Accounting for Nuts: Blame a misalignment of incentives for the scandal at Diamond Foods.

Accounting for Nuts:  Blame a misalignment of incentives for the scandal at Diamond Foods.   

The Wall Street Journal’s Holman Jenkins opines:  “Business people talk about “alignment of incentives.” The lesson here may concern a peculiar misalignment of incentives.”  He explains:

Here’s the executive summary: Diamond was a cooperative owned by California walnut growers until it became a publicly traded company owned by shareholders in 2005. Lately reporters and a shortseller-connected analyst have been poking around a $60 million payment the company made to growers in September 2011, which some growers apparently understood to be a “topping up” payment because they had been “underpaid” for the 2010 crop.

Diamond, for its part, has described the payment as an “advance” on the 2011 crop. But, oddly, some growers say they got money despite having already opted not to renew their contracts for the 2011 crop.

To some, the episode suggests a routine sort of accounting fraud—a company boosting its 2010 profits by hiding some of its costs in 2011. But wait. It’s also true that Diamond buys walnuts under multiyear contracts with growers that give it considerable freedom to name its own price (since Diamond is also obligated to take all the nuts the growers produce). Why exactly would Diamond pay out money to growers they apparently weren’t expecting, especially to those who were already leaving?

One possible reason is that growers still own much of the company’s stock as a result of the conversion from a cooperative.

Not every grower was in favor of the IPO in 2005, explains Jenkins.

The “new” Diamond would no longer be answerable to growers. It would have every incentive to get its nuts cheaply, even importing them from China. Mr.Mendes said the IPO would help the company expand the market for nuts, but it was also clear that Diamond would diversify its operations, expanding its snack food business and reducing its dependence on walnuts.

Most growers voted for the IPO anyway, while agreeing to continue selling their crop to Diamond under new multiyear contracts. Diamond would remain committed to absorbing their full production while making a “good faith” effort to pay them the market price, subject to adjustments for quality, grade and other factors.

Students of incentive alignment will not be surprised what happened next. Almost immediately came complaints that Diamond was paying its growers 10 cents a pound less than growers were getting from independent buyers. A lawsuit claimed the captive growers had been scalped out of $52 million in the first two years after the IPO.

Diamond was run for growers; the new Diamond for shareholder profits.