Introduction
To most Italians, prior to 2003, Parmalat represented a brilliant example of the Italian economic marvel. Calisto Tanzi, Parmalat's founder had taken over his family's salami and preserves business and had transformed it into an industrial giant in the time of thirty years.
Calisto Tanzi started by applying new technologies to the milk business. Along with milk, Parmalat also branched out into other areas such as juices, sauces, baking products, yogurts, soups and mineral water. Parmalat grew at a phenomenal rate of 50% a year. Tanzi diversified his business with acquisitions of TV channel (Odean TV), soccer club (Parma F.C.) and tourism (Parmatour).
Parmalat Finanziaria Spa, a holding company was listed on Milan stock exchange in 1989. The Tanzi family was the controlling shareholder via a non-listed company. It was a group of 58 companies (33 based outside Italy) with aggregate sales of $720 million. The acquisition drive became more intense in the 1990's with the aggregate sales of $3.6 billion in 1996 and almost $10 billion in 2002. But most of his acquisitions were financed with debt.
The Collapse
A very distinctive aspect of Parmalat's balance sheet was the presence of high levels of debt and cash at the same time. In spite of the various acquisitions the company faced severe losses. The projects including soccer team and the tourism company were under huge debts. Even with this deficiency Parmalat enjoyed an investment grade credit rating and was able to borrow increasing amounts of capital from the investors. The group was still pursuing its apparent strategy of holding a huge amount of cash to be used in mergers and acquisitions whilst financing its cash needs through bonds. At the end of 2002 Parmalat Finanziaria was the listed holding of a multinational food group made up of more than 200 companies spread around 50 countries.
In 2002, the annual reports indicated $ 4.3 billion cash against $9.3 billion of debts. The reality was that most of the cash reported in the balance sheet did not exist i.e. it had already been consumed. Tanzi's empire collapsed in December 2003. Parmalat defaulted on € 150 million bond. The management claimed that this had occurred because a customer, a speculative fund named Epicurum Fund defaulted on its bills. However it was soon found out the Epicurum Fund was owned by Parmalat. As a result S & P downgraded the bonds to junk level and the share prices collapsed dramatically. Calisto Tanzi admitted of the fraudulent activities and an investigation was commissioned.
The Fraud Triangle
The fraud triangle can be aptly used to illustrate the phases of fraud. There are three factors to a fraud triangle and each of them is explained below in relation to Parmalat Scandal.
Perceived Opportunity: An opportunity is generally provided as a result of weakness in internal control system such as lack of policies and procedures, easy to access information and lack of supervision & review.
Lack in corporate governance regulations: Parmalat was a company with concentrated ownership. The Tanzi family was the controlling shareholder. From the case it is clear that they were the dominant shareholders and had ample opportunities to expropriate investors. Mr. Tanzi who was the CEO and Director of Board had full control over decisions. The other board members rather than representing the faceless shareholders, bonded with the management who had the ultimate power to select or remove them.
Loopholes in Italian corporate and securities law: The Parmalat scandal took place during the term of Italy's billionaire media mogul Silvio Berlusconi as a prime minister. He promoted the legislation to reduce penalties for fake accounting instead of increasing them. This provided more opportunities to commit fraudulent activities.
Perceived Pressure: Organizations always face pressure to achieve unrealistic and unattainable financial goals, improved earnings and higher share prices.
In case of Parmalat, Tanzi was always under constant financial pressure to reduce the ever-growing debts. Business ventures like Parmatour and Parma F.C. were debt ridden. Huge amount of capital were invested in these ventures which had been running at loss from beginning. The company tried to hide its financial loss every year which turned into a mess.
Rationalization: It is very difficult to understand how Calisto Tanzi would justify his fraudulent actions which led to thousands of job cuts, lost of investor's money etc. Though some might think that his huge donations to help the poor and sick, restore old churches and spread awareness about AIDS as a philanthropic gesture to justify his wrong doings, other might disagree.
Significant frauds involved in the Parmalat Scandal
Parmalat Scandal is a classic example of occupational fraud. The types of fraud allegedly carried out by Calisto Tanzi and his executives are countless. Some of them bare similarities to those of Enron, while others are of a more simple character.
False financial records
During the investigation it was realized that Parmalat's financial statements had been false for a long time. The technique used was quite simple. Parmalat hid the losses, overstated assets or recorded non-existent assets, understated its debts and diverted company cash to family members. It recorded non-existent repurchases of bonds. It sold receivables falsely described as non recourse, in order to remove the liabilities from the records. It mischaracterized debt or, simply, did not record it.
Fake Companies
According to some charges, numerous shell companies were set up to generate fake profits for Parmalat. Economic experts and analysts determined to the role of these entities as one of the various tactics to understate debt and hide losses.
Asset Misappropriation
Mr. Tanzi had had invested in various other business ventures apart from milk and dairy products. A TV channel (Odean TV) was one of the ventures that went bankrupt. Mr. Tanzi had guaranteed to pay out the debt. During the criminal investigations it came to light that the money to cover the TV channel's debt was paid via Parmalat. This was first of the many large cases where Parmalat's money was used to cover Mr. Tanzi's debt in other business areas. It was also revealed that huge amounts of money were siphoned-off to Mr. Tanzi's family.
Parmalat owned various wholly-owned subsidiaries, amongst which the most significant was Bonlat. It was a waste basket of the group for the last 5 years of its life situated in Cayman Islands. It was the holder of the Bank of America's false account. Uncollectible receivables were transferred from the operating companies to these nominee entities, where their real value was hidden. Fictitious trades and financial transactions were organized to offset losses of operating subsidiaries and to inflate assets and incomes. Securitization schemes based on false trade receivables and duplicate invoices were recurrently used to finance the group. This scheme allowed Parmalat to receive something like 1 billion in loans from banks while recording them as assets, which gave rise to Parmalat's overvaluation. In short, Parmalat and its confederates were operating something similar to a Ponzi scheme.
On December 11 2003, Consob (Italian equivalent for SEC) asked Grant Thornton, the auditor of Bonlat, which held a bank account with Bank of America where all Euros 3.95 billion of Parmalat's group cash was supposedly deposited, to investigate whether Parmalat's statement concerning the bank account was true. Bank of America replied that the document confirming the bank account was a forgery and Parmalat never had the money.
Forgery
The key element in this case is the outright forgery of a letter saying that the dairy company had $4.9 billion in deposit with the Bank of America. This deceit was committed by the finance director of Parmalat. A document with Bank of America letterhead was scanned and then added to a document verifying a deposit account with the bank. This fraud was done on behalf of the organization.
Factors leading to the committal of the frauds
There are many factors which facilitated the committal of various frauds in the Parmalat case. They are
Lack of internal control systems
Loopholes in the Italian Corporate and Securities law
Concentrated ownership of the organization
Lack of corporate governance laws
Affiliations between directors and owners
Independent board member's lack of expertise in finance and risk management
Corrupted entanglements with statutory auditors and
The investment banks engaged by the company to place risky debt securities among retail investors.
Significant Parallel between Enron and Parmalat
The US famously had Enron and Italy had Parmalat. The Parmalat scandal is regarded as Italy's Enron, though the damage caused by the Parmalat scandal was more disastrous than Enron in USA. The Parmalat scandal cost Italy 1% of its GDP. In the Financial Times' opinion (Charles Pretzlik, Dec. 21 2003) "the dimensions of the bankruptcy of Enron for the American economy comparing to the bankruptcy of Parmalat's were peanuts."
Although the impact of these scandals on relative economies was different, the two bankruptcies have many elements in common.
Falsified Financial Statements
Both Enron and Parmalat gave the appearance of financial strength and stability which wasn't the reality. Both of them presented falsified financial statements to hide their rising debts and fund their future investments.
The Offshore Companies
Enron and Parmalat have both abundantly used companies off-shore to avoid paying taxes, to hide enormous passivity's, to deceive the directives of the Antitrust. In other words, give an image of company in constant growth of dimensions and billing.
To achieve these objectives, Enron created about two thousand hidden companies. They represented around 45 percent of the total of the business activities. Eonia, the SPE that was accused of hiding the real situation of Enron was able to clean a great part of the Group indebtedness through complex derivatives structures.
In the same way, Parmalat created a complex net of companies. The Camfield, an SPE constituted in Singapore, was the one reportedly supplying powder milk to Cuba for about €10 million, when, in reality, it was a pure financial invention built on the base of false documents that allowed to raise a huge budget. Bonlat, a wholly owned subsidiary, was to account for €3.95 billion.
Cayman- The Caribbean safe
It has become very famous with Parmalat case, but the Cayman's islands are the most used "tax heaven" by the international companies and by the management of Enron. The islands are the fifth world financial center and there are 629 banks. In the files of the Chamber of Commerce of the Cayman there are the budgets and the secrets of 60,411 companies. Enron alone has constituted about 692 companies. Parmalat, on its side, based here the Bonlat Financing Corporation, the center of all the book-keeping secrets of the financials of Parmalat and the Fund Epicurum, unknown entity before November 10 which Parmalat initially claimed to be an investment fund in which it had invested €529 million before it was discovered that it was actually a creation of Parmalat itself.
Optimism of the Analysts
Up to few weeks before the failure, the analysts believed that the industrial and financial reality of Parmalat justified the price of €3 for share. Citigroup announced on the 12 November of 2003 that it has even improved its rating on Parmalat bringing from "to hold" to "to buy".
Sell-side analysts have received considerable criticism for failing to provide an earlier warning of problems at Enron. On October 31, 2001, just two months before the company filed for bankruptcy, the mean analyst recommendation listed on First Call (which compiles and distributes analyst recommendations) for Enron was 1.9 out of 5, where 1 is a "strong buy" and 5 is a "sell." Even after the accounting problems had been announced in October 2001, reputable institutions such as Lehman Brothers, UBS Warburg and Merrill Lynch issued "strong buy" or "buy" recommendations for Enron.
Superficiality of the rating agencies
The optimism of rating's agencies is a constant of the worse cracks. The principal agencies of rating declassed Enron and Parmalat to the level of junk from investment grade only a few days before or even after the declaration of bankruptcy.
Relationship with Political Powers
One line of investigation was whether the respective government officials were aware of Parmalat's & Enron's troubles. Could they have acted to protect the interests of the shareholders, creditors and workers? In both the cases, the companies top officials did have some tie-ups with the government.
Kenneth Lay, CEO of Enron was believed to have influence over the Bush administration's energy policy. The fact that Lay and Enron had been some of the largest donors to Bush and his Republican Party did not go undetected. Enron and its executives and directors, according to the Centre for Public Integrity, had given Bush US$623,000 since 1993. Lay, as well as a mate of George Bush senior, had backed Bush junior ever since his unsuccessful bid for Congress in 1978.
In the Parmalat case, Mr. Tanzi became very well known for his Catholic passion and his political connections with Christian Democrats leaders. In particular, he was considered to be a close friend of Ciriaco De Mita, the powerful leader of the ruling Christian Democrat party during the1980's.
Corporate Governance and regulation
Parmalat is a shining example to date for corporate governance abuses. Generally, Italian corporations both listed and unlisted, are owned by a small number of shareholders. These shareholders are often related by family ties or shareholders' agreements, and are able to exert their power over the corporation if they want to.
The primary problem of corporate governance in continental Europe and in most of the world is different. There, few listed companies are widely held. Instead, the typical firm in stock exchanges around the world has a dominant shareholder, usually an individual or a family, who controls the majority of votes. Often, the controlling shareholder exercises control without owning a large fraction of the cash flow rights by using pyramidal ownership, shareholder agreements, and dual classes of shares (La Porta, Lopez-de-Silanes, and Shleifer, 1999).
These differences in ownership structure have two obvious consequences for corporate governance, as surveyed in Morck, Wolfenzon, and Yeung (2005). On the one hand, dominant shareholders have both the incentive and the power to discipline management. On the other hand, concentrated ownership can create conditions for a new agency problem, because the interests of controlling and minority shareholders are not aligned.
Family-controlled firms are not always better governed than widely held ones. Family control does help to protect shareholders' interest against managerial abuses, since the controlling owner and the manager are often the same person. Moreover, the controlling family is likely to commit more human capital to the firm and to care more about its long-run value (Bertrand and Schoar, 2006). However, families like managers in a widely held company, can abuse their power and use corporate resources to their own advantage. When this happens in a family-controlled firm, things are even worse than in a widely held company, because controlling families cannot be ousted through a hostile takeover or replaced by the board of directors or by the shareholders' meeting.
Self-dealing or tunneling is the transfer of value from firms where the controlling shareholder owns a small fraction of the cash-flow rights (lower down in the pyramid) to firms where the controlling shareholder owns a large fraction of cash-flow rights (higher up in the pyramid) (Johnson, La Porta, Lopez-de-Silanes, and Shleifer, 2000). Value can be transferred in many ways: related-party transactions (transactions with the dominant shareholder, a director, or parties associated with them) at other than arm's-length terms; the biased allocation of intangible assets and liabilities; excessive director compensation; and others.
In Parmalat, the controlling shareholders expropriated corporate resources via self-dealing.
Legislative Measures
After the Parmalat collapse several legislative measures have been taken to ensure that history does not repeat itself. Some of them are:
Strengthening Internal Governance Mechanisms
Several reforms have strengthened internal governance mechanisms by requiring that executive directors regularly inform the board of directors and the board of auditors of business developments and related-party transactions, and most importantly, that at least one director and one board-of-auditors member be elected by minority shareholders. The reforms also entrusted the board of auditors with greater powers and somewhat tightened their members' independence requirements.
In its 2003 corporate law reform, Italy revised its previously lax regime on self-dealing transactions. Directors now have to disclose to the whole board and to the board of auditors any direct or indirect interest they might have in a transaction. Prior board-of-directors approval is required for transactions in which the chief executive officer has an interest. While interested directors need not abstain from voting, the board resolution must adequately explain the reasons for the transaction and the benefits deriving to the company. This mandatory justification of the transaction's fairness has to be more detailed and analytical when the corporation decides for it under the influence of its parent company.
Empowering Shareholders
Italian companies' shareholders formerly had to deposit their shares with a bank five days prior to the meeting, which prevented them from selling their shares during those five days and hence severely discouraged voting, especially by institutional investors. In 2003 this provision was repealed; the default rule is now no deposit obligation, although company bylaws may require an up to two-day deposit obligation.
Enhancing Disclosure Requirements
In Europe, major disclosure reforms have been enacted, that mainly cover four spheres
Corporate governance
Self dealing and insider trading
Compensation
Financial reporting.
Companies must declare whether they comply with the stock exchange corporate governance code.
Tougher public enforcement
Italy has restructured and strengthened their public enforcement. It has tightened public enforcement over financial and auditing. Italy has also granted CONSOB greater powers. It also provides for criminal sanctions in cases of market abuse.
Apart from the above mentioned steps I believe there are various measures that should be undertaken for the future protection of shareholders and community.
Rulemaking is not the only answer to corporate wrongdoing. It is necessary to create a culture that encourages a more ethical approach and rewards responsible behavior.
Regulation, in reaction to financial fraud, can make doing business more expensive and slash corporations and markets efficiency.
Building a culture of good governance might be a cheaper and more effective means of fighting fraud. If opportunities for fraud are to be reduced, it is necessary to close the loopholes, reduce excessive reliance on finance and as professionals, find the courage to speak out if all is not as it should be. The recent frauds share common failures of governance caused by the separation of ownership and control in large corporations. The firm's nominal owners, the shareholders, exercise virtually no control over the day-to-day operations of the company. Instead, control is vested in the hands of professional managers.
The short-term view taken by some investors can act as an incentive to management looking for quick-fix financial solutions to industrial problems. In Parmalat's case the board of directors was composed of nine executives out of 13 members. And the company's three independent directors were either close friends of chief executive officer Calisto Tanzi, or members of the boards of banks doing business with Parmalat.
Investors can help improve financial markets by taking a more long-term view, consistently exercising their rights and rewarding companies with good corporate governance. Regulation and enforcement cannot be the only answer. Corporations can take voluntary steps to introduce better corporate governance standards. These measures would reduce the risk of financial frauds and send a message to investors and stakeholders.
