The Parmalat situation started out as a fairly standard - if stunningly large - accounting fraud. Managers allegedly used various accounting tricks to avoid disclosing sizeable losses, possibly with the collusion of at least some auditors and lawyers. According to this morning's WSJ, however:
As the probe advances, one of the chief questions remains: Where did the money go? Much of the alleged fakery appears to have been aimed at hiding losses, according to a person familiar with the matter. But prosecutors also say they now suspect that individuals were siphoning off some cash for themselves, this person said. ...
Prosecutors looking into Parmalat are alleging Mr. Tanzi, who stepped down this month, misappropriated at least $600 million from the business over the years, according to a person familiar with the widening probe at the Italian dairy conglomerate.
In other words, the Parmalat problem has expanded from "mere" accounting fraud into a classic example of the corporate governance problems associated with large publicly held corporations. I thought it might be useful to spend a few minutes explaining how the corporate governance problem at Parmalat differs from that at, say, Enron.
My professional career has been devoted to the study of large publicly held corporations. The key governance problem in such firms, of course, is the separation of ownership and control. The firm’s nominal owners, the shareholders, exercise virtually no control over either day to day operations or long-term policy. Instead, control is vested in the hands of professional managers, who typically owned only a small portion of the firm’s shares.
Separation of ownership and control occurs in its purest form in the truly public corporation in which stock ownership is dispersed amongst many shareholders, no one of whom owns enough shares to materially affect the corporation’s management. As Professors Berle and Means famously explained: “The separation of ownership from control produces a condition where the interests of owner and of ultimate manager may, and often do, diverge ....” Adolf A. Berle and Gardiner C. Means, The Modern Corporation and Private Property 6 (1932). Preventing such divergences, or at least minimizing their effects, has been the primary concern of scholars and regulators. Enron stands as a classic example that, despite all our work, unscrupulous managers can still - and always will - use their control over such corporations to benefit themselves at the expense of their shareholders (not to mention creditors, employees, and other stakeholders).
Yet, not all publicly held corporations exhibit a complete separation of ownership and control. Some public corporations have a single shareholder (or a small cohesive group of shareholders acting together) who own a majority of the voting stock of the corporation. Many more have a single shareholder or group who owns less than a majority but nevertheless ows a sufficiently large block to give it effective voting control. (The classic example is John D. Rockefeller, Jr.’s struggle to oust the chairman of the board of Standard Oil of Indiana. Rockefeller controlled only 14.9% of Standard Oil’s stock. After an admittedly long and difficult contest, however, Rockefeller ultimately prevailed in attracting enough support from other shareholders to ust the chairman.)
The presence of a controlling shareholder solves the classic separation of ownership and control agency problem. Managers who pursue their own self-interest will be displaced by the controlling shareholder.
Yet, the presence of a controlling shareholder introduces a new divergence of interest; namely, that between the majority shareholder and the minority shareholders. Precisely because of the power exercised by a controlling shareholder over management, it is very easy for the controlling shareholder to extract non-pro rata benefits for itself at the expense of the minority. At Hollinger, for example, Lord Conrad Black allegedly not only caused the corporation to pay large management fees to companies controlled by hom or his cronies, but also caused the company to spend $8 million of its own money to buy FDR historical papers Black then used in writing his FDR biography. If the prosecutors are right, Parmalat controlling shareholder and CEO Tanzi joined that club sometime ago.
Because of the potshots some European comentators took at Anglo-Saxon capitalism after Enron, it is tempting to make much of the Parmalat scandal (even for me). Yet, in truth, there is no room for jingoism in this context. The problem of majority shareholder abuses is no respecter of national boundaries. In juxtaposition to Parmalat, for example, one could cite the Anglo-US example of Hollinger, or the domestic US example of Adelphia.
There are no easy solutions to the problem of dealing with a controlling shareholder. Forcing a majority shareholder to give up control is no answer, both because of the enfringement on contract and property rights and because it solves one governance problem by restoring the agency problem associated with dispersed ownership. Transparent accounting rules is key, but enforcement is a problem. Accounting fraud will be with us as long as there are unscrupulous businessmen and dishonest or incompetent lawyers and auditors. Attempts to drive out every last residue of fraud are more likely to burden honest corporations with undue regulations than to prevent bad actors from acting badly. Instead, what we should strive for is a cost-effect system of better accounting rules and responsible enforcement that strives only to reduce the problem to manageable proportions.
Land of milk and money: Calisto Tanzi stands trial in Milan in 2005
Following the discovery of a $14bn black hole in Parmalat’s finances in 2003, the ensuing investigation triggered an eight-year marathon of court cases across Europe and the US, disgracing the Tanzi family, causing at least one fatality and bringing one of Europe’s most successful football clubs to its knees.
Here, World Finance gives a brief insight into the scandal that engulfed Italy’s largest milk processor, senior executives, politicians, blue-chip banks, accountancy firms and more than 130,000 hapless shareholders:
– During the 80s and 90s, Parmalat is hailed as the jewel of Italian commerce, as entrepreneur Calisto Tanzi converts his father’s Parma-based ham retailer into a global dairy and food giant with a speciality for long-life milk.
Upon entering court, Parmalat Chief Financial Officer Fausto Tonna greets journalists: “I wish you and your families a slow and painful death.”
– In 2003, bondholders learn nearly €4bn ($4.5bn) of funds being held in a Bank of America account don’t exist. The bank dubs the transfer document a forgery and trading in Parmalat shares is frozen. Calisto Tanzi, along with various family members and senior executives, is arrested. Upon entering court, Parmalat Chief Financial Officer Fausto Tonna greets journalists: “I wish you and your families a slow and painful death.” Meanwhile, at the firm’s offices, investigators discover computers have been smashed and thousands of documents shredded.
– In 2004, Parmalat’s debts are fixed at €14.3bn ($16.1bn), eight times the figure the firm had admitted to. After a series of denials, Bank of America’s former Chief of Corporate Finances in Italy, Luca Sala, admits to participating in a kickback scheme. US creditors file a $10bn class action suit against Parmalat’s former auditors, while Parmalat’s administrators – operating under replacement CEO Enrico Bondi – separately sue Bank of America, Citigroup, Deloitte Touche and Grant Thornton for $10bn each.
– In 2005, Bondi relists a reconstructed Parmalat on the Milan Stock Exchange while trials continue.
– In 2008, Fausto Tonna is sentenced to two-and-a-half years in jail for masterminding a complex web of offshore subsidiaries in order to hide the company’s parlous position. Bank of America, Citigroup, Morgan Stanley, Deutsche Bank and UBS all stand trial on charges of market rigging.
– In 2010, 72-year-old Calisto Tanzi is given an 18-year sentence and subsequently launches an appeal. Meanwhile, under Bondi’s leadership, the new-look Parmalat recoups more than €2bn ($2.3bn) in bank settlements.
– In 2011, after a three-year trial, a Milan court acquits Morgan Stanley, Bank of America, Deutsche Bank and Citigroup of market rigging. Prosecutors’ demands for €120m ($135.2m) of the bank’s profits to be impounded are met with fierce opposition and described as “the death of consumer rights”. A consumer watchdog promises to join shareholders in another case to challenge the verdict. The Italian Government blocks French firm Lactalis’ bid to takeover Parmalat.