Across different legal regimes, the structure of share ownership likely determines the nature of the fraud. Discuss
Across different legal regimes, the structure of share ownership likely determines the nature of the fraud.
The article by Coffee (2005) suggests that the US and Europe differ in their experiences
of corporate governance failure. Analyse the arguments that Coffee uses to support his
assertion, and evaluate his conclusion that, ‘across different legal regimes, the structure
of share ownership likely determines the nature of the fraud’ (p. 209).
use the following material a mandatory sources
J.C. Coffee, Jr. “A Theory of Corporate Scandals: Why the USA and Europe Differ”
(2005) 21 (2), Oxford Review of Economic Policy, 198–211.
This article sets out the key differences between corporate scandals in countries with
closely held companies, such as many European nations, and in countries with
dispersed shareholding, such as the UK and the US.
G.A. Ferrarini & P. Giudici “Financial Scandals and the Role of Private Enforcement:
The Parmalat Case” (2005), European Corporate Governance Institute Law Working
Paper No. 40/2005. DOI: 10.2139/ssrn.730403
Week 5: Gatekeeper failure in corporate scandals
The Parmalat failure and role of the board of directors
Article: Ferrarini & Giudici: pp. 2–20
Parmalat was Europe’s Enron. Although the circumstances of the two corporate failures
were, at one level, completely different, both collapses led to financial scandals that
reverberated well beyond Italy and the US, respectively. And both corporate failures
highlighted systemic and fundamental flaws in governance practice. In the case of
Parmalat, the root cause of the failure was the behaviour of the major shareholder who
controlled the company. Those fundamental flaws in governance were not detected by
‘gatekeepers’—that is, those external professionals charged with monitoring
management by providing verification or certification services to investors. Most
particularly, with Parmalat, the auditors, as external gatekeepers, failed to detect the
frauds, and they may even have orchestrated them.
The article by Ferrarini & Giudici (2005) contains, on pp. 5–18, the story of the
Parmalat failure. Read the account to learn how the actions of a determined wrongdoer
were allowed to continue by the inaction and collusion of those charged with
safeguarding the governance of the company. You will readily see how governance
failure can have an impact on many lives and livelihoods.
Parmalat was a dairy company with an international profile. Calisto Tanzi was the
controlling shareholder and a high-profile individual with political connections in Italy.
In the 1990s, Parmalat launched an international acquisition campaign and diversified
into other markets such as football and tourism. By 2003 Parmalat was a multinational
food group with 200 companies spread over 50 countries.
In the financial markets Parmalat was considered by analysts to have an opaque and
arrogant attitude towards investors. A characteristic of Parmalat was the number of
bond issues. (A bond is a debt security in which the authorised issuer owes the holders
a debt and, depending on the terms of the bond, is obliged to pay interest and/or to
repay the principal at a later date, termed maturity. A bond is a formal contract to repay
borrowed money with interest at fixed intervals.) The high amount of debt that
Parmalat had was supposedly balanced by its cash reserves.
In October 2002, Parmalat attempted a number of bond issues that alerted some
analysts that all might not be well in the company. The share price of the company
plunged, and the bond issue was ultimately cancelled. The appointment of a new chief
financial officer led to a revival in the share price, but a number of undisclosed
activities by Parmalat came to light. On 8 December 2003, Parmalat was unable to
repay a bond that had matured, and its share price collapsed. The document evidencing
the company’s cash reserves held with the Bank of America was revealed to be a
forgery. On 27 December 2003, Parmalat was declared insolvent, and Mr. Tanzi was
Once Parmalat had failed, what had taken place quickly came to light. For a long period
the financial statements of the company had been falsified. The company had a
mountain of debt brought about by its poor performance and by the Tanzi family
siphoning off money. Losses were hidden using offshore wholly owned entities,
including a Cayman Islands entity called Bonlat. Money was siphoned off by the Tanzi
family who diverted money to companies owned by family members. The frauds were
Management was assisted in its wrongdoing by gatekeepers such as the auditor and
lawyer, who were arrested. It was the auditor who suggested the use of Bonlat and who
helped Parmalat conceal the losses. The lawyer was the mastermind of the complex
web of companies used to carry out the fraud.
The Parmalat failure led to a flurry of litigation, as well as a political debate about
capital markets in Italy. A European Parliament resolution passed as a result of
Parmalat called for transparency, supervision, and oversight to be improved as well as
enforcement. Within Italy, raising money through bond issues has become much more
Parmalat was listed on the Milan Stock Exchange, and companies listed on that
exchange who have chosen not to follow the Corporate Governance Code issued by
Borsa Italiana are expected to justify their decision. Parmalat did not follow the Borsa
Italiana recommendations, having only 3 out of 13 apparently independent directors in
2003. One of the supposedly independent directors was an old school friend of Mr.
Tanzi; one was his lawyer; and one had a number of directorships in related companies.
It is clear that the independent directors were not really independent. It is also clear that
non-executive directors did not supervise management. As pointed out on p. 19 of the
article by Ferrarini & Giudici, the independent directors were not prepared to delve into
the financial intricacies, instead relying on assurances from Mr. Tanzi. In addition, civil
and criminal liability of directors occurs rarely in Italy, creating little incentive for the
independent directors to carry out their roles with care. But such measures may not
guarantee good corporate governance. The appointment of
independent directors and the high risk of liability for US directors did not prevent the
failure of Enron in the US.
Auditors and other gatekeepers
Article: Ferrarini & Giudici: pp. 20–41
The legal and economic rationale behind the use of auditors and other external
gatekeepers to protect the interests of shareholders was that gatekeepers such as
auditors do not gain from fraud, but risk losing reputation and being legally liable if
they allow it to take place. Therefore, gatekeepers are incentivised to monitor their
client companies and to denounce wrongdoing. Even though gatekeepers are paid by
the client companies, it was considered by proponents of law and economics reasoning
that no fee could match the costs of a loss of reputation. Also, companies cannot fire
gatekeepers without giving rise to significant questions in the market. It should
therefore be possible for gatekeepers to act in the interests of investors and creditors.
But this rationale is shattered by failures such as Enron and Parmalat.
The unrecognised factor that was identified following the failure of Enron was that
auditing firms had, in the 1990s, also become involved in offering consulting services
to companies. These lucrative consulting services allowed client companies to apply
pressure on audit firms in their consulting roles. Also in a growing confident market,
the incentive of valuable consulting fees may have outweighed the reputational risks for
audit firms. Also the risk of legal liability reduced in the 1990s with a general
relaxation of the laws in a number of states.
There were clear auditing failures that contributed to the Parmalat collapse. Grant
Thornton (UK-based chartered accountants), the auditor for Parmalat, had allowed the
offshore entities to be created. Grant Thornton was due to be replaced as Parmalat’s
auditors in 1998. Bonlat (the Cayman Islands entity mentioned above) was created as a
shield at that time to hide the activities of the offshore entities that would be outside of
the control of the replacement auditors. Deloitte Touche Tohmatsu, the replacement
auditors, carried out consulting services for Parmalat. There is some evidence that
findings by the audit arm of Deloitte were suppressed by the consulting arm.
Some commentators argue that the failures of the auditors were brought about by lax
auditing rules in Italy. You will see on pp. 27–33 of their article that Ferrarini &
Giudici do not agree with this view. The authors analyse primary supervisor liability,
auditor independence, liability rules, and private enforcement against auditors in Italy
as possible causes of the failures. Regarding primary supervisor liability, the authors
argue that Italian national auditing standards reflect international standards and that
independence rules in Italy are in fact very high. Although the level of enforcement in
Europe generally is lower than in the US, the liability framework in Italy is very strict.
But the authors acknowledge that levels of private enforcement in Italy are very low.
Read the authors’ analysis of auditing rules in Italy and see whether you agree that the
failure of the auditors was not brought about by lax auditing rules.
In Italy, a board of statutory auditors is charged with monitoring the company. The
system was considered to be flawed, as statutory auditors were appointed by controlling
shareholders. It was therefore made possible for minority shareholders holding 3% or
more of shares to appoint the statutory auditor. This is what happened in Parmalat
where, in 1999, institutional investors appointed a statutory auditor. At the end of her
term in 2002, the statutory auditor declined to be reappointed. Institutional investors
could not reach the threshold to appoint a new statutory auditor. Subsequently, many
Italian fund managers sold Parmalat shares, seeing the stepping down of the statutory
auditor and her non-replacement as dangerous signs. When Parmalat failed in 2003,
only 8 of 166 Italian pension funds held Parmalat shares.
Other gatekeepers are underwriters who will, as one of their roles, check prospectuses
issued by companies. Investment banks invest in companies, and investment banks
such as Bank of America came under scrutiny after the Parmalat failure. Attorneys
involved in financial transactions and securities placements are supposed to detect
irregularities in companies when carrying out due diligence, which is a process of
checking that all the documentation of a company is in order. Right up until the failure
of Parmalat, most analysts were recommending that investors buy or hold shares in the
Enforcement in the European context
Article: Ferrarini & Giudici: pp. 41–57
Enforcement is the global term used to describe actions brought against alleged
wrongdoers. European jurisdictions such as Italy are not able to bring class actions (that
is, group actions), whereas such actions are available in the US. An insolvency
procedure, where the liquidator who looks after the winding up of the company brings
an action against the gatekeepers on behalf of the creditors, is the main remedy
available in Italy. Direct private enforcement by investors is not common, perhaps
because the court system is slow and inefficient, but also because collective actions are
Public enforcement is one approach. On pp. 42–43 of their article, Ferrarini & Giudici
argue that penalties such as imprisonment are needed for securities frauds, to act as a
sufficient disincentive to others. Fraud should be prevented by mandatory disclosure.
Public enforcement of wrongdoers allows a nuanced approach to sanctions, where the
penalty can be crafted to fit the extent and impact of the wrongdoing. However, no
public body can assess the social cost of wrongdoing with
complete accuracy. Another advantage of public enforcement is that public enforcers
usually have strong investigative powers. The problems with public enforcement are a
lack of efficiency, a lack of resources, and the risks of public servants being corrupted
or compromised. It is for that reason that, rather than relying solely on public
enforcement, private parties are incentivised to report wrongdoing through mechanisms
such as damages, restitution, and other monetary rewards.
On pp. 45–50, Ferrarini & Giudici argue that class actions should be available in
European countries. They also consider the merits of contingency fees, where lawyers
receive payment only if they are successful. The system in Europe generally allows the
courts to order that the costs of the successful litigant to be paid by the unsuccessful
litigant. Read and evaluate the arguments of Ferrarini & Giudici, focusing on whether
the adoption of the US enforcement techniques may have made recovery possible from
those who caused the Parmalat failure.
Derivative actions, where one litigant brings an action on behalf of a company, with the
consent of the court, are permitted in Italy. However, discovery, where a defendant is
required to provide copies of documentation, is limited in Italy and other European
jurisdictions compared with the US. This limitation will affect the access to information
by litigants and thus the viability of derivative actions, making such actions rare.
Ferrarini & Giudici conclude, on p. 55, that the Italian system does not encourage a real
interplay between public and private enforcement.
Gatekeeper failure across ownership regimes
Article: Coffee: pp. 198–204
As this week’s readings show, corporate scandals occur in many countries. The article
by Coffee (2005) examines why different sorts of corporate scandals occur in different
jurisdictions. It also considers why a wave of scandals may occur in one economy, but
not in another, similar economy. Certainly, a well-recognised reason for corporate
scandals is a stock market bubble. The eventual bursting of the bubble brings scandals
to light. Nevertheless, the so-called ‘dot-com’ crash in 2000 led to a number of
financial scandals involving accounting irregularities in the US, but not generally in
Europe, with the notable exception of Parmalat. Also the scandals in Europe did not
involve earning manipulation by management—that is, accounting irregularities.
In his article, Coffee argues that the differences between jurisdictions are caused by
different patterns of share ownership. In jurisdictions where companies are closely held
by controlling shareholders, such as many European jurisdictions, those controlling
shareholders tend to be the wrongdoers. They will exploit the private benefits of
control, such as control over the finances of the company. In jurisdictions such as the
US, where share ownership is widely dispersed, the controllers will be
the managers. Corporate managers may engage in earning manipulation. All types of
jurisdictions have gatekeeper failures, but Coffee argues that different reforms in the
different jurisdictions may be justified, as the types of wrongdoing are different.
Part II of Coffee’s article (pp. 200–204) focuses on fraud in dispersed ownership
regimes such as the US. Financial restatements are accounting irregularities that are
identified. Figure 1 on p. 200 shows the increase in these restatements in the period
from 1997 to 2002. Contributing factors were over-optimism about earnings growth
and increases in executive remuneration, as there was a shift from a cash-based system
to an equity-based system. As you have seen from last week’s material, an equity-based
system creates incentives for short-term financial manipulation by managers. The scale
of compensation and the extent to which it is equity-based is much higher in the US
than in Europe. The reason for this is that institutional investors in the US pushed for
equity-based compensation in an attempt to align managerial incentives with the
performance of the company.
National political and cultural factors in corporate governance failures
Article: Coffee: pp. 204–211
Part III of the article by Coffee (pp. 204–207) focuses on fraud in concentrated
ownership regimes. Controlling shareholders do not need to incentivise management
with equity, as they can directly monitor and replace management. Controlling
shareholders are less concerned with the day-to-day share price, because they are not
likely to sell their shares on the open market. Controlling shareholders involved in
wrongdoing will extract private benefits of control, often through financial transactions.
For example, in a process known as tunneling, minority shareholders may be forced to
sell their shares at less than market value. Controlling shareholders may force the
company to engage in related party transactions with companies that they also own.
Part IV of the article (pp. 207–208) examines gatekeeper failure across ownership
regimes. There is divergence of interest between various groups in the company. In a
dispersed ownership system, managers are the villains and shareholders may be the
victims, whereas in a concentrated ownership system, managers may be controlled by
large shareholders and minority shareholders may be the victims.
Gatekeepers such as securities analysts may be effective in a dispersed ownership
system, but the volume on trading in a concentrated ownership regime may not be
sufficient to support a profession of analysts. Also, in a concentrated ownership regime,
analysts’ predictions cannot take into account the ability of the majority controlling
shareholder to squeeze out the minority shareholders. This ability to squeeze out must
affect the value of the shares.
In systems with dispersed ownership, gatekeepers may not detect inflated earnings. The
solution may be to ensure that the gatekeeper does not report to those people it is
expected to monitor, but rather an independent audit committee. But such a solution
will not work in companies that are closely held, as the controlling shareholder is likely
to control the composition of the audit committee. In jurisdictions dominated by closely
held companies, a solution may be the appointment of the auditor by minority
This week’s work has been designed to provide you with a brief overview of the
Parmalat failure in Italy and to help you consider the factors contributing to that failure,
particularly the deficiencies in the actions of gatekeepers such as the auditors. One of
the ways in which governance can be understood is through examples of companies
where it has failed. It is also useful to understand the role of gatekeepers in governance.
Next week you will go on to the reaction to corporate scandals in the UK, US, and
Europe. This week explores the background to the corporate scandals at the beginning
of the millennium and the regulatory responses in the US, UK, and EU.
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