PARMALAT The Relationship Between, Internal Control and Fraud: What Have We Learned from Parmalat?

Introduction The company Parmalat was opened in 1961 by Calisto Tanzi. Initially it was a small pasteurization plant in Parma. Four decades later the company had emerged into a global giant, becoming listed on the Milan stock exchange in 1990. At the end of 2003, the biggest corporate scandals in history of Italy came to light as a 8 billion EUR hole was discovered in Parmalat's accounting records (it is equivalent to 1% of Italian GDP). In 1999, Parmalat set up a subsidiary in the Cayman Islands called Bonlat. The first indication of financial problems came in early 2003 as the company tried to sell 500 million euro in bonds. After this CFO Fausto Tonna resigned in March replaced by Alberto Ferraris. The crisis became public in November 2003 when questions were raised about transactions with mutual fund Epicurum, another Cayman-based company linked to Parmalat causing its stock to plummet. As a result of this action Ferraris resigned, less than a week later replaced by Luciano Del Soldato, who resigned in December, unable to get cash from Epicurum fund, needed to pay debts and make bond payments. On 15 December Tanzi himself resigned as CEO and then, Enrico Bondi took on as the companys president. Parmalat's bank, Bank of America, claimed a document showing 3.95 billion euros in Bonlat's bank account was a forgery. Shortly after the first revelations, Parmalat went into bankruptcy protection. An audit during the early days of the probe put the company's debt at US$18 billion, eight times higher than the company claimed in its accounts. Global outlook on the case sources of problems since1990: Parmalat increased its total debt by It generated It spent It paid 13.2 bn, 1.0 bn cash flow, and simultaneously,

5.4 bn in mostly unproductive acquisitions, 5.3 in commissions and interests,

2.3 bn was siphoned off for various purposes.

Effect of this policy: Policy of the board led to huge losses instead of making profits, but ten years of fraud have covered such losses. Cooking the books was possible, because Parmalat was using the network of almost 300 companies, which were connected in various ways with the main company-mother. In reality, problems of Parmalat should have been revealed years before, but many investors had been turning a blind eye to Parmalat's curious debt-issuing practices - and its corporate governance flaws. Individuals involved in the case: On 5 October in Milan preliminary hearings began to determine whether 32 individuals and companies associated with the events that led to Parmalat's insolvency ten months ago should be tried. In the dock sat 29 people, ranging from the founder to former company financial officers and accountants. Under Italian law, institutions can be indicted as well as people, and therefore we have an indictment for 3 of them: Bank of America and auditors: Deloitte & Touche SpA and Grant Thornton's former Italian branch. Alleged crimes listed on the indictment included market rigging, providing false information to auditors and blocking the work of stock market regulator CONSOB. Key players in the case: Calisto Tanzi CEO and the director of the Board Francesca Tanzi and Stefano Tanzi Calisto Tanzis children Fausto Tonna and Luciano Del Soldato Chief Financial Officers Gian Paolo Zini - outside counsel for Parmalat (accused of circumvent Italian antitrust laws) Parmalat SpA executives: ex: Giovanni Bonici, Gianfranco Bocchi, Claudio Pessina What is more amazing, in this case are involved also many influential politicians as Romano Prodi (former EU President), Massimo D'Alema (first post-communist prime minister), Ciriaco Da Mita (former prime minister). They considered Parmalat as a pillar of Italian economy and therefore the company was under special rights. This case not only revealed all drawbacks of Italian system of ruling, but also danger which may occur when business and politic are linked each other. The role of corporate governance in Italy and in particular at Parmalat I think that first of all, we should find a clear definition of Corporate Governance (CG) and later I try to describe the role of CG in Italy and of course in Parmalat. In the literature I encountered very simple definition of CG CG is about two things 2

accountability and communication (Emerging Trends in Corporate Governance). How can we explain these two terms? Accountability is about how those entrusted with day-to-day management of a company's affairs are held to account to shareholders and other providers of finance. The second aspect is how the company communicates that accountability to the wider world: not only to shareholders, but also to potential investors, to employees, to regulators and to other groups with a legitimate interest in its affairs. After this short introduction, we can go now to the role of CG in Parmalat. In my humble opinion, the key governance problem in such family-run firms is the separation of ownership and control. The firms nominal owners, the shareholders, exercise virtually no control over either day to day operations or long-term policy. Clearly what has happened in Parmalat, indicates that boards - when they are not truly independent and not truly vigilant have bigger temptation to catch fraud. Parmalat definitely lacked board independence (the board comprised nine insiders, one affiliated outsider, and only three independent directors), which was also a result of its structure as a family-run company, fairly typical for the Italian market as a whole. Within these businesses, loans are obtained through relatives, employees are composed of relatives and family friends, business transactions are carried out on goodwill or through close relationships and much is done in secrecy. Parmalat was also weak on the composition of key board committees. Insiders sat on each key board committee. Moreover, members of audit and remuneration committee also sat on the executive committee with founder and boss Tanzi. The executive committee, which consisted of company executives, proposed actions for board approval and then implemented them. In this case the role of external auditors is also very significant. Despite an apparent atmosphere conducive to improprieties, many professed that Italy had the most stringent regulations in Europe regarding corporate auditing. Italian law requires that companies rotate between auditing firms every 9 years and restricts auditors from providing other services to their clients. Nevertheless, Parmalat evaded the law by finding a loophole that allowed its previous auditor, Grant Thornton, to remain as a subcontractor. Deloitte & Touche took over accounting for Parmalat. However, a new unit called Bonlat was formed and Grant Thornton remained as auditor for the new unit. As required by law, Parmalat also has a board of statutory auditors, none of whose members serve on the board of directors. But the level of independence for the statutory auditors is impossible to discern from the information provided by the company. I think, that one more vital case should be mentioned in that place. Under Italian law the election of internal statutory auditors members takes place through the socalled "voto di lista" mechanism, which generally speaking prefers a majority shareholder. The collapse of Parmalat revealed that 4 of its 13 board members were Tanzis relatives and the rest 3

were employees or had a business relationship with the company. In July SEC announced that Parmalat had agreed to adopt corporate governance changes that include creating a shareholder-elected board, maintaining a majority of independent directors, and separating the roles of chairman and chief executive officer. Steps initiated by the Italian government Starting with the Italian legal system, 80% of all crimes went unpunished in 2003. The Supreme Court hears roughly 10,000 appeals a year and the courts are burdened with a backlog of above 5 million cases. Italian law also stipulates that sentences under 2 years are to be suspended and sentences under 3 years automatically receive probation. Due to Italian law, many crimes in the past, including the infamous Clean Hands trials, have gone unpunished, leading many to believe that the rich and powerful are above the law, so therefore I think that proposal of the government to introduce a new crime with a 12-year prison sentence when investors are seriously harmed (as in the Parmalat case) seems very reasonable. In February 2004 Prime Minister Silvio Berlusconi's government proposed legislation aimed at preventing another Pamalat, but his coalition partners started squabbling over the plan even before details were revealed. Under this bill, the central bank's oversight power over the sale of corporate bonds by banks would pass to a new regulator called the Authority To Safeguard Investors, replacing stock market regulator Consob. The purpose of the new regulator is to protect investors and ensure market transparency. The regulator will be able to call on the tax police to carry out investigations. The bill keeps the Bank of Italy's veto power over banking mergers and acquisitions, but the bank will have to share it with the existing competitions regulator. Ministers said the dual authorization would help prevent foreign takeovers. More and more financial frauds in the world forced IAS Board to implement new IAS and financial reporting in order to guarantee transparent view of each company. New IAS will enhance disclosure, along with the Transparency Directive and will be in force since January 2005. Could this type of fraud have occurred in Poland, why or why not? Polish analysts agree that this kind of fraud with the same size as Parmalat could not have occurred in Poland. Why? I will try to confirm my statement using some examples. One of the anylysts from the Fitch agency has said recently about the polish bond market: "The majority of bonds issuer would be classified to the category of junk bonds". This sentence reveals that polish companies are not nowadays in good financial situation and here we can ask a question: What is the main reason of this? I am sure that not only difficult situation on the polish market and stronger competition are the main reasons of this state. On the other hand, we can not declare that managers were 4

detrimental to their companies, but in fact some of them estimated the economic situation too optimistic. I perceive some reasons why huge financial and corporate governance scandal could not have occurred in Poland: 1. We do not have so many companies with such tradition and managers with so good opinion. 2. Companies are aware of frequent control from the side of financial institutions and supervisory bodies (example: polish parliamentary investigative commission). 3. We do not have so many big family-run companies (firms owned and run by families in Italy amount to 90 percent of all businesses). 4. Polish capital market is not well-developed and it is not popular to issue ex.: junk bonds by firms. 5. More and more polish firms pay attention to the principles of corporate governance (on 24 November The Warsaw Stock Exchange accepted a document: Best Practices in Public Companies 2005 in 2004 90% of listed companies fulfilled at least one of the principles of CG) Despite this argumentation, in Poland we can indicate some examples of managers and companies involved in "dark interests"(especially in the first years of transformation), but of course we can not compare the scale of their activities to Parmalat. One of the most famous cases is PZU, the largest insurance company in Poland. 2 presidents of PZU, Wadysaw Jamro y and Grzegorz Wieczerzak, were accused of having secret illegal offshore bank accounts, but the investigation is not finished and nowadays Poles can every day read in newspapers more astonishing details about this case. Conclusion The Parmalat case illustrates perfectly an accounting fraud, but by some people it is considered in terms of a corporate governance scandal. In my work, I tried to show these both aspects and a lesson which results from this complicated case should be the following: how managers have to follow the rules of corporate governance in order to minimize risk in corporate environment and how to protect the interests of companies shareholders.