Patisserie – and How to Avoid Disasters

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:

  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. 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.
  6. 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.
  7. 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.
  8. 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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Lax Regulation (Globo, GRG) and Japanese Trust AGM

Globo was one of those AIM companies that turned out to be a complete fraud. Back in December 2015 the Financial Reporting Council (FRC) announced an investigation into the audits of the company by Grant Thornton (GT). Even the cash reported on the balance sheet in the consolidated accounts of the parent company proved to be non-existent (or had been stolen perhaps). I have previously complained about the slow progress and the lack of any information on this investigation.

But former shareholders need no longer hold their breath – the FRC have announced that they have dropped the investigation on the basis that there is no realistic prospect of a finding of “misconduct” by Grant Thornton UK. It would seem that GT relied on the audits of the subsidiary companies in Greece and elsewhere over which the UK authorities have no jurisdiction.

There may be on-going investigations by other bodies including a review of the activities of GT in Greece but this makes it appear that the chance of action is fading away. Not that shareholders were ever likely to recover their losses. It is disappointing that the FRC have not taken a tougher line on this matter as questions about the accounts of Globo were publicly raised a long time before it went bust, and I even spoke to some staff of Grant Thornton UK at a Globo meeting telling them they needed to examine their accounts carefully. One would have thought that they would have done a very thorough examination of the subsidiary audits, but it seems not so.

I was about to submit my comments on the Kingman “Review of the Financial Reporting Council” – all ten pages of it – but will now have to amend it to include more criticism. I’ll publish it on the Roliscon web site a.s.a.p.

Another example of regulatory inaction is the announcement that the Financial Conduct Authority (FCA) will not be doing anything about the past activities of the Global Restructuring Group (GRG) at the Royal Bank of Scotland (RBS). After a review they found no evidence that RBS artificially distressed firms for their benefit (that’s not what the complainants say) although they did find inappropriate treatment of customers. But the FCA decided they could do nothing because some parts of the activities of GRG were unregulated and action against the senior management had little hope of success. So the perpetrators are off the hook.

I received an interesting newsletter from White & Case, one of the leading commercial law firms, which summarized the latest report from the FCA on their enforcement activities. It was headlined “FCA Enforcement – More cases, increased costs, fewer fines” which put the report in context. The number of “open cases” has doubled in two years while the number of staff has remained the same, i.e. more work but no more resources. Enforcement action has slowed down, probably for that reason, and fines have also dropped. Only 16 fines were imposed in the last year.

JPMorgan Japan Smaller Companies Trust

Yesterday I attended the AGM of JPMorgan Japan Smaller Companies Trust (JPS) which turned out to be a more interesting meeting than I anticipated. This is one of my Brexit hedges – pound falling means any overseas investment is likely to be a good one, and I always like small cap funds.

This trust has a good track record – NAV up 27.8%, 20.8% and 12.2% in the last three years so it is well ahead of its benchmark. Not knowing much about the Japanese market the presentation from the fund managers (via video from Japan) was particularly interesting. Equity markets in Japan have been buoyed by QE activities from the Bank of Japan – apparently they have not just been buying bonds but also equities in the stock market! But the economy is facing major structural challenges from an ageing and declining population. This was one slide they presented:

Japan's Structural Challenge

However, the managers are not too concerned because they ignore “macro” trends when investing anyway. They clearly think they can still achieve good results because of a focus on specific areas of the market, e.g. healthcare, employee benefits (staff are being paid more as they become in short supply), robot appliances, etc. Also corporate governance is improving, albeit slowly, which is of benefit to minority shareholders.

The other interesting issue that arose at this AGM was the proposed new dividend policy. They changed the Articles at the meeting to allow the company to pay dividends out of capital and also proposed a resolution to adopt a new dividend policy of 1% of assets per quarter, i.e. 4% dividend yield per annum when it was nil last year. This prompted a vigorous debate among shareholder attendees with complaints about it meaning shareholders will be paying more tax, often on unwanted dividends. The retiring Chairman, Alan Clifton, said the board had proposed this because they were advised that this would help to make the company’s shares more attractive to investors. The shares are currently on a persistent wide discount of about 11% and it was hoped this would close the discount. Also as most private shareholders now hold their shares in ISAs and SIPPs, there would be no tax impact on them. I pointed out direct shareholders could always sell a few shares if they wished to receive an “income” but there are obviously many small shareholders who do not understand this point or prefer to see a regular dividend payment. At least the above summarized the key points in the debate.

When it came to the show of hands vote on the resolution, it looked to me as though there were more votes AGAINST than FOR. The Chairman seemed to acknowledge this (I did not catch his exact words), but said that the proxy votes were overwhelmingly in favour. He then moved on to the other resolutions. I suggested he needed to call a poll, which of course nobody fancied because of the time required even though it would be legally the correct thing to do. So instead it was suggested that perhaps the count of hands was wrong so that vote was taken again – and narrowly passed this time. My rating as a trouble maker has no doubt risen further.

Anyway, I actually abstained on the vote on that resolution because I am in two minds on the benefit. As Alan Clifton pointed out, the impact of a similar change at International Biotechnology Trust (IBT) where he was also Chairman was very positive. My only comment to him was I thought 4% was a bit high. The board will no doubt review the impact in due course, but it seems likely that it will have a positive impact on the discount as the shares will immediately look more attractive to private investors.

In conclusion, what I expected to be a somewhat boring event turned out to be quite interesting. That is true of many AGMs. Japan might have more difficult “structural” challenges even than the UK, with or without Brexit. As regards the regulatory environment covered in the first part of this article I suggest the laws and regulations are too lax with too many loopholes. I think they need rewriting to be more focused on the customers or investors interests.

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

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Brexit, HBOS, Globo and the FRC

Is it not heartening that the Brexit divorce bill, and other terms, have been settled? The exact cost is unclear but it could be up to £40 billion – a lot of money you may say! However, the fact that the key negotiators, Mrs May, Barnier et al, all looked somewhat glum about the deal when announced perhaps tells us that it was a compromise in which both sides had to concede ground. Or perhaps they were just tired. The terms of any future arrangements including trade deals still need to be worked out so it’s a long way from being concluded.

Now that £40 billion figure, sounds a lot, even if it is spread over some years. Hard line brexiteers will be unhappy. But it’s all relative. For example the annual UK Defence Budget is over £35 billion and rising. In addition, I have just read the Financial Reporting Council’s report on the HBOS audit and you can see there on page 7 that HBOS had to write off £63.3 billion in loan losses. That was only one smaller sized UK bank. According to the Bank of England, the financial crisis that affected HBOS caused £7.3 trillion of losses in total in the UK.

The report from the Financial Reporting Council (FRC) on the audit of HBOS is a quite tedious and turgid document. To remind you, HBOS was a bank that almost went bust after making imprudent commercial property loans financed by short term debt. When Lehman’s collapsed and debt became difficult to raise, HBOS had to be supported by the Government and then bailed out by a merger with Lloyds TSB. The latter’s shareholders are currently pursuing a claim against the company and its directors over that event.

The reason the audit of HBOS was examined by the FRC was because the company obtained an unqualified audit report suggesting that it was a “going concern” when it soon turned out to be otherwise. These events date back to 2008 – that’s 9 years ago which shows the speed with which the FRC typically operates.

One interesting comment made in the FRC report is that it suggests on page 11 that liquidity support from central banks may be considered “a normal funding source…..and therefore reliance on such support does not mean that the bank is not a going concern…..”. As banks with a positive balance sheet are usually assumed to be eligible for “lending of last resort” from the Bank of England that might mean that HBOS would be considered to be a going concern even if it ran out of cash (which is the reason most banks go bust, not because of defective balance sheets – Northern Rock is a good example).

The report also refers on page 29 to “market expectations” at the time. Market participants did not expect the financial crisis to get worse which affected the auditor’s views. So now we know why the FRC let the auditors of HBOS (KPMG) off the hook!

As I mentioned in a blog post a couple of weeks ago (see https://roliscon.blog/2017/11/22/standard-life-uk-smaller-companies-and-frc-meetings/ ), I attended a meeting with the FRC organised by ShareSoc/UKSA. One of the issues raised was the lack of feedback from the FRC on the progress of investigations. I followed up with one of the speakers after the meeting, specifically about the case of Globo. I asked what was the status on the investigation of the audit of their accounts by Grant Thornton. As readers may know, Globo was a company that went into administration in 2015 after it was revealed that the revenue of the company was probably fictitious (see https://www.sharesoc.org/campaigns/globo/ for details). The report of the administrators made it clear that the cash on the balance sheet of Globo plc seemed to have disappeared, bringing into doubt the preceding audit report on that ground alone let alone the revenue recognition issue.

The FRC announced an investigation in December 2015, i.e. two years ago. What have the FRC been doing, when will the investigation likely conclude, are there any preliminary conclusions, etc, etc? All of these questions are very relevant as the answers might provide the basis for legal action by shareholders against the auditors and others. After several email exchanges with FRC staff, the only answer I managed to elicit is that the investigation is on-going. It has not even been turned into a “Formal Complaint”.

The reason more information could not be supplied is that it might prejudice “the overarching requirement for fairness”. My response was “I really do suggest that the FRC needs to reconsider its policies in this area. You have too much emphasis on treating those who have been complained about (i.e. auditors) fairly, while those who have complained are treated unfairly. This rather suggests, as we already knew, that the FRC is dominated by auditors who are the people it is supposed to be regulating”.

You will be amused to read in the FRC’s Publication Policy document (para. 3) that “Transparency contributes to public confidence in independent disciplinary arrangements….” but then proceeds to spell out all the restrictions it imposes that thwart it.

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

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