Food for Thought From Kraft Heinz

We have a fascinating enforcement action from the Securities and Exchange Commission to study, this time against Kraft Heinz Co., which is paying $62 million to settle charges that it committed accounting fraud with a bogus cost-savings scheme. The case is a glimpse into how strategic imperatives can pressure internal controls — and at least one SEC commissioner says the case also demonstrates shortcomings in SEC penalty policy.

The settlement was announced last Friday. Kraft and two of its former top executives, chief operating officer Eduardo Pelleissone and chief procurement officer Klaus Hofmann, were accused of cooking the books from late 2015 through 2018, using various bits of accounting chicanery that manipulated contracts with Kraft’s suppliers. As a result of those shenanigans, Kraft overstated the cost savings it was supposedly making by $208 million. Everything finally unraveled when Kraft had to restate three years’ worth of financial reports in 2019, and here we are.

As outlined in the SEC’s settlement order, much of the chicanery involved multi-year contracts that Kraft’s procurement team would negotiate with suppliers. Those suppliers would offer Kraft up-front cash payments, in exchange for future purchase commitments. Such “prebate” agreements, as they’re called, are legal; but U.S. Generally Accepted Accounting Principles specify that when up-front cash and discounts are tied to future commitments, the expense savings must be recognized across the whole life of the contract. 

That’s not what Kraft did, according to the SEC. Instead, the company recognized the expense savings right away — which had the effect of lowering Kraft’s cost of goods sold, and therefore boosting pretax income. Thanks to loose internal controls and poor documentation, Kraft’s procurement team ran this specific scheme 54 times in 2017 and 2019, artificially lowering cost of goods sold by some $50 million. Ultimately the company had to restate 295 transactions for a total of $208 million.

Meanwhile, Pelleissone and Hofmann ignored clear evidence of the bogus transactions. For example, in one email Hofmann warned Pelleissone of the need to align on a “story” for Kraft’s global controller about the purpose of the supplier payments and the importance of not linking those payments to future obligations.

Final result: Kraft pays a penalty of $62 million; Pelleissone pays $315,000 in disgorgement, interest, and penalties; and Hofmann has agreed to pay a penalty of $100,000 pending court approval. As usual, all parties neither admit nor deny the SEC’s findings.

What the Kraft Case Is Really About

We could dissect the accounting control failures in this case all day long, but how useful would that discussion be, really? Every company has its own system of internal accounting controls, so specific lessons might not be widely applicable. And when you have the participation of senior executives — as we do here, with a chief operating officer and a chief procurement officer — those internal controls could be overridden anyway.

The truly useful lesson is about the forces that drove Kraft employees to commit accounting fraud in the first place. 

That brings us to 3G Capital, the private equity firm that created the Kraft Heinz behemoth; and the corporate culture that those senior executives allowed to take root.

3G and Berkshire Hathaway (yes, of Warren Buffett fame) first acquired H.J. Heinz in 2013, and then merged that business with Kraft in 2015. 3G’s senior leadership then did what all private equity firms like to do: assume that they know best, and cut costs. 

Indeed, 3G is notorious for its cost-cutting. It practices zero-based budgeting, where executives need to begin each year with a blank page and justify every single expense. It eliminates employees with gusto, and 3G reportedly cut 10 percent of Kraft Heinz staff within the first year of 3G taking over.

Our point today, however, is that 3G made cost-cutting a strategic goal for Kraft. It tied employees’ performance metrics and compensation to their ability to cut costs. Procurement division employees said internally that Pelleissone “push[ed] like crazy” for them to meet cost savings goals, and increased cost savings targets to unreasonable levels.

Faced with that relentless pressure to cut costs, employees then engaged in the prebate chicanery we mentioned above, and lots more. 

That’s the lesson for internal control and compliance officers. If your business is based on a misguided strategic goal, eventually it will warp your corporate culture to the point where misconduct is the only way to execute the strategy — and then, all the internal controls in the world won’t do you any good. 

In fact, as I read the SEC’s order against Kraft, I couldn’t help but think of Wells Fargo, and its notorious unauthorized customer accounts scandal.

In that case, Wells executives based their strategy on selling ever more products to customers, and measured success using something they called the cross-sell metric. Over time, pressure on employees to hit the cross-sell metric became so great, they believed they had no choice but to engage in the unauthorized accounts misconduct. 

Figure 1, below, is a chart I derived from Wells Fargo to diagram how misconduct risk flows from strategic goals. It works just as well for Kraft. 

 

 

Wells Fargo’s strategy focused on selling multiple products per customer, which led to sales fraud. Kraft’s strategy focused on cost cutting, which led to accounting fraud. 

For both, however, the root cause was the same: senior management setting a strategy that left the company exposed to misconduct; and then creating incentives that drove employees toward committing misconduct rather than away from it.

A Word From Commissioner Crenshaw

Aside from all these accounting and strategic blunders from Kraft, we were also treated last Friday to a statement from SEC commissioner Caroline Crenshaw. She said the Kraft case demonstrates how companies strategically plan their delivery of bad news to obscure its effect on the markets — and therefore, the SEC should not necessarily base its penalties for corporate misconduct on whatever benefits the company gains from a securities law violation.

For example, Kraft first disclosed the SEC’s investigation into its accounting on Feb. 21, 2019. Kraft also said it recorded only a $25 million increase in cost of products sold in connection with its response to the SEC’s investigation, and that it didn’t expect the investigation to be “material to its current period or any prior period financial statements.” 

That same day, however, Kraft also booked a massive goodwill impairment of $15.4 billion — basically admitting that the merger of Kraft and Heinz in 2015 had failed. That was the announcement that dominated headlines, and sent the company’s share price into a tailspin. 

Three months later, on May 6, 2019, Kraft subsequently announced that it would restate financials for 2016, 2017, and 2018. On June 7, 2019, Kraft filed an annual report containing the restated financial results. Instead of the $25 million mentioned in February, the final cost had risen to $208 million; and Kraft said it hadn’t found any misconduct by any members of senior management — even though we now have a settlement with Kraft’s chief operating officer in hand, and another with the chief procurement officer pending. Huh? 

The Kraft example, Crenshaw said, is far from unique. So shouldn’t corporate penalties be based on actual misconduct, rather than “quantifiable benefits” of misconduct that might be impossible to determine, because the company buries the violation in a pile of other bad news? 

Crenshaw’s words are worth quoting at length:

[T]he imprecision of measuring corporate benefits is not just a result of complexity. Corporate defendants strategically release bad news in ways that dampen or obscure the market’s reaction. The resulting change in stock price therefore may not be an effective way to measure corporate benefits … 

In considering the appropriate penalty to impose in actions brought by the SEC, I am concerned about corporate issuers benefitting from information bundling.  To the extent corporations thereby make it more difficult to measure corporate benefit, that merely reinforces my inclination in setting penalties to focus more heavily on other factors, such as punishing misconduct and effectively deterring future violations.

Crenshaw has talked before about the need to revisit SEC penalty policy, in favor of a more muscular use of them to punish companies for misconduct. I believe she is a stalking horse of sorts for chairman Gary Gensler, staking out bold positions so he can come in later with more measured proposals that still advance the football in the same direction.

So when Crenshaw speaks, I take notes. I’d advise others to do the same.