By: Robert Proudfoot, Staff Member
On February 8, 2012, Diamond Foods released the
results of its Audit Committee Investigation Findings regarding the accounting
of crop payments to walnut growers and it found: 1) the payments were accounted
for in the wrong fiscal accounting periods by $20 million in 2010 and $60
million in 2011, and 2) internal control over financial reporting had material
weaknesses.[1] As a result of the internal audit
findings, CEO Michael J. Mendes and CFO Steven M. Neil were placed on
administrative leave[2], Procter
& Gamble called off its $2.35 billion sale of Pringles[3]
to Diamond Foods, and Diamond shares are trading around $24 a share, off from
September 2011 highs of $90. So,
what went wrong? In nutshell,
Diamond Foods and their walnut growers had a vague contract that did not 1)
have a proper escalation clause of higher market prices, 2) explicitly state
when payments would be made and how they would be accounted for, and 3)
adequately prepare both parties for being adverse parties with adverse
interests after being a collective cooperative for almost 100 years.
Diamond Foods was founded in 1912 as a walnut
cooperative to market and sell walnuts collectively and voted to convert to a
for-profit company and go public in 2005.[4]
While many growers opted to
partake in the IPO by signing long-term contracts to sell exclusively to
Diamond Foods[5],
some immediately started voicing concerns about inherent adverse interests
presented between a for-profit company and its commodity suppliers (i.e. the
company wants the lowest price possible to increase earnings whereas the
growers desire the highest price for their crop).[6] While growers did receive
stock in the newly converted for-profit company with potential for capital gain
and dividend income, this did not completely offset the adversity of the
parties.[7] The long-term walnut agreement signed
by growers as a condition for receiving shares[8]
in Diamond Foods was summarized in its 2011 Annual Report:
[Diamond Foods] have entered into long-term Walnut Purchase Agreements
with growers, under which they deliver their entire walnut crop to us during
the Fall harvest season and we determine the minimum price for this inventory
by March 31, or later, of the following calendar year. The final price is
determined no later than the end of the Company’s fiscal year. This purchase
price will be a price determined by us in good faith, taking into account
market conditions, crop size, quality, and nut varieties, among other relevant
factors. Since the ultimate price to be paid will be determined subsequent to
receiving the walnut crop, we must make an estimate of price for interim
financial statements. Those estimates may subsequently change and the effect of
the change could be significant.[9]
Under this contract, Diamond Foods received the
walnut crop in the fall, made its first payment in March the following year and
a final make-up payment, as determined by Diamond Foods, almost a full year
after the growers tendered their goods. Frustrated from their unequal bargaining power and
years of payments below market price, the growers unsuccessfully attempted to
form a class action to sue for breach of contract, claiming the contract was
one of adhesion and unconscionable.[10] California state law requires that all
nut sales be in writing and state the full purchase price,[11]
unless both parties agree to waive this requirement, as were the case with
walnut growers having long-term grower contracts with Diamond Foods.[12] This ambiguity in contract price led to
grower discontent when walnut prices skyrocketed from increased demand.[13] The ambiguity also allowed Diamond
Foods to temporarily exploit the uncertainness of payment terms to manipulate
the payments’ accounting by pushing their reporting to next fiscal year to
improve annual earnings.[14]
The recent implosion of Diamond Foods once again
demonstrates the importance of strong, clear contracts between agricultural
growers and commodity buyers—especially for converted cooperatives that are now
publicly traded for-profit companies.
[1] Diamond
Foods Announces Audit Committee Investigation Findings, Diamond
Foods (Feb.
8, 2012), http://phx.corporate-ir.net/phoenix.zhtml?c=189398&p=RssLanding&cat=news&id=1658627.
[3] Diamond
Foods Issues Statement Regarding Termination
of Pringles Transaction,
Diamond Foods (Feb. 15, 2012), http://phx.corporate-ir.net/phoenix.zhtml?c=189398&p=RssLanding&cat=news&id=1661222.
[4] Shermain D. Hardesty, The
Conversion of Diamond Walnut Growers, 23 Journal
of Cooperatives
40, 40-41 (2009), available at http://purl.umn.edu/56901.
[5] Shermain D. Hardesty, The
Bottom Line on the Conversion of Diamond Walnut Growers, 8 Agric.
and Res. Econ. Update
(Univ. of Cal. Giannini Foundation), no. 4, at 1, 11 (2005) available
at
http://sfp.ucdavis.edu/cooperatives/reports/giannini_diamond.pdf.
[6] Holman W. Jenkins, Accounting
for Nuts: Blame a misalignment of incentives for the scandal at Diamond Foods, Wall
Street Journal
(Feb. 10, 2012), http://online.wsj.com/article/SB10001424052970203824904577214853918682554.html.
[9] Diamond
Foods 2010 Annual Report,
Diamond Foods, at 18 (Sept. 15, 2011),
http://www.sec.gov/Archives/edgar/data/1320947/000119312511249300/d232533d10k.htm.
[10] Walnut Producers of
California v. Diamond Foods, Inc, 114 Cal.Rptr.3d 449, 454 (Cal. Ct. App.
2010).
[11] Cal. Agric. Code § 62801
(West 1983)
[13] John Jannarone, Hidden
Flaw in P&G’s Diamond Deal, Wall Street Journal (Sept. 27, 2011), http://online.wsj.com/article/SB10001424052970204831304576595000985103090.html.
This post was written in February 2012. Please see the press release about Oaktree Capital Management's $225 million investment in Diamond Foods(released on May 23, 2012):http://investor.diamondfoods.com/phoenix.zhtml?c=189398&p=RssLanding&cat=news&id=1699044
ReplyDeleteAlso, Diamond Foods has implemented a new Walnut purchase agreement with shorter contract periods, clearer pricing mechanisms, and accelerated payment times. See the new form here: http://www.sec.gov/Archives/edgar/data/1320947/000119312512244357/d356490dex991.htm
A brief explanation of the new walnut contract and funding can be found in a Diamond Foods Presentation (PDF): http://investor.diamondfoods.com/phoenix.zhtml?c=189398&p=irol-presentations