Last week the U.S. Securities and Exchange Commission (SEC) charged two former executives and imposed a $62 million fine on the Kraft Heinz Company. The action was for improper procurement practices that altered language of certain supplier agreements to reflect a lower cost-of-goods- sold (COGS) than actually existed. The practice led to the company’s misrepresentation in its financial statements. The SEC specifically charged Kraft’s former Chief Operating Officer Eduardo Pelleissone and its former Chief Procurement Officer Klaus Hofmann for their misconduct related to the scheme.
Background
As far back as 2015, Supply Chain Matters had focused on forces impacting the consumer product goods industry (CPG) and their respective supply networks. Declining profits and meager sales growth spawned activist investors to influence certain CPG, food, and beverage firms to consolidate.
The prime disruptor in this industry was Brazil based 3G Capital demonstrating what was often described as a blitzkrieg of cost cutting predicated on zero-based budgeting tenets. With an acquisition model described in the analogy of a swimming shark with tendencies of buy, squeeze and repeat with the next target. What was termed the “3G Effect” was continual declarations of steep cost cuts, often because of the pressures of activist investors, all in an effort to boost short-term shareholder cash divided or stock buyback efforts.
Specifically, the 2015 merger among Heinz-and Kraft Foods shook the industry and its supply networks to their foundations in that wringing out savings from supply chain processes and procurement agreements was the ongoing formula of such efforts
The CPG industry saga came to a head in 2019 when Kraft Heinz reported a stunning multi-billion financial setback. During that time the company reported sharply lower quarterly revenues and earnings that were far lower than consensus estimates. That included a 14 percent decline in adjusted earnings before interest, taxes and restructuring costs (Adjusted EBITA) on total revenue growth of a mere 0.7 percent. The company had to additionally write down the value of its Kraft and Oscar Mayer brands by a whopping $15.4 billion and slash its quarterly dividend to shareholders by 35 percent.
It was during that same period that the company disclosed the involvement in an ongoing SEC investigation regarding the company’s procurement practices.
SEC Findings
The published SEC press release indicates:
“According to the SEC’s order, from the last quarter of 2015 to the end of 2018, Kraft engaged in various types of accounting misconduct, including recognizing unearned discounts from suppliers and maintaining false and misleading supplier contracts, which improperly reduced the company’s cost of goods sold and allegedly achieved “cost savings.” Kraft, in turn, touted these purported savings to the market, which were widely covered by financial analysts. The accounting improprieties resulted in Kraft reporting inflated adjusted “EBITDA,” a key earnings performance metric for investors. In June 2019, after the SEC investigation commenced, Kraft restated its financials, correcting a total of $208 million in improperly-recognized cost savings arising out of nearly 300 transactions.”
A statement from Anita B. Bandy, Associate Director of the SEC’s Division of Enforcement, indicates that: “Kraft and its former executives are charged with engaging in improper expense management practices that spanned many years and involved numerous misleading transactions, millions in bogus cost savings, and a pervasive breakdown in accounting controls. Kraft and its former executives are being held accountable for placing the pursuit of cost savings above compliance with the law.”
An SEC charging document specifically indicates that:
“The expense management misconduct was carried out by KHC’s procurement division employees, across multiple geographic zones, and involved several strategies employed to misrepresent the true nature of transactions, resulting in accounting errors and misstatements. Out of the 295 transactions that KHC ultimately corrected in connection with the restatement, approximately 59 were part of the procurement division’s expense management misconduct, including the following types of transactions.” These transactions were noted as Prebate, Clawback and Price Phasing transactions.
The document further indicated that:
“Pelleissone, KHC’s then Chief Operating Officer and Global Head of Operations, was presented with several warning signs indicating that expenses were being managed through manipulating supplier agreements, imposed pressures on the procurement division to deliver unrealistic savings targets, and, as a member of the company’s disclosure committee, unreasonably approved KHC financial statements that he should have known were materially false and misleading.”
The report noted that in 2017, costs for many ingredient and packaging supplies had increased significantly due to adverse inflation and unfavorable foreign exchange rates. Specifically: “The combined impact of the increased raw material costs and savings already realized in prior years made it more difficult for procurement division employees to achieve additional, incremental savings in 2017 and 2018.”
Without admitting or denying the SEC’s findings as to them, Kraft Heinz consented to cease and desist from future violations and pay a civil penalty of $62 million, whereas Pelleissone consented to cease and desist from future violations, pay disgorgement and prejudgment interest of over $14,000, and pay a civil penalty of $300,000. And without admitting or denying the SEC‘s allegations, Hofmann consented to a final judgment permanently enjoining him from future violations, ordering him to pay a civil penalty of $100,000, and barring him from serving as an officer or director of a public company for five years. The settlement with Hofmann is subject to court approval.
Supply Chain Matters Perspectives and Reader Takeaways
We submit that the takeaway and lessons to be learned from this Kraft Heinz development is obviously how inherent conflicts and zeal in business goal setting, individual performance expectations and management bonus structures can create a moral divergence for supply chain and procurement teams. So much so that in this particular case, they extended beyond the notions of regulatory laws and in ethical business practices. As blatantly stated by the SEC official, company executives placed the pursuit of cost savings above compliance with the law.
What made this development more poignant was our observation that 3G Capital exhibited tendencies to purposely recruit younger, less experienced procurement professionals into roles with enormous responsibilities in terms of spend management and oversight. That is not to state that this is purely a negative, since younger professionals can have the inherent skills to eventually excel and grow into a senior responsibility role over time with proper mentoring and oversight. The conflict is in molding such professionals to achieve goals regardless of the implications and without a sense of where ethical lines must be adhered to.
Certain suppliers were, in turn, placed into rather difficult circumstances regarding their participation in such schemes. This was contrasted to the carrot for maintaining longer supply contracts.
As Supply Chain Matters has frequently noted from our observations of industries driven solely by the zeal for wringing out perpetual cost savings from supply chain participants, there is always a price to be paid in short- and longer-term business support capabilities.
We trust that supply chain management curriculums and executive training will henceforth reference this Kraft Heinz development as an example of the extremes.
Bob Ferrari
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