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Tesco

Board composition, remuneration and supply chain management

Tesco is the UK's largest retailer, with further substantial businesses in Central Europe and Asia.

Background
In the summer of 2014, its board made the decision to appoint a new CEO, which we viewed positively, as the retailer had been underperforming, leading to a series of profit warnings. In addition, in September 2014, the business announced that it had identified an overstatement of profits, principally due to the accelerated recognition of commercial income and delayed accrual of costs.

The company’s new management identified three immediate priorities, namely regaining competitiveness in its core UK business, protecting and strengthening the balance sheet and rebuilding trust and transparency with key stakeholders. In the UK, it reset its target margins significantly and embarked on a far-reaching turnaround programme to reverse negative like-for-like sales growth and market share loss. It also initiated extensive restructuring, with large UK property write-downs and the sale of a number of assets, including its South Korean business.

More recently, we successfully engaged with the company on improving its board effectiveness, executive remuneration and supply chain management, which we describe below.

Our engagement
In meetings with the new directors, in particular the chair, we raised our concerns about size, skills gaps and a lack of diversity on the board. The chair acknowledged that the board would benefit from appointing new non-executive directors, while emphasising the importance of gender and geographic diversity, as well as retaining the right board dynamics.

We also intensively engaged with the company on its executive remuneration schemes, which were extremely skewed towards shareholder-oriented metrics, including the high weighting of relative total shareholder return. The remuneration chair acknowledged the need to review the executive remuneration policy and to include more stakeholder-related performance targets. This was particularly important for Tesco, as some of the retailer’s earlier problems directly arose from losing focus on the needs of the key stakeholder groups of customers, suppliers and employees.

In addition, at meetings with the new executive CEO and CFO, chair and head of global supply chain management, we raised concerns about Tesco’s treatment of its suppliers, specifically in relation to payment practices. As part of its own internal response to the accounting issues identified in September 2014, Tesco carried out an inquiry into previous commercial practices and shared these findings with the UK Groceries Code Adjudicator, which subsequently completed an independent investigation into these issues. The findings of this report confirmed many of our concerns. The adjudicator’s report found Tesco to be in breach of rule 5 of the Groceries Supply Code of Practice, in relation to the timely release of supplier payments. The adjudicator did not find any evidence that Tesco had breached rule 12 by requiring payments in order to secure better positioning or an increase in shelf space. As the regulatory body’s authority to levy financial penalties did not come into force until April 2015, after the period under investigation, no fines were imposed.

Changes at the company
To improve board effectiveness, in line with our engagement request, Tesco initially rightly focused on establishing the optimal board composition. The retailer has substantially widened its membership base, hiring non-executive directors with an appropriate range and balance of skills, experience and knowledge that reflect its new strategic direction. The newly appointed non-executive directors possess critical skills and knowledge of value to the board, for example direct experience of food, grocery, property, IT and retail brand development, as well as relevant experience in key regions, such as the UK and Southeast Asia. In addition, the appointment process took into account the benefits of diversity, including gender, resulting in female representation on the board of 25%. We were also pleased that the company undertook an external board evaluation to ensure the effectiveness of its board.

We are satisfied with the changes made to Tesco’s executive remuneration schemes, in particular the improved alignment of its incentive plans with its strategic priorities, including rebuilding the trust with its key stakeholders. In a meeting with the chair of the remuneration committee, the company acknowledged that the committee had specifically taken into account our recommendations in devising a more balanced and aligned executive long-term incentive plan (LTIP), considering its stakeholders, including customers, suppliers and employees, thus demonstrating greater alignment with the strategic focus.

In September 2016, the Grocery Code Adjudicator published its views on the progress made by Tesco towards the recommendations set out in its original report. According to the report, the retailer has put in place the appropriate systems to avoid late payments, unilateral deductions and data input errors. Furthermore, sufficient steps have been taken to provide more transparency and clarity in its dealings with suppliers. Elsewhere, a survey, commissioned by the adjudicator, carried out on behalf of the majority of direct suppliers, showed that most UK retailers have improved their behaviour in the past few years, with Tesco emerging as the highest performer, with 65% of those supplying the retailer stating that its practices had improved.

The positive findings of the progress report were also confirmed at the 2016/17 interim results announcement, as the retailer reported a strong improvement in its supplier surveys, with the UK supplier satisfaction measure at 78%, up significantly on the 51% from 2014/15. We are encouraged by these positive developments, which illustrate that Tesco has been successful in rebuilding trust and creating transparent relationships with its suppliers, including the redefinition of its payment terms and practices.

Overall, we have been impressed by the capabilities of the new executive team over the past few years, in particular given the sheer size and scope of the issues at hand.

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Roland Bosch Roland Bosch is sector lead for financial services and responsible for corporate engagements in Europe and the US. He engages with corporate boards on relevant strategic, governance, social and environmental issues to foster long-term sustainable value creation. Prior to joining Hermes EOS, he worked as an investment manager at F&C Asset Management, where he was responsible for managing institutional equity portfolios, as well as providing investment analysis and recommendations. Before that, Roland was based in the Netherlands, working as an investment manager for insurance group Achmea and as an equity analyst at HSBC. Roland is a certified investment analyst (RBA), EFFAS financial analyst and holds a degree in Business Economics from Groningen University. Roland is fluent in Dutch and English, with a good working knowledge of German and French.
Read all articles by Roland Bosch
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Microsoft

Engagement objectives:

Social & ethical: Rebuild trust with suppliers and establish new payment terms

Governance: CEO remuneration to include stakeholder-related performance targets

Governance: Retail, grocery and technology experience on the board