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ITALY: Corporate Governance Lessons from Europe's Enron

by By Michael Gray, Compensation Analyst; Carlotta Amaduzzi, Global Analyst; and Stephen Deane, Publications DirectorInstitutional Shareholder Services

Europeans are labeling it their Enron. The U.S. Securities and Exchange Commission is calling it "one of the largest and most brazen corporate financial frauds in history." And one investigator gushes, "The whole is truly beyond all limits....In every company we have found forgeries and falsifications of all sorts. But in this case we are really beyond the limits of the imagination."

Parmalat Finanziara, the Italian dairy and food giant, is fast joining Enron and WorldCom as a household name for corporate scandal. The alleged financial fraud at Parmalat spans more than a decade and involves sums whose estimates have ballooned from EUR 4 billion to more than EUR 8 billion. Founder, chairman, and chief executive Calisto Tanzi has been ousted from the company and board and is under arrest. Enrico Bondi, who replaced Tanzi in December, has been given new authority to act as sole administrator of Parmalat. He has 180 days to save what he can of the company.

While Bondi races against time to unearth the sources of the scandal, some corporate governance experts are already drawing lessons.

The Corporate Governance Significance

"Clearly what has happened in Parmalat, and Ahold a few months ago, indicates that boards -- when they are not truly independent, when they're not truly vigilant -- risk what I'd call laxity of compliance mechanisms to catch fraud," Peter Clapman, Senior Vice President and Chief Counsel of TIAA-CREF, told the Friday Report. He emphasized that the latest scandal exposes a global problem, not a uniquely Italian one.

Clapman urged every country to undertake reforms "designed to minimize the risk of this happening [again]." For one, he recommended that regulators be given the authority and put the systems in place to regulate corporate conduct and the functioning of professions such as accountants and lawyers.

Clapman also suggested that the Italian legislature consider ways to rein in the country's web of pyramid holdings, which enable an entity with relatively small capital in the underlying major company to control it through layers of other companies in the pyramid.

While such pyramid systems are predominately an Italian phenomenon, Clapman noted that other European markets also have ways to distort shareholder voting power, such as double voting rights in France and cross-ownership or family ownership elsewhere. "All countries have got to look carefully at their own unique ways in which they have fostered this distortion of [the principle of] one-share, one-vote," he commented. "Companies should be managed with the goal of enhancing the interests of all shareholders, not just a narrow group."

Ken Bertsch, vice president and director of corporate governance at Moody's Investors Service, in a separate interview also emphasized the corporate-governance significance of the Parmalat scandal.

"I think it clearly is significant in a couple of respects," he told the Friday Report. "One is it's another in these series of blowups that we've had that have put great stress on the need for accountable structures. The second point is that, despite the [scandal at] Royal Ahold and some other instances, there was some feeling in Europe that it was more of an American problem. Which it's not. I think it's a problem. Which isn't to say it's not an American problem either. But...this was a very serious case, apparently, of fraud on the same scale as Enron and WorldCom and actually for a much longer period of time." (Bertsch noted that only one bond rating company -- Standard & Poor's -- had issued ratings of Parmalat.)

"It Could Happen Here"

Two summers ago, as storm clouds of U.S. corporate scandals hung over an international corporate governance conference in sunny Milan, some of the European speakers uttered Cassandra-like warnings.

"There is no room for complacency on this side of the ocean," Luigi Spaventa, chairman of Consob, the Italian security market regulator, told the annual meeting of the International Corporate Governance Network (ICGN) in July 2002. Added Jaap Winter, a top European company law expert: "It could happen here." [Friday Report, July 19, 2002]

Clapman, who was chairman of the ICGN at the time, also cautioned the international audience of institutional investors and securities regulators against thinking that the scandals at the time represented a uniquely American issue.

"All the right things were said by the right people in Milan," Clapman now recalls. But he suspects that many of the participants, including decision-makers from developed markets in Europe and Asia, were "taking some quiet pleasure" in what they viewed as a U.S. problem. "It suggests that many people were not convinced that there was a global problem and therefore cast a blind eye at the flaws in their system."

Fast forward nearly two years, and it appears that, until the scandal broke, many investors had also been turning a blind eye to Parmalat's curious debt-issuing practices -- and its corporate governance flaws. "Investors Missed Red Flags, Debt at Parmalat," announced a headline in Thursday's Wall Street Journal. As numerous commentators have pointed it, it is difficult if not impossible to detect outright fraud. But Parmalat's poor corporate governance practices stood out as clearly as the Gothic cathedral in Milan against the summer sky.

Parmalat's Corporate Governance Rating and Practices

On Dec. 19, 2003, when the scandal broke, Parmalat had a particularly poor rating on Institutional Shareholder Service's Global Corporate Governance Quotient, which measures corporations' governance practices against a set of 61 criteria. Parmalat placed at the bottom of all 69 Italian companies that were rated, sharing the cellar with three other companies.

Parmalat also had a dismal corporate governance score when measured against all other companies in the MSCI EAFE index, which comprises companies on major indexes in Europe, Asia, and the Far East. Parmalat outperformed just 2.8 percent of the other companies on the EAFE index, scoring ahead of just 46 other companies.

What produced such poor corporate governance scores?

Parmalat shares many of the same weaknesses in corporate governance structure and practices as those found in other family-controlled companies. But the combination of shortcomings across so many different areas drove Parmalat's poor rating. Some of the key weaknesses follow.

Parmalat lacked board independence. At the time of the last public filings, the board comprised nine insiders, one affiliated outsider, and just three independent directors. The company was family-owned and went public in 1990. Its structure is fairly typical of the Italian market as a whole.

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 consists of company executives, proposes actions for board approval and then implements them.

The role of its external auditors has become a focus of current inquires into the scandal. Parmalat met the letter -- but may have skirted the spirit -- of an Italian law that requires external auditors to be elected every three years and to be rotated out after three terms. The current auditor, Deloitte & Touche spa, was set to serve until the next election in 2004. But when the previous auditor, Grant Thorton International, left Parmalat, it stayed on as primary auditor of the parent's Cayman Islands subsidiary, Bonlat. Both firms insist that they have been the victims of the fraud perpetrated by the company.

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.

Under Italian law the election of internal statutory auditors members takes place through the so-called "voto di lista" mechanism. This mechanism allows shareholders who represent a certain percentage of capital set in the company's bylaws (3 percent in the case of Parmalat) to present a list of candidates to elect internal statutory auditors and their alternates. Each shareholder with the required percentage of capital is allowed to present and vote one single list of candidates. No candidate may stand for election on more than one list. Whenever there is a majority shareholder, it is safe to assume that it supports the election of the winning candidates.

A lack of timely disclosure concerning executive and director compensation and directors and officers stock ownership, coupled with a complete lack of disclosure of progressive practices -- on such topics as board guidelines, evaluations, term limits, and retirement age -- contribute to the remaining poor performance in the company's comparative rating.

The Real Issue: Starting Afresh

Are there other scandals waiting to be unearthed? It's impossible to tell, comments Clapman, who faced similar questions in Milan after Enron imploded. Scandals may have been committed before recent reforms, but only come to light after them.

Is there a silver lining to the latest scandal? Clapman believes that it will prompt authorities to undertake needed reforms, just as the U.S. scandals led to far-reaching initiatives.

"The real issue is not whether scandals will be uncovered," he remarked, "but whether starting afresh...there are institutions and laws and regulations and improved practices designed to prevent new scandals from developing from this date forward."



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