23 Mar 2012
Parmalat proved that even the mightiest can fall. Yet the foundering of modern regulatory authorities, the letdown by accountancy firms, credit rating agencies and banks, all contributed to what became Europe’s largest bankruptcy. Parmalat today still exemplifies what is fundamentally wrong with the system. It is this thought that still gives investors a feeling of unease; the catastrophe is still in recent memory.
Significant steps are required in order to level the competitive playing field and enforce market discipline on all financial institutions, no matter their size. Although regulations can control the corporate environment and strive to prevent incidents such as Parmalat from happening, they are never likely to be able to prevent them entirely.
Today, the market remains haunted by the concept that ‘bigger is better’. Not only is this notion flawed at its core, it also illustrates that money talks – something that will always triumph in the face of regulatory efforts, no matter how stringent.
Founded in 1961 by Calisto Tanzi, Parmalat was an Italian group that was seen as a leading force internationally in dairy and food production. It was hailed as a gem in Italian business and became particularly renowned for producing UHT milk, which was an immediate international triumph. The speed of its success across the globe was phenomenal. The company’s name was advertised by the likes of Niki Lauda, Nelson Piquet and Bernie Ecclestone. With the help of an estimated 36,000 workforce across 139 plants and via high-profile sponsorship, Parmalat was able to diverge into other industries such as TV, football and beverages. By being the face of hugely celebrated sporting events, Parmalat grew into a household name.
Not long after its initial success, Parmalat initiated an aggressive push into acquiring companies in the Americas, including US foods producer Beatrice Foods. Parmalat seemed prudent and safe; as well as numerous individual shareholders, it also held a rock-solid credit score, several highly-valued institutional investors and creditors, and moreover US listed securities. Yet, unbeknownst to many, several of these company purchases were financed with debt, leading to Parmalat’s debt ratings deteriorating. In spite of the decline, Parmalat continued its good deeds, building cathedrals in Parma, sponsoring sports celebrities and bestowing money for good causes just like any good Catholic company was expected to in Italy.
All was running smoothly and Parmalat seemed squeaky clean to the world until it experienced some trouble attempting to sell €500m worth of bonds in early 2003. The warning indicator went completely unnoticed until the implosion followed shortly after, when the company defaulted on a €150m bond obligation.
The default was a rather small debt given Parmalat’s status and magnitude. Its reputation ought to have dictated its bond obligation fulfilment. Although Tanzi originally attributed the default to fleeting issues of liquidity, a prudent regulatory mechanism would surely have at least raised the correct preliminary enquiries.
The ugly truth
That was the turning point for Parmalat. In December 2003, Europe’s largest corporate con finally came to light when Bank of America proclaimed that Parmalat’s €3.95bn account was nonexistent. According to the bank, the transfer document was a forgery, and trading in Parmalat shares was immediately frozen. It therefore came as no surprise, despite the late alarm, that Parmalat’s bonds were swiftly downgraded to junk status by credit rating agencies.
Soon after the rating downgrade, Tanzi was jailed along with numerous family members, CFO Fausto Tonna and two Italy-based executives of the company’s former auditing firm, Grant Thornton. Remarkably, it emerged that Tonna, who had forged the Bank of America documents for the €3.95bn account, was actually the company’s auditor of financial operations, meaning he was in effect his own monitor. Many have argued that a number of similar, more recent, situations could have been avoided had proper auditing occurred and adept practices been in place. This signifies yet another systemic malfunction, and one which continues to be a widespread issue across Europe, namely that too much power and trust is given to individuals in high positions. A better system would have company auditors independent of in-house functions to ensure the corporate governance within large institutions is unblemished.
Parmalat at last filed for bankruptcy protection on December 24, in what became known as the biggest corporate fraud in Europe’s history. Nobody knows with certainty whether missing funds were used to plug operating losses, pay creditors, or illegally enhance the financial situation of its management. Tanzi confessed to embezzling about €470m to deal with losses in other family-owned corporations and admitted that he was aware that accounts were being falsified. These frauds were committed, he said, to conceal losses of around $10bn largely in Parmalat’s subsidiaries based in Latin America. Meanwhile, bogus balance sheet figures allowed Parmalat to continue borrowing. This could not have taken place if sufficient due diligence had been carried out. Yet this circular argument creates a ‘Catch-22’ situation. The level of due diligence prescribed by regulators for companies of such magnitude and international standing would have likely revealed very little – another breakdown in the mechanism of a system that is run by the ‘money talks argument’. It also enhances the fact that investors still exist within a world that places too much trust into companies that supposedly too big to fail.
Parmalat’s debts were eventually fixed at €14.3bn in 2004, an amount eight times that which the firm had previously admitted to. Overall, Parmalat had been plagued with a surplus of power, a fragmented auditing system, deceitful managers and directors, a clear deficit of transparency, and auditors who failed or simply stole from it. Parmalat’s governance structure was rotten, epitomising a notable issue associated with European governance – a majority shareholder who exploits the company rather than monitoring its management.
But why was the Parmalat scandal so » momentous? It seemed absurd and mindboggling that for over 13 years Parmalat had been able to bury its losses by recording non-existent assets, exaggerating its income and understating its debt. Parmalat had created well over 260 foreign entities, including Cayman Island subsidiary Bonlat, which helped unload its underperforming and fabricated assets and to hide its debts. The fact that fraud went undetected for so long sent jitters through the entire financial sector; if it can happen at Parmalat, it could happen anywhere.
The Parmalat scandal raised the well-known gatekeepers’ question concerning financial intermediaries, credit rating agencies, auditors and even solicitors. Furthermore, it enforced the existing problem of questionable corporate regulation in Italy. Yet it is not just corporate governance standards at the time that are the most worrying aspect of this; the issue now is that no real efforts were made to reform this enforcement system following the Parmalat scam.
The accounting calamity at the dairy foods giant exposed a disturbing deficiency of transparency at what was then considered Europe’s largest corporation. The fact that Parmalat’s stock traded on the New York Stock Exchange and sold over $1.5bn in bonds to investors in the US was testimony enough – once again a sign of placing too much trust in companies primarily because of their size and apparent weight.
But even banks, which typically play an important role in monitoring companies, failed horribly in this capacity. In fact, numerous lenders were ultimately targeted for possible roles in aiding the fraud. These included Bank of America, Citicorp, and J.P. Morgan, each of which placed Parmalat bonds, as well as Deutsche Bank, Banco Santander, ABN, Capitalia, and Unicredito.
While most of these banks claimed that they were also victimised by the company, some observers have argued that the banks may have sought profitable deals with Parmalat that conflicted fundamentally with their monitoring responsibilities.
Faith in the system
The failure of Parmalat was especially shocking because it represented the failure of modern regulatory authorities which are by law obliged to protect investors. Similar insufficient regulatory mechanisms also allowed the ABN AMRO merger with RBS, and led to Goldman Sachs’ civil fraud of misleading investors during the US housing market failure, which led it to be fined $550m by the SEC in 2011.
Comparable flippancy caused insurer Skandia, the oldest company listed on the Swedish stock exchange, to get away with “unsuitable, unethical and illegal acts” that affected its investors and status. All these examples indicate that the same insufficient regulatory mechanisms that failed to prevent the Parmalat crisis are still happening now. Especially because the institutions should serve as the eyes and ears of the regulators, and both owe a duty of care to the investors.
Banks, law firms, credit agencies and accountants – none of them picked up any of the wrongdoing at Parmalat. The concept of ‘money talks’, as we have seen, was a major factor in why irregularities were overlooked. But this system still prevails. The psychology of how financial markets operate and the emphasis they place on a company’s standing are of extreme importance. This is because it is built on trust and confidence, such as the reliance Parmalat gained from all the auditors, regulators and investors through its international eminence and the listings on its regulated exchanges. Due to this positive confidence, a “lighter touch approach” was applied to Parmalat, which meant abnormalities were hard to spot. Many believe that, should the current economic theory be allowed to persist in the same manner, the equivalent could happen again. This can be related to companies, sovereigns, and lenders, and would be impossible to prevent.
The culture of modern Western capitalism, some say, can be a selfish one. So it is more likely that the truth lies in the fact that banks may well have been aware of what was going on, but because they saw risk as managed on their part they were fine and failed to be concerned with the ramifications that could take place in the wider financial system. A similar example was the $2bn rogue trading scandal that engulfed UBS in summer last year. On one hand it is an example of monitoring mechanisms failing, while on the other it shows that even with monitoring mechanisms in place, the system can be too slow to respond. It also raises the question as to whether the market would ever have learned of this incident if the trade had made the bank some money, rather than the huge profit loss.
Too big to save?
The notion that some corporations and countries are simply ‘too big to fail’ is a well known concept within the financial sector. Parmalat’s bankruptcy represented 1.5 percent of Italian GNP and was proportionally larger than the combined ratio of the later Enron and WorldCom bankruptcies to US GNP. Parmalat also controlled over 50 percent of milk derivatives in Italy. Nobody could have believed that such a vast market player could collapse in such a spectacular manner. But the evidence is there for all to see.
A comparable ‘too big to fail’ mentality is currently being applied to Italy’s sovereign state. With an economy seven times larger than Greece, an Italian bailout could cost Europe an estimated €1.2trn. But most believe the EU will not allow Italy to fail, given its size. Some feel the focus should be on whether Italy is actually too big to save. This sort of thinking perpetuates in cycles, because if individual countries cannot help, the ECB and EU will. If these fail to deliver there is still the IMF, and surely each one of these is ‘too big’ to be allowed to fail. Numerous significant steps have been taken to combat this culture but the market is still fully aware that, in the short term, vulnerability remains.
The ECB got it right last year when it warned that banks, countries and corporations require more scrutiny from regulators concerning the risks they pose to the financial system. But ten years after the Parmalat scam we are still haunted by the idea that bigger is better. The question will be whether the ‘money talks’ model will continue to triumph over any future regulatory endeavours.