By Greg Ruel
On Wednesday, Sept. 19, an Atlanta-based litigation boutique announced its investigation into potential breaches of fiduciary duty by officers and directors of Chipotle Mexican Grill (CMG). Just four days prior, a separate law firm announced a class-action suit against Chipotle on behalf of shareholders who purchased stock in the company between Feb. 1, 2012, and July 19, 2012. In fact, over the last five weeks we have tracked nearly a dozen class-action suits and investigations involving Chipotle, reaffirming the long-term sustainability risk of the company suggested by its "F" ESG Rating.
The current wave of lawsuits charge directors and management with issuing false and misleading statements that failed to express the effects that thinning demand and higher prices would have on Chipotle's margins and financial results. Facts that were allegedly misrepresented include:
- Chipotle did not have the pricing power to implement price increases sufficient to offset rising food costs, and as a result the company's margins would be under pressure as Chipotle would be unable to pass these commodity costs along to consumers.
- Demand for Chipotle was slowing due to the economy and increased competition, and could not support the company's aggressive 2012 earnings forecasts.
- Chipotle was experiencing a deceleration of growth as it was becoming a mature company.
At least one law firm is looking into separate claims against the board for breaches of fiduciary duty.
Directors and officers sold shares during the class-action period worth a collective $167 million, selling at prices ranging from $369.50 in February to a height of $440.40 on April 13. As of morning trading on Sept. 21, Chipotle was at $338-$399, down more than 22% from when CFO Jack Hartung sold 10,000 shares on that April high date. Incidentally, Chipotle is in the 30% of S&P 500 companies yet to institute any type of clawback policy.
Here are the total insider sales that took place over the class-action period (Feb. 1, 2012, to July 19, 2012):
- Co-CEO Montgomery Moran sold 160,000 shares worth $63.7 million
- Chairman and Co-CEO Steve Ells sold 150,000 shares worth $58.5 million
- CFO Jack Hartung sold 67,300 shares worth $27.7 million
- Robert Blessing Jr. sold 20,000 shares worth $7.7 million
- Chief Marketing Officer Mark Crumpacker sold 15,297 shares worth $5.8 million
- Director Albert Baldocchi sold 10,000 shares worth $3.7 million
The directors and officers emptied 422,597 shares into the open market between Feb. 6 and April 13, with the stock climbing nearly 20% between those dates (from $371.63 to $440.40). Incidentally, the last day of these insider sales, April 13, marks the highest price of the Chipotle's stock since that date and only two dollars short of Chipotle's 52-week high.
In July, Chipotle's stock crashed more than 20% when same-store sales growth announcements were sluggish. Comparable same-store sales declined from 12.7% in the first quarter to 8% in the third quarter. By the end of August, Chipotle's stock was down to $288.64, nearly 35% below April highs.
Misleading statements and potential insider trading aren't the only legal troubles Chipotle has had in 2012. In May, the U.S. Department of Homeland Security sent a subpoena to the company regarding the hiring of undocumented workers. That was not the first time the company had been accused of this offense. In 2010 and 2011, the company fired hundreds of employees after U.S. Department of Homeland Security's Immigration and Customs Enforcement (ICE) agency identified undocumented workers in Minnesota, Virginia, and Washington, D.C.
Further governance concerns relate to board composition; there has been just one independent director added in the past five years. Five of the seven directors on the board have served for between 13 and 17 years, and the same five individuals chair all major committees. Moreover, none of these directors has ever served on another board in the GMI Ratings coverage universe. While we often condemn boards for having too many overcommitted directors, Chipotle is at the other end of the spectrum and may be suffering from a lack of sufficient experience. All told, the board consists of the five long-tenured directors whose only directorship is at Chipotle: the company's two co-CEOs and a private investor who joined the board in 2007. Baldocchi, a 15-year board veteran mentioned above for selling stock worth nearly $4 million in February, currently serves as the board's lead director.
Inherent in some of these concerns are indications the franchise has peaked. The company is experiencing fallout from a pressured economy and shaky consumer confidence. Declining comparable sales means growth will likely need to come from new store openings. Additional store openings could be risky without a pickup in consumer spending, and the company clearly has impending legal and governance issues to resolve that are much more serious than rounding pennies.