Why on earth are Tesco shareholders suing themselves?

It's been a tough time for Tesco (LSE: TSCO) shareholders recently.

In 2013, the company closed down Fresh & Easy, its ill-fated attempt to grow a retail chain in the US. This involved writing off more than a billion pounds in the process.

But the problems have continued. Over the last year, the company's shares have almost halved in value.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

There have been plenty of reasons for this. Some have affected the food retail industry as a whole Sainsbury's and Morrisons shares have been horrible performers too but others are specific to Tesco.

The most significant was the revelation in September that Tesco's first-half profits had been overstated by £260m. There was a restatement and the managers involved were suspended. Three are now reported to have left the company and the Serious Fraud Office is investigating the case.

The impact of this event is still being felt as last week, a group of Tesco shareholders announced plans to sue the company.

That £260m overstatement is a much smaller figure than the billion-pound plus write-off that emerged thanks to Fresh & Easy. But the need to restate profits was a big hit to the company's reputation and share price.

And the fact that it looks like fraud, opens the door to litigation.

Shareholders who bought Tesco during the period that the profits were overstated and still held them when the revelations came out, can claim the company misled them when they invested. They dealt on the back of fraudulent information.

By clubbing together and forming a 'class', they can sue Tesco for compensation through a single lawsuit, rather than having to conduct individual actions.

As usual, the clear winners in these cases are the lawyers. But to what extent will the shareholders be winners if the suit is successful?

Tesco lawsuit: other shareholders are paying the price

There will also be an ongoing impact on the shares from the publicity surrounding the case and the distraction it causes the present directors, which will also have a negative impact on shareholder value.

I can understand the desire for vengeance; but the class action could end up just transferring value from the set of Tesco shareholders who are not members of the class action, to the set who are. Is it fair and just that someone who bought shares five years ago and still holds them, ends up compensating a more recent buyer?

The real perpetrators who should to be punished, of course, are those managers responsible for the fraud.

However, one problem with this is that the Serious Fraud Office seems to move at a glacial pace.

Ideally, we could seek financial redress from rogue directors the risk of losing everything could act as a deterrent.

Occasionally, fraudsters do end up going to prison. In the UK-listed small and mid-cap world, I can immediately think of Carl Cushnie of Versailles plc (sentenced to six years) and Michael Bright of Independent Insurance (seven years) as two examples.

In both these cases, shareholders lost their entire investment, because the companies were insolvent when the frauds were uncovered.

The bottom line is that I don't like the 'compensation culture'. I'm all for investor protection and robust regulation; but hoping to be bailed out when a risk investment goes wrong doesn't feel right. Especially when your compensation comes from your fellow shareholders.

I wrote last week about the importance of being able to trust the directors running the companies you invest in. And the Tesco case goes to the heart of that. It shows how a company under pressure, with a bad corporate culture, can betray that trust. It also shows that dodgy dealings can happen in blue chips as well as on the Alternative Investment Market (Aim).

So how should investors protect themselves?

Avoid beards and personalised number plates

That means we have to make subjective judgements. There's no magic formula here, but it obviously helps if you can meet management.

Also, try to read between the lines of statements is management being open and cautious; or are they always optimistic and inclined to gloss over problems? Take a look at the accounting policies too and see if they seem aggressive or conservative.

Developing some rules of thumb can help. An old colleague of mine used to avoid companies where the CEO had a beard (clearly hiding something) or personalised number plates (too flash). This might be flippant; but it might be a better backstop in the long run than relying on class action lawsuits!