Dick Smith leaders accused of inflating profits to meet expectations

News Coverage by by Sue Mitchell - AFR

July 12, 2016

The directors and managers of consumer electronics chain Dick Smith have been accused of inflating earnings to meet market expectations by deliberately buying too much stock, booking rebates from suppliers as profits and disguising weak retail sales with low-margin commercial sales.

As Dick Smith’s administrators prepared to release on Wednesday their report to creditors, letters sent by the lawyers for Dick Smith’s receivers and bankers to former directors and managers outlined a litany of alleged “wrongful acts” that contributed to the retailer’s demise.

The receivers also alleged that the banks, National Australia Bank and HSBC, were misled into providing loans to Dick Smith, foreshadowed claims against executive directors for misleading and deceptive conduct, and alleged that directors and officers breached their duties by failing, for example, to have proper reporting systems and controls in place.

Dick Smith collapsed in January, less than two years after its $520 million float, owing more than $400 million to creditors, including about $140 million to NAB and HSBC, and depriving consumers of $20 million in dishonoured gift cards.

Former Dick Smith CEO Nick Abboud at the opening of a new Sydney CBD store in 2013. Sasha Woolley

The letters, reported exclusively online by The Australian Financial Review on Monday, from Norton Rose Fulbright follow a long-running investigation by Dick Smith’s receiver, James Stewart from Ferrier Hodgson, and identify circumstances that may give rise to a claim against Dick Smith’s directors’ and officers’ insurance policies.

Ferrier Hodgson told creditors last week that 10 former Dick Smith directors and managers would be examined in the NSW Supreme Court and questioned about their role in the retailer’s collapse.

They include former chief executive Nick Abboud, former chief financial officer Michael Potts, former chairman Rob Murray, former chairman Phil Cave, the managing director of Anchorage Capital Partners, which bought Dick Smith from Woolworths in 2012 and floated it a year later, and another Anchorage representative on the Dick Smith board, Bill Wavish.

Anchorage Capital Partners bought Dick Smith from Woolworths in September 2012 for $94 million and floated it 15 months later, in December 2013, for $520 million, making a five-fold return on its investment.

Any excess rebate was booked as a reduction in the cost of sales in the month that the rebates were negotiated, potentially before the sale of the stock and before the receipt of the agreed support, in breach of accounting standards.According to the receivers, from at least July 2014 Dick Smith’s management undertook a program of “maximising” rebates by suppliers – buying excess and unsaleable stock and booking certain types of rebates as an increase in profits or a reduction in marketing expenses rather than spending the rebates on marketing and customer discounts.

“The desire to maximise rebates was driving buying behaviours,” Norton Rose Fulbright alleged, and buying decisions were made based on rebates rather than on customer demand.

The executive directors and non-executive directors of Dick Smith did not have systems in place to ensure adequate reporting or management of stock purchases, it alleged. This behaviour started in at least July 2014, when Anchorage was still a major shareholder.

Dick Smith documents showed that the board and management were concerned about the market’s perception of the company’s performance and “there was a concern and focus to meet or exceed performance expectations in the prospectus”.

“By reason of Dick Smith’s treatment of rebates, Dick Smith was able to in effect ‘borrow’ profit from a subsequent year,” Norton Rose Fulbright alleged.

Dick Smith also engaged in a practise of “uplifting” invoices for private label goods from as early as December 2014, with suppliers withdrawing invoices they had previously issued without rebates and issuing new invoices with rebates and an equivalent increase in the cost of the stock.

These rebates were booked as a reduction in marketing costs, even though the invoice showed a direct link between the (increased) cost of the stock and the rebate. Under accounting standards the rebates should have been treated as a reduction in the cost of inventory.

According to Norton Rose Fulbright, non-executive directors were unaware of this behaviour, “but took no steps to implement proper reporting or controls”.

The receivers also raised concerns about sales to commercial customers, saying they may have been used to mask poor retail performance.

Commercial sales were made at zero or minimal margins but helped Dick Smith report like-for-like sales growth – an important indicator of retail health watched closely by investors and analysts.

“Like-for-like sales growth in Australia and NZ retail divisions [excluding online] was negative in every week except three over 2015 and 2016, despite figures in the board packs showing modest comparable sales growth,” the letters said.

The receivers also alleged that the Hong Kong office, which was run by Mr Abboud’s cousin, was used to facilitate commercial sales and negotiate “non traditional” inventory such as suitcases, which attracted extra rebates.

“Neither the board nor the finance and audit committees appear to have queried any aspect of Dick Smith’s commercial sales operations, including the poor or non-existent margins,” Norton Rose Fulbright alleged.

They said non-executive directors were likely unaware of these practices, but executive directors appeared to have knowledge of the accounting practices and the focus on rebates.

The letter also reveals that Dick Smiths’ auditor Deloitte queried the use of rebates in September 2015, but when Dick Smiths’ chief financial officer, Mr Potts, investigated the allegations he formed the view that they had no substance.

By October 2015 consultants retained to investigate issues relating to stock levels had identified about $180 million in “problem inventory”, which needed to be written down by $60 million, and raised concerns about other issues including inaccurate stock values.

However, Dick Smith’s executive directors did not share with the board the consultants’ findings for another month, in late November 2015. At that point, Dick Smith finally announced writedowns of $60 million.

Information provided by Dick Smith’s executive team was inadequate, the receivers have alleged, but there were no records of the non-executive directors asking for detailed information about the company’s trading performance, rising inventory levels and use of rebates.

Mr Cave, Mr Wavish and Mr Murray were contacted for comment on Monday, while Mr Abboud and Mr Potts could not be reached.

A spokesman for Mr Cave said he declined to comment on the allegations, but reiterated a comment made to the AFR last week that he would co-operate fully with the investigation.

In its submission to a Senate inquiry in March, Anchorage Capital Partners claimed that it sold its controlling interest “more than two years before Dick Smith fell into financial difficulty” and had left Dick Smith in a strong financial position when it severed ties in February 2015.

Mr Murray, who took over as chairman from Mr Cave in February 2015, also declined to comment, citing the potential legal proceedings, “other than to say that I do not agree with a single assertion made in the document”.

Sources questioned why the receiver had issued the letters before the administrators, led by Joseph Hayes at McGrath Nicol, published their report into the causes of the collapse. That report, due on Wednesday, is believed to stop short of linking the company’s failure to individuals.

The extent of the board’s and executives’ knowledge and their role in the company’s collapse will become more clear when they are forced to answer questions in the NSW Supreme Court in September.

National Australia Bank and HSBC claim they were misled into providing a syndicated banking facility in June 2015 and were misled again in November 2015 when HSBC advanced another $20 million with the approval of NAB.

If the receivers’ allegations are proven, the banks – NAB and HSBC – will be able to claim against Dick Smith’s directors’ and officers’ insurance policies.
Read more: http://www.afr.com/business/accounting/dick-smith-leaders-accused-of-inflating-profits-to-meet-expectations-20160710-gq2tjv#ixzz4E8YUIbaf

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