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

Corporate Governance

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

not sophisticated.

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

not possible.

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


In summary

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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