Europe's corporate governance
Parma splat Jan 15th 2004 From The Economist print edition
What are the lessons from the scandal at Europe's largest dairy-products group?
WHEN the Parmalat scandal first began to unfold in December, it was easy to jump to the conclusion that the collapse of this huge publicly-quoted group, still 51%-owned by the Parma-based family of its founder Calisto Tanzi, exemplified little more than the dark side of Italian business. But as more and more details of the company's disappearing billions have come to light, it is clear that this is no uniquely Italian affair. At the heart of the scandal lies a letter, purportedly from the Bank of America—founded a century ago this year (with no little irony) as the Bank of Italy—in which the bank confirmed that Bonlat, a Parmalat subsidiary based in the Cayman Islands, had deposits of close to €4 billion ($5.5 billion) with the bank. Fausto Tonna, Parmalat's former chief financial officer and one of ten people (including his wife) who are currently under arrest over the affair, has told prosecutors that he benefited personally from funds held by subsidiaries in Luxembourg, and he has alleged that the company took kickbacks from the Swedish packaging group Tetra-Pak—an allegation that the Swedish company has denied. The splat from Parmalat is spreading far and wide. As in the comparable scandal at Enron, the attention of investigators has been sharply focused on the auditors. Until 1999, Grant Thornton, an international network of accounting firms, was Parmalat's main auditor. But Italy's rules on the mandatory rotation of auditing firms at regular intervals forced the group to switch that year to Deloitte & Touche, one of the big four global accounting firms.
Rotation of auditors—one of the more controversial measures introduced in July 2002 by the Sarbanes-Oxley act, America's response to Enron, WorldCom and other corporate scandals—seems to have been of little use here. Grant Thornton continued as the auditor of Bonlat and relied on the Bank of America letter for evidence of the Parmalat subsidiary's assets until, in mid-December 2003, Bank of America said that the document had been forged: the cash simply did not exist. Without the money, Parmalat's empire came crashing down. It is now operating under a new bankruptcy law—protected from immediate liquidation by its creditors—which was rushed through Italy's parliament at the end of last year. Last week, Grant Thornton expelled its Italian member from the network. “We do not tolerate behaviour that deviates from our ethical standards,” it said, mindful no doubt of the fate of Arthur Andersen, the auditing firm which was forced to disband after the disclosure of its role in the scandals at its erstwhile client, Enron. But how could Grant Thornton's Italian arm have failed to detect the forgery? Standard practice is for auditors to write independently to banks for confirmation of cash balances. Grant Thornton, it seems, relied on Parmalat's internal mail to deliver its letters seeking confirmation, an astonishing lapse that allowed the fraud to continue. Several of the firm's employees are now under investigation, and on January 8th magistrates called in the first Deloitte partners to explain their firm's role in the affair.
Transatlantic similarities The parallels with America's corporate scandals do not end with the fallibility of auditors. The lack of independence of non-executive directors on the board is another issue in common. Parmalat's was stuffed with family members and local cronies. Despite a 1999 reform that imposed independent directors on listed Italian companies, big ones such as Parmalat were allowed to opt out. Moreover, Mr Tanzi was both chairman and chief executive of the group, now acknowledged in America and Britain as a potentially dangerous combination. There also
seems to have been close complicity between him and the chief financial officer, with Mr Tanzi and Mr Tonna echoing the roles of Jeff Skilling and Andrew Fastow at Enron, of Bernie Ebbers and Scott Sullivan at WorldCom, and of Dennis Kozlowski and Mark Swartz at Tyco. And everywhere there were employees who either knew or suspected what was going on but who, for one reason or another, were dissuaded from blowing the whistle. The Parmalat case may seem to differ in the simplicity of its fraud. The audited statements from Bonlat were used to show cash balances that were reported by the parent company as offsetting high levels of debt on its balance sheet. Each quarter a set of forged documents would show purported cash holdings at Bonlat that matched the head office's requirements. Deloitte seems to have accepted Grant Thornton's audits unquestioningly, while bankers and investors took the audited group figures as reassurance that, although complex, the group's finances were essentially sound. They failed to ask why a company with so much cash needed to borrow so much. The deceit continued for several years and might have originated as an effort to cover up losses at the group's Brazilian operation (said to be considerable), or to conceal the Tanzi family's siphoning off of cash, or to retrieve complicated financial derivatives deals that went badly wrong. Whatever the case, and it may have been a combination of several things, matters clearly got wildly out of control. But the fraud may have been more sophisticated than it might at first appear. “What is the one line in an audited balance sheet that no one questions?” asks a former auditor with Deloitte &Touche. “Answer: the cash and other short-term assets line. And that is precisely where this fraud was directed.” Moreover, it was not sufficient for Bonlat and other group entities merely to claim fictitious cash balances. They also had to generate a paper trail of false sales to show where the money was supposedly coming from.
Embedded deception “None of this has a specifically Italian flavour,” argues Christopher Seidenfaden of Unicredit Banca Mobiliare, an Italian bank. “We're talking about a fraud that could have happened anywhere.” Umberto Mosetti, a law professor attached to Deminor, a consultancy that specialises in corporate governance and shareholder rights, says that the main legal issues in the Parmalat case are false accounting, insufficient disclosure and the provision of misleading information to investors. Largely through takeovers, Parmalat had become an international business, and it was clever at exploiting the different standards of financial markets. Lawsuits have already started to fly in America, where the company sold more than $1.5 billion-worth of bonds to American investors, including several big life-insurance companies. While there are specific local Italian rules and laws that were broken by Parmalat and/or its auditors, the fraud went way beyond them.
“It fooled a lot of people that Parmalat was able to maintain a New York listing for its American Depository Receipts (ADRs),” notes Mr Seidenfaden. Investors were reassured that Parmalat was satisfying American regulatory requirements. They were also reassured by the repeated willingness of the biggest international banks to underwrite new bond issues for the company. Citigroup and Deutsche Bank—respectively America's and Germany's leading banks—both underwrote Parmalat bonds, as did Bank of America. Once Parmalat had gathered its audited numbers, however, it was almost impossible for external parties to crack the fraud. Mr Tanzi fought a long-running legal battle with Lehman Brothers, an investment bank which he accused of rigging the markets in order to damage Parmalat. Credit-rating agencies asked plenty of questions, but they were unable to see past the deception. Regulators from Milan to New York were also hoodwinked and there was no way they could reasonably throw out Parmalat's filings. Giulio Tremonti, Italy's finance minister, has suggested that more effective local regulation might have prevented the fraud. He has proposed a law that would change the regulatory responsibilities of the country's different agencies. The idea of tougher regulation for Italy's financial markets is fine, but there are suspicions that Mr Tremonti is playing politics. By trying to shift responsibilities, he is explicitly attacking the powers of the Bank of Italy, which oversees all banking activities—including the issuing of bonds. Under Antonio Fazio, its governor, the central bank has been stoutly independent, often acting against the government's wishes. “The real danger is that poor legislation will be rushed through,” says Mr Mosetti. “Then we could be worse off.”
Italy has a reputation for poor corporate governance combined with the shameless exploitation of minority shareholders. But much the same can be said of other European countries, including France, the Netherlands and Switzerland, where this week Adecco, the world's largest temporary-employment agency, said it expects to delay the announcement of its 2003 results because of “possible accounting, control and compliance issues...in certain countries”. Most European countries have mere codes of practice for corporate governance, rather than legal statutes, and progress towards meeting the standards of the codes has been patchy at best. In Germany, a government-appointed commission led by Gerhard Cromme, a former chief executive of ThyssenKrupp, a steelmaker, published recommendations for the reform of corporate governance, a so-called “Kodex” of best practice, in February 2002. With this, Germany's first governance code ever, the government was hoping to boost foreign investment. But the majority of the Cromme recommendations are voluntary, though firms that do not comply have to explain to shareholders why. So far, most German companies have introduced uncontentious measures in the Kodex, such as improving communication between the supervisory board and shareholders. Many of them have set up a separate audit committee, as also suggested by the Kodex, and some have strengthened the independence of their supervisory boards by, for instance, limiting to two the number of board seats available to former members of the company's management. Nevertheless, they have largely ignored the bits of the Kodex that they do not like. For example, the implementation of Cromme's recommendation that management-board members' individual pay be disclosed is “catastrophic”, says Marco Becht at the European Corporate Governance Institute in Brussels. In France, a series of official reports has suggested improved governance, proposing, for instance, that one-third of board members should be independent in companies where there is a controlling shareholder (for example, family businesses that go public). In October last year, MEDEF and AFEP, two business associations, jointly published a report on the governance of listed companies. It makes impressive reading. But it is not law. On some fronts there has been progress. Last year, France introduced a law banning individuals from holding directorships in more than five separate companies. That led to a slew of resignations among directors who had appointed each other to their respective boards. But progress is being stoutly resisted by companies such as Michelin, which (like Parmalat) is quoted but also family-controlled. The tyremaker is almost the only big French company to have adopted none of the governance reforms recommended by the Viénot report on the subject in 1999. What's more, France has a scandal of its own which may yet grow to Parmalat proportions. On December 23rd 2003, America's Securities and Exchange Commission (SEC) settled a court case brought against Vivendi Universal and two of its former
French bosses, Jean-Marie Messier and Guillaume Hannezo. According to the SEC, the two men undertook a systematic fraud between 1999 and 2002, the year of Vivendi's eventual near-collapse, when they were ousted from power. Arguably, this alleged fraud was less brazen than the scheme at Parmalat. But many of the mechanisms were the same. Vivendi's alleged wrongdoing relied on false accounting, inadequate disclosure and the use of complex deals between entities in a huge international group.
Let Brussels sprout? To get reliable access to international financial markets and to regain investors' confidence, big companies in Italy and other European countries shaken by corporate scandal need to adopt better standards of governance. Given the international nature of the problem, it is not surprising that the European Commission is interested in the issue. In its Financial Services Action Plan (FSAP), published in 1999, the Brussels executive reviewed EU member countries' codes of corporate governance and argued that Europe's divergent guidelines on the subject remained an obstacle to the creation of a single capital market.
At present, European Union (EU) countries have more than 35 governance codes of varying stringency. Britain alone has produced 11, and its governance rules are the most advanced, says Stephen Davis of Davis Global Advisors, a governance consultancy (see chart). The biggest difference in governance practices among EU members lies in the role of the employee and the strength of shareholders' influence. In Austria, Denmark and Germany, the employees of companies of a certain size have the right to appoint some members of the supervisory board, while in France and Finland companies can allow workers to elect supervisory-board representatives. In all other EU countries a single-board structure is prevalent, with one or more managers running the company under the stewardship of a board of directors elected (for the most part) by shareholders.
The quality of transparency and disclosure across Europe is, at best, uneven, though things have improved since the introduction of tougher listing rules on national stock exchanges following the flotation of Europe's big bourses a couple of years ago. They will improve even more when a single set of international accounting standards (IAS) becomes compulsory for all EU companies next year. Enforcing the new rules, though, is bound to be tricky. In some European countries there is still no enforcement of accounting standards at all. The most immediate concern of the International Accounting Standards Board (IASB), which created the IAS rules, is the approaching inclusion within the EU of eight former Soviet block countries, as well as Cyprus and Malta. Sir David Tweedie, head of the IASB, warned last week that the newcomers would struggle with IAS. Even some existing EU members in southern Europe could, he said, find it tricky to comply. American regulators have long had a low opinion of European accounting and auditing. The Sarbanes-Oxley act was even extended to cover European companies listed in America because the SEC so distrusted European practices. Though the EU is about to introduce common standards, audit rules for European firms are still national, and the enforcement of accounting rules is generally pretty weak. The drive for EU governance reform gained momentum in the wake of America's corporate scandals and the Sarbanes-Oxley act. In November 2002, a committee led by Jaap Winter, a Dutch law professor, presented its final report on corporate governance in the EU and the modernisation of company law to Frits Bolkestein, the EU commissioner for the internal market. In response to the Winter report, in May 2003 the European Commission published an action plan for improving governance in EU countries. In it, it identified priority areas for reform and fixed deadlines by when change should be achieved. The plan does not call for Sarbanes-Oxley-style laws or the introduction of a panEuropean governance code. That would have been unrealistic considering the EU's patchwork of national legal and regulatory systems. Moreover, in America the entire country was in shock after Enron and WorldCom and (more or less) willing to live with tough new laws. Each of Europe's recent scandals—Lernout & Hauspie in Belgium, Ahold in the Netherlands, Kirch in Germany, Skandia in Sweden, and now Parmalat in Italy—has thoroughly shaken only one of its 15 member countries. There has not been the cumulative effect that was felt in America.
A realistic road map In the short term (this year and next) Brussels wants union members to focus on improving disclosure and shareholder communication, and on strengthening the role of independent non-executive directors. The commission is also suggesting that member states make the pay of company directors more transparent. Next month Mr Bolkestein will publish a proposal suggesting that each EU member state set up a national accountancy overseer, similar to America's Public Company Accounting Oversight
Board, established by the Sarbanes-Oxley act to watch over the accountants who watch over the accounts. In the medium term, from 2006-08, the commission is planning to get countries to reform multiple voting rights, golden shares, board structures and other more contentious issues. In the longer term, beyond 2009, Brussels policymakers are hoping to introduce another directive on company law. “It's a sensible road map with a focus on what is feasible,” says Holly Gregory of Weil, Gotshal & Manges, an international law firm. Of course, expectations about corporate-governance reform need to be managed. Good corporate governance is not an insurance policy against fraud. Even very vigilant company directors, credit-rating agencies and investors can be duped by forged documents—but hopefully not for as long as seems to have occurred at the poorly governed Parmalat. The EU can only hope to make it more difficult for fraud to happen. But that in itself would be a welcome achievement.