the profits were a mirage because the revenue recognition was exceedingly dubious. One of the key issues to look at when researching companies is whether they are recognizing future revenues and hence profits – for example on long-term contracts. Even big companies such as Rolls-Royce have been guilty of this “smoke and mirrors” accounting practice although the latest accounting standard (IFRS 15) has tightened things up somewhat. IT and construction companies are particularly vulnerable when aggressive management are keen to post positive numbers and their bonuses depend on them. Looking at the cash flow instead of just the accrual based earnings can assist.

But Quindell is a good example where learning some more about the management can help you avoid potential problems. Relying on the audited accounts is unfortunately not good enough because the FRC and FCA don’t seem able to ensure they are accurate and give a “true and fair view” of the business. Rob Terry, who led Quindell, had previously been involved with Innovation Group but a series of acquisitions and dubious accounting practices led to him being forced out of that company in 2003. The FT has a good article covering Mr Terry’s past business activities here: https://www.ft.com/content/62565424-6da3-11e4-bf80-00144feabdc0 . They do describe Terry as “charismatic” which is frequently a warning sign in my view as it often indicates a leader who can tell a good story. But as I pointed out in a review of the book “Good to Great”, self-effacing and modest leaders are often better for investors in the long-term. Shooting stars often fall to earth rapidly.

One reason I avoided Quindell was because I attended a presentation to investors by Innovation Group after Terry had departed. His time at the company was covered in questions so far as I recall, and uncomplimentary remarks made. They were keen to play down the past history of Terry’s involvement with the company. So the moral there is that attending company presentations or AGMs often enables you to learn things that may not be directly related to the business of the meeting, but can be useful to learn.

The ShareSoc blog article mentioned above is here: https://www.sharesoc.org/blog/regulations-and-law/the-quindell-story-and-the-frc/

Note though that subsequently the FRC have taken a somewhat tougher line in the case of the audit of BHS by PWC in 2014. Partner Steve Dennison has been fined half a million pounds and banned from auditing for 15 years with PWC being fined £10 million. But the financial penalties were reduced very substantially for “early settlement” so they are not so stiff as many would like. I fear the big UK audit firms are not going to change their ways until their businesses are really threatened as happened with Arthur Anderson in the USA over their audits or Enron. That resulted in a criminal case and the withdrawal of their auditing license, effectively putting them out of business. The UK needs a much tougher regulatory regime as they have in the USA.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Lack of Transparency at the FRC

The Financial Times ran an interesting article on Friday (13/4/2018) headlined “FRC criticised over transparency”. It reported that the Financial Reporting Council answered only 6 out of 52 Freedom of Information requests since 2013. Atul Shah, Professor of Accounting at the University of Suffolk, was reported as saying: “This shows that there is a real problem within the soul of the FRC. It is a public regulator and not a private members’ club, and it has clear duties of transparency, accountability and reliability which it has been avoiding over many years”. He went on to say they have been fobbing of public queries over a long period and that it was really shocking.

How can they reject so many requests? Because only certain parts of their operations are covered by the Freedom of Information Act and they can claim they cannot comment on on-going investigations.

The Local Authority Pension Funds Forum (LAPFF) sent a long submission to the public consultation on the Corporate Governance Code echoing many of those complaints and adding others and saying that the FRC suffers from “internal cultural problems”. They are clearly very unhappy with the activities of the FRC. The FRC has seen fit to respond with a 5-page rebuttal letter which they have published on their web site.

I have of course covered this issue of the culture and processes of the FRC in two previous blog posts which are here: https://roliscon.blog/2017/12/10/brexit-hbos-globo-and-the-frc/ and here: https://roliscon.blog/2017/11/22/standard-life-uk-smaller-companies-and-frc-meetings/

My view is that although the FRC is under-resourced, the approach that it takes should be reformed. Too many times major accounting and audit issues take years to investigate, and often simply result in no action. For smaller companies, complaints can disappear into a black hole with no response being received at all to complaints. Reform is required.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Audit Quality and the Caparo Judgement

There was a very good letter from Guy Jubb and Mark Solomon on the subject of the Caparo legal judgement in the Financial Times yesterday (6/2/2018). It was headlined “It is time the curse of Caparo was broken”. Here is some of what it said:

….the joint inquiry into Carillion by the parliamentary Work and Pensions Committee, and Business, Energy and Industrial Strategy Committee, must examine closely the little-known consequences of the Caparo judgment (Caparo Industries plc v Dickman [1990] 2 AC 605), which, in summary, ruled that auditors do not owe a duty of care to any one shareholder but rather to the body of shareholders as a whole, represented by the board of directors. The court decided that it would not be fair to visit what was viewed as indeterminate liability to investors for purely financial loss upon auditors and their firms. This all means that, as a practical matter, the auditors of listed companies are, in the normal course, immunised from the risk of being sued by investors for audit failure. It just never happens.”

The Caparo judgement overturned the previously assumed responsibility of auditors to the shareholders of a company and the general public to ensure that the accounts of a company could be depended upon. The judgement seemed to rely on the fact that shareholders have no contractual relationship with the auditors but only with the company who appoints them.

This judgement made it exceedingly difficult for shareholders to pursue auditors, and although there are possible “derivative” actions there are other obstacles that have been introduced over the years that reduce the potential liability of auditors. One is that they are now mostly not simple partnerships with the partners being individually and personally liable, but Limited Liability Partnerships. Secondly auditors write their contracts with companies and these now limit the scope of liability substantially – they frequently exclude liability for omissions that one would expect auditors to identify.

With the declining quality of audits, and the lack of competition between the big four audit firms, it is surely time to revisit the whole legal framework under which auditors operate. With companies often more interested in reducing audit costs than ensuring the accounts can be relied upon, one can see why and how the standard has been reduced over the years.

It’s not just Carillion that has shown how dubious are current audit standards but the problems in the banking crisis faced by RBS and HBOS were a direct result of lax audit reports. It also extends to numerous smaller companies – indeed too many to mention.

How to fix these problems? These are my suggestions:

  1. Auditors should have a statutory responsibility to the owners (i.e. the shareholders) in a company.
  2. Auditors should personally be liable for failings and not be able to hide behind LLP structures.
  3. Contracts between auditors and companies should be based on “model” contracts as laid down by the Financial Conduct Authority or the Financial Reporting Council, and drawn up based on the advice of investors.

I shall write to my Member of Parliament on this subject as this is something the Government needs to take in hand. I suggest readers do the same. How do you contact your M.P.? Simply go here for contact information: https://www.parliament.uk/mps-lords-and-offices/mps/

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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