Review Case 8-3 Parmalat: Europe’s Enron
Respond to the following:
Yellow Group Question
Decide on several Accounting Irregularities and Failures. How might these have been prevented according to expert professional sources?
Below is case 8-3:
Case 8-3 Parmalat: Europe’s Enron1
After the news broke about the frauds at Enron and WorldCom in the United States, there were those in Europe who used the occasion to beat the drum: “Our principles-based approach to accounting standard-setting is better than your rules-based approach.” Many in the United States started to take a closer look at the principles-based Page 534approach in the European Community and that is used in International Financial Reporting Standards (IFRS), which relies less on bright-line rules to establish standards, as is the case in the United States, but may have loopholes making it relatively easy to avoid the rules. In the end, it was not the approach to setting rules that brought down Parmalat. It was a case of greed, failed corporate leadership, and sloppy auditing.
Parmalat began as a family-owned entity founded by Calisto Tanzi in 1961. During 2003, Parmalat was the eighth-largest company in Italy and had operations in 30 countries. It was a huge player in the world dairy market and was even more influential within Italian business circles. It had a network of 5,000 dairy farmers who supplied milk products and 39,000 people who were directly employed by the company. The company eventually sold shares to the public on the Milan stock exchange. The Tanzi family always held a majority, controlling stake in the company, which in 2003 was 50.02 percent. Tanzi family members also occupied the seats of CEO and chair of the board of directors. The structure of Parmalat was primarily characterized by the Tanzi family and the large amount of control that it wielded over company operations. It was not unusual for family members to override whatever internal controls existed to perpetrate the accounting fraud.
The Parmalat scandal broke in late 2003, when it became known that company funds totaling almost €4 billion (approximately $5.64 billion) that were meant to be held in an account at the Bank of America did not exist. On March 19, 2004, Milan prosecutors brought charges against Parmalat founder Calisto Tanzi, other members of his family, and an inner circle of company executives for their part in the Parmalat scandal. After three months of investigation, the prosecutors charged 29 individuals, the Italian branches of the Bank of America, and the accountants Deloitte & Touche and Grant Thornton. The charges included market rigging, false auditing, and regulatory obstruction following the disclosure that €15 billion (approximately $21.15 billion) was found to be missing from the bank accounts of the multinational dairy group in December 2003. Former internal auditors and three former Bank of America employees have been jailed for their roles in the fraud. The judge also gave the go-ahead for Parmalat to proceed with lawsuits against the auditors. Parmalat’s administrator, Enrico Bondi, is also pursuing another lawsuit against Citigroup in New Jersey state courts. Despite all its troubles, Parmalat has recovered and today is a thriving multinational food group with operations in five continents through either a direct presence or through license agreements.
U.S. Banks Caught in the Spotlight
Parmalat had induced U.S. investors to purchase bonds and notes totaling approximately $1.5 billion. In addition, in August 1996 Parmalat sponsored an offering of American Depositary Receipts (ADRs) in the United States, with Citibank, N.A., headquartered in New York City, as depositary. Parmalat actively participated in the establishment of the ADR program. This activity made Parmalat subject to SEC rules. The SEC’s inquiries focused on up to approximately €1.05 billion ($1.5 billion) of notes and bonds issued in private placements with U.S. investors. The banks investigated included Bank of America, JP Morgan Chase, Merrill Lynch, and Morgan Stanley Dean Witter. Parmalat’s administrator, Enrico Bondi, helped the authorities identify all the financing transactions undertaken by Parmalat from 1994 through 2003. During the investigation, it was noted that Parmalat’s auditor from 1990 to 1999, Grant Thornton, did not have copies of crucial audit documents relating to the company’s Cayman Islands subsidiary, Bonlat. The emergence of a €5.16 billion (approximately $7.28 billion) hole at Bonlat triggered the Parmalat collapse. The accounting firm has since handed over important audit documents to investigators.
One of the most notable fraudulent actions was the creation of a completely fictitious bank account in the United States that supposedly contained $5 billion. After media reports exposing the account surfaced, the financial institution at which the deposit supposedly existed (Bank of America) denied any such account. The company’s management fooled auditors by creating a fictitious confirmation letter regarding the account. In addition to misleading the auditors about this bank account, the company’s CFO, Fausto Tonna, produced fake documents and faxed them to the auditors in order to hide the fact that many of the company’s dealings were completely fictitious.
Page 535Parmalat’s management also used “nominee” entities to transfer debt and sales in order to hide them from auditors and other interested parties. A nominee entity is a company created to hold and administer the assets or securities of the actual owner as a custodian. These entities were clearly controlled by Parmalat and most existed only on paper.
Using nominee entities, the Parmalat management created a method to remove uncollectible or impaired accounts receivable. The bad accounts would be transferred to one of the nominee entities, thus keeping the bad debt expense or write-off for the valueless accounts off the Parmalat income statement. The transfers to nominee entities also avoided any scrutiny of the accounts by external or statutory auditors (in this case, Italian-designated auditors under the country’s laws).
Creating revenues was another scheme in which the nominee or subsidiary entities were used; if a non-Italian subsidiary had a loss related to currency exchange rates, management would fabricate currency exchange contracts to convert the loss to a profit. Similar activities were undertaken to hide losses due to interest expense. Documents showing interest rate swaps were created to mislead the auditors or other parties. Interest rate swaps and currency exchange contracts are both instruments usually used to hedge on the financial markets, and sometimes to diversify the risk of certain investments. Parmalat abused these tools by creating completely fictitious contracts after the fact and claiming that they were valid and accurate. The understatement of debt was another large component of the Parmalat fraud, as was hidden debt. On one occasion, management recorded the sale of receivables as “non-recourse,” when in fact Parmalat was still responsible to ensure that the money was collectible.
There were many debt-disguising schemes in relation to the nominee entities. With one loan agreement, the money borrowed was touted as being from an equity source. On another occasion, a completely fictitious debt repurchase by a nominee entity was created, resulting in the removal of a liability from the books, when the debt was still in fact outstanding. Parmalat management also incorrectly recorded many million euros’ worth of bank loans as intercompany loans. This incorrect classification allowed for the loans to be eliminated in consolidation when they actually represented money owed by the company to outsiders.
The fraud methods did not stop at creating fictitious accounts and documents, or even with establishing nonexistent foreign nominee entities and hiding liabilities. Calisto Tanzi and other management were investigated by Italian authorities for manipulating the Milan stock market. On December 20, 1999, Parmalat’s management issued a press release of an appraisal of the Brazilian unit. While this release appeared to be a straightforward action, what Tanzi and others failed to disclose were the facts relating to the appraisal itself. The appraisal came from an accountant at Deloitte Touche Tohmatsu and was dated July 23, 2008, nearly 19 months prior to the press release. This failure to disclose information in a timely and transparent manner demonstrates yet another way that Parmalat was able to exert influence and mislead investors.
Missing the Red Flags
The fraud that occurred at Parmalat is a case of management greed with a lack of independent oversight and fraudulent financial reporting that was taken to the extreme. As an international company, Parmalat management had many opportunities to take advantage of the system and hide the fictitious nature of financial statement items. As with many frauds, the web of lies began to untangle when the company began to run out of cash. In a discussion with a firm in New York regarding a leveraged buyout of part of the Parmalat Corporation, two members of the Tanzi family revealed that they did not actually have the cash represented in their financial statements.
At the beginning of 2003, Lehman Brothers, Inc., issued a report questioning the financial status of Parmalat. Ironically, Parmalat filed a report with Italian authorities claiming that Lehman Brothers was slandering the company with the intention of hurting the Parmalat share price.2 Financial institutions failed to examine the accusations thoroughly and continued to loan money to Parmalat due to the supposed strength and power wielded by the company throughout the world. As Luca Sala, former head of Bank of America’s Italian corporate finance division, observed, “When you have a client like Parmalat, which is bringing in all that money and has industries all over the world, you don’t exactly ask them to show you their bank statements.”3
Failure of Auditors
The external auditor during the fraud, primarily Grant Thornton, SpA, failed to comply with many commonly accepted auditing practices and thus contributed to the fraud. The largest component of Parmalat’s fraud that ultimately brought the company down was the nonexistent bank account with Bank of America. The auditors went through procedures to confirm this account, but they made one fatal mistake: They sent the confirmation using Parmalat’s internal mail system. The confirmation request was intercepted by Parmalat employees and subsequently forged by Tonna or an agent acting on his behalf. The forgery consisted of creating a confirmation and printing it on Bank of America letterhead and then sending it back to the auditors.
Parmalat accused Grant Thornton and Deloitte Touche Tohmatsu of contributing to its €14 billion collapse in December 2003. Parmalat filed suit against the auditors and other third parties, seeking $10 billion in damages for alleged professional malpractice, fraud, theft of assets, and civil conspiracy. Parmalat argued that the headquarters for both Grant Thornton and Deloitte had “alter ego” relationships with their Italian subsidiaries that tied them inextricably to the alleged fraud. According to the complaint, the relationships were highlighted by the firms’ own claims to being “integrated worldwide accounting organizations.” Judge Lewis Kaplan in U.S. District Court for the Southern District of New York granted a motion by Deloitte USA to dismiss Parmalat’s first amended complaint due to Parmalat’s failure to show that poor auditing of Parmalat USA was equivalent to fraud at Parmalat in Italy.
The frauds continued for many years due, in large part, to the failures of the auditors. Italian law requires both listed and unlisted companies to have a board of statutory auditors, as well as external auditors. Parmalat’s statutory board should have become suspicious of what might be happening when two CFOs departed within a six-month period during the fraud. Also, analysts were puzzled by the increasing debt levels. Yet the board just stood idly by even though it had received information about the scope of the problems. The board never reported any irregularities or problems, despite receiving complaints, because of the influence of the Tanzi family. After the fraud was discovered and resolution of the issues began, it became clear that the statutory audit board did nothing to prevent or detect the fraud.
Resolution of Outstanding Matters
Following an investigation, the founder of Parmalat, Calisto Tanzi, was sentenced in Milan to 10 years in prison in December 2008 for securities laws violations in connection with the Italian dairy company’s downfall in late 2003. Tonna, the CFO, was sentenced to 30 months in jail following a trial in 2005, and other officers reached plea bargain deals. Bank of America settled a civil case brought by Parmalat bondholders for $100 million.
Bondholders in the United States and Italy had alleged the U.S. bank knew of Parmalat’s financial troubles, but nevertheless sold investors Parmalat bonds that ultimately soured—allegations Bank of America denied. Both sides said the agreement cleared the way for future business between the companies. In a statement following the settlement, Bank of America stated that the record of court rulings in the case “makes it clear that no one at Bank of America knew or could have known of the true financial condition of Parmalat. We have defended ourselves vigorously in these cases and are satisfied with this outcome today.”
After the accounting and business problems surfaced, a court battle ensued regarding who was responsible for the audit failures. The umbrella entities of Deloitte and Grant Thornton, Deloitte Touche Tohmatsu, and Grant Thornton International, along with the U.S. branches of both firms, were included in a lawsuit by Parmalat shareholders. Questions were raised as to whether or not the umbrella entities could be held liable for the failures of a country-specific branch of their firm. The courts held that due to the level of control that the international and U.S.-based branches wielded over the other portions of the firm, they could be included in the lawsuit.4
Legal Matters with Bank of America
On February 2, 2006, a U.S. federal judge allowed Parmalat to proceed with much of its $10 billion lawsuit against Bank of America, including claims that the bank violated U.S. racketeering laws. Enrico Bondi was appointed as the equivalent of a U.S. bankruptcy trustee to pursue claims that financial institutions, including Bank of America, abetted the company in disguising its true financial condition. Bondi accused the bank of helping to structure mostly off-balance-sheet transactions intended to “conceal Parmalat’s insolvency” and of collecting fees that it did not deserve.
The lawsuit against Bank of America was dismissed. Parmalat appealed the dismissal of its lawsuits, accusing Bank of America and Grant Thornton of fraud. Bondi filed notice of Parmalat’s appeal to the U.S. Court of Appeals for the Second Circuit in New York. Bondi and the Parmalat Capital Finance Ltd. unit had accused Grant Thornton of helping set up fake transactions to allow insiders to steal from the company. Parmalat Capital made similar claims in a lawsuit against Bank of America. On September 18, 2009, U.S. District Judge Lewis Kaplan said Parmalat should not recover for its own fraud, noting that the transactions also generated millions of euros for the company. “The actions of its agents in so doing were in furtherance of the company’s interests, even if some of the agents intended at the time they assisted in raising the money to steal some of it,” Kaplan wrote. A Bank of America spokesman said in a statement: “It has been our view all along that Parmalat Capital Finance, a participant in the fraud, was not entitled to seek damages from Bank of America, which had no knowledge of the fraud and was damaged by it. We are pleased that the court has agreed.”5
The SEC Charges
The SEC filed an amended complaint on July 28, 2004, in its lawsuit against Parmalat Finanziaria SpA in U.S. District Court in the Southern District of New York. The amended complaint alleged that Parmalat engaged in one of the largest financial frauds in history and defrauded U.S. institutional investors when it sold them more than $1 billion in debt securities in a series of private placements between 1997 and 2002. Parmalat consented to the entry of a final judgment against it in the fraud.
The complaint includes the following amended charges:
Parmalat consistently overstated its level of cash and marketable securities by at least $4.9 billion at December 31, 2002.
As of September 30, 2003, Parmalat had understated its reported debt by almost $10 billion through a variety of tactics, including:
Eliminating about $6 billion of debt held by one of its nominee entities.
Recording approximately $1.6 billion of debt as equity through fictitious loan participation agreements.
Removing approximately $500 million in liabilities by falsely describing the sale of certain receivables as non-recourse, when in fact the company retained an obligation to ensure that the receivables were ultimately paid.
Improperly eliminating approximately $1.6 billion of debt through a variety of techniques including mischaracterization of bank debt as intercompany debt.
Between 1997 and 2003, Parmalat transferred approximately $500 million to various businesses owned and operated by Tanzi family members.
Parmalat used nominee entities to fabricate nonexistent financial operations intended to offset losses of operating subsidiaries; to disguise intercompany loans from one subsidiary to another that was experiencing operating losses; to record fictitious revenue through sales by its subsidiaries to controlled nominee entities at Page 538inflated or entirely fictitious amounts; and to avoid unwanted scrutiny due to the aging of the receivables related to these sales: The related receivables were either sold or transferred to nominee entities.
In the consent agreement, without admitting or denying the allegations, Parmalat agreed to adopt changes to its corporate governance to promote future compliance with the federal securities laws, including:
Adopting bylaws providing for governance by a shareholder-elected board of directors, the majority of whom will be independent and serve finite terms and specifically delineating in the bylaws the duties of the board of directors.
Adopting a Code of Conduct governing the duties and activities of the board of directors.
Adopting an Insider Dealing Code of Conduct.
Adopting a Code of Ethics.
The bylaws also required that the positions of the chair of the board of directors and managing director be held by two separate individuals, and Parmalat must consent to having continuing jurisdiction of the U.S. District Court to enforce its provisions.Accounting in the Global Environment
Accounting and auditing standards and regulation of the accounting profession often are country specific. In addition to complying with any locally applicable rules, however, Deloitte firms follow general professional standards and auditing procedures promulgated by Deloitte Touche Tohmatsu. Member firms regularly cross-check each other’s work to ensure quality, and they cooperate and join together under the direction of a single partner to provide audit services for international clients.Accounting firms often assert that their foreign affiliates are legally separate, thus limiting the asset pool available to investors who file suit. They typically argue that you can’t pursue the worldwide organization because one unit fails to meet its audit responsibilities. However, a closer look at what is done in reality presents a different view.Partners and associates of member firms participate in global practice groups and attend Deloitte Touche Tohmatsu meetings. Although disclaimers on the firm’s website assert the legal separateness of Deloitte Touche Tohmatsu and its members, Deloitte Touche Tohmatsu’s goal is known to be to provide clients with consistent seamless service across national boundaries. Similar to other Big Four international firms, member firms use the Deloitte name when serving international clients in order to project the image of a cohesive international organization.