Fraud at Patisserie Valerie -- What Can We Learn?

The emergence of a major fraud at the UK based retail “coffee and cakes” chain Patisserie Valerie led to the failure of the business*, despite desperate efforts of its high-profile major investor and Executive Chairman, Luke Johnson, to fund it before it sunk into administration, including putting in a reported £10m of his own cash as an unsecured loan, now probably all lost.

The aftermath has stimulated a debate about the whether the role and personality of Luke Johnson, considered previously to have been an extremely successful entrepreneur, was a contributing factor; was this a failure of effective governance? Or is fraud just something that no-one, however talented, can guard against?

We suggest it is helpful to examine the issue from the perspective of Strategic Risk and Strategic Warning. In our work on Strategic Risk we emphasise the importance of “foraging for surprise” in the “Realm of Ignorance”, i.e. actively looking for potential strategic or existential threat. In this context, the threat of fraud, in any business, maybe a relatively uncommon occurrence, but it is hardly unknown. It is unwise to fall into the trap of believing that an uncommon occurrence is an impossible one. Trust is necessary in all businesses. At the same time unconditional trust might be considered a step too far.

Efforts to combat deception and fraud have, over time, led to a relatively robust framework of checks and controls in the finance profession. Yet these still inevitably rest on human behaviour and always susceptible to outright deceit by those most trusted to be honest. Also, as we know, audits cannot be relied upon to reliably detect fraud.

So, is fraud, like death and taxes, always with us? Is it a risk about which we can do nothing, despite the potential to bring about the death of the enterprise? We suggest not.

Firstly, boards should accept that the threat from a fraud represents a Strategic Risk that can be anticipated. Secondly, they might ask themselves, how long do companies have to try and recover from a major fraud after it has been uncovered? The answer to this question is, typically, not long enough. Thus, the focus is on what might give us some early warning of a fraud being perpetrated. To put this into the language of Strategic Warning: what could represent high-value indicators of possible fraud?

This is not a simple question to answer – if it was we would presume that fraud would be much less common than is experienced. After all, the fraudsters are, by definition, intent on hiding their activities. At the same time, fraudsters also know that their discovery is probably inevitable in time, (unless their intentions is a “temporary” fraud, which it is expected will be recovered from before detection, such as a sales manager who creates fictitious customer orders in order to meet a target in one month believing, or hoping, that a recovery in actual sales in future periods will allow the fiction to pass unnoticed.) Thus, the challenge is to identify what might be high-value indicators of potential fraud, which also might provide early warning and then to be able to monitor these indicators.

One of our favourite definitions of risk blindness is “familiarity with inferior (or incorrect) information”. Naturally, not all inferior information results from fraud, but it is, we hope, self-evident that fraudsters rely on creating risk blindness through familiarity with incorrect information. Boards rely on information provided to them by the executive and the organization at large. It would be impractical if not impossible to treat all of this as “inferior or incorrect”. At the same time, it is possible to be sensitive to and, from time to time, actively seek information that is contradictory to the standard board pack data. Such information, which may provoke a sense of surprise or suggest uncertainty or be plainly different is, by definition, high-value.

In the case of Patisserie Valerie, there are two examples in the public domain which may illustrate this principle. The first relates to the proximate cause of nearly all corporate failures: running out of cash. It is reported that the company’s cash position was overstated by (£54m or more), and “secret” overdrafts of c. £10m were unknown to the board — i.e. the content of bank accounts were very different from what was being reported. Perhaps it is asking too much for finance directors to occasionally give direct access to a bank statement to the non-executive directors (though, why not?); however Mr. Johnson was an Executive Chairman, so perhaps we may assume he could have done that check himself from time to time. In the event, apparently, he did not, for if he had we must presume that a significant discrepancy would have been apparent much earlier on, perhaps with enough warning to have saved the company.

The second example of high-value information could have been an indicator that the reportedly strong performance of the chain was at odds with the experience of some other branded hospitality chains and, according to a number of customer anecdotes reported in the press subsequently, very much at odds with the customer experience. Some customers have openly questioned whether Mr. Johnson can possibly have visited any of the rapidly expanded number of Patisserie Valerie outlets. They suggest that had he done so he would have seen at first-hand practically empty sites next to other relatively prosperous venues, suggesting that the Patisserie Valerie value proposition was either not as strong as believed or was not being delivered reliably or to a high enough standard.

We do not know and cannot confirm whether these reported experiences were in fact representative of the majority of the Patisserie Valerie estate, but let us assume for the moment that they could have been. We observe that the erosion of a business’ value proposition is itself a Strategic Warning that frequently is a causal factor in declining cash flow. It does not seem impossible that, in view of Mr. Johnson’s previous track record, the board had assumed that the strategy for rapid expansion of the chain was bound to succeed. Individuals in the business, aware of an expectation of success, may have initially sought to “massage” the numbers to soften bad news, similar to the example of the sales manager cited above. Then when the bad news kept coming or worsened, the deception became ingrained. Had “from the field” observations been seen to be at odds with reported sales, this could have been a powerful high-value early warning signal.

This, we know and accept, is speculation. We only indulge in it to illustrate some important principles. The critical importance of high-value indicators for effective Strategic Warning cannot be underestimated. It is a challenge for boards to seek to identify and monitor such indicators, but one that they have an absolute duty to confront. Secondly this case illustrates the key value to boards and directors of “foraging for surprise” and paying heed to the feeling. Surprise is itself an indicator that something is inconsistent with our mental models of reality. Boards and directors need to develop an acute sense of surprise being a clue to the existence of risk blindness.

*Note: Following administration and some closures the Patisserie Valerie business was sold to new owners by administrators and continues to trade.
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