In January 2002, a European magazine published an article titled “Enron: Could It Happen Here?” At the time the article was published, perhaps most people outside the United States would have answered “no” to that question. In the wake of massive corporate frauds at Enron and WorldCom, there was a feeling outside the United States that such scandals were “an American problem” caused by the more aggressive business environment and practices there. However, a family-owned Italian firm was about to show the world that massive corporate scandals can happen anywhere.

A BRIEF BACKGROUND CHECK

After Calisto Tanzi inherited his father’s company at age 22, he directed it into the production of dairy products in 1961 and created the Parmalat brand in 1963. Parmalat was the first Italian manufacturer of branded milk. In 1966, using packaging technology from Tetra Pak, Parmalat created its signature product: milk pasteurized at ultrahigh temperatures (UHT), giving milk a shelf life of over six months. UHT milk provided Parmalat with a technological competitiveness in the milk industry, placing Parmalat ahead of its competition. In 1970, the law permitted the sale of whole milk in grocery stores, removing the limitation of specialty milk shops. Parmalat quickly became the dominant milk supplier of Italy.

The “Champion’s Milk”

Parmalat became known as the “champion’s milk” after sponsoring the Ski World Cup and world-champion Formula One race-car driver Nicki Lauda in the 1970s. The company moved into new markets with the production of cheese, butter, and a variety of desserts near the end of the decade. As it increased in popularity, Parmalat also began international expansion through acquisitions in Germany and France, which marked the beginning of a global dairy empire.

The Pious Pioneer Sports Marketer

Calisto Tanzi, an almost legendary figure in Italy, was the author of such growth. It was he who discovered the power of sports marketing to make Parmalat a famous brand. He had friends in important government positions that helped pass laws favoring Parmalat. A pious Catholic, Tanzi was a generous benefactor who sponsored the restoration of Parma’s eleventh-century basilica and funded its professional soccer team. And he seemed modest about his achievements. He didn’t smoke, drank little, and drove his own Lexus. Throughout Parmalat’s expansion, Tanzi maintained a paternalistic approach to the business. “He would stand, for example, at the plant, spoon in hand, ready to taste the first sample each time new yogurt [flavor] was launched.”

Going Public and Going Global

In 1989, the firm was acquired by a holding company and changed its name to Parmalat Finanziaria SpA. The milk giant showed healthy profits every year, and its balance sheet appeared strong, with large amounts of cash on hand. This allowed Parmalat to go public in Italy and raise capital in the United States and other countries by selling shares and issuing bonds. The company used this new capital to expand into Latin America, where it dominated the dairy markets in Brazil, Argentina, Venezuela, and several other countries.

By the early 1990s, Parmalat was popular not only among grocery shoppers, but investors and creditors deemed the firm a profitable business partner. Large international banks collected hefty fees by helping the company issue bonds, list stock in foreign markets, and raise capital to fund international acquisitions. As CFO Alberto Ferraris put it, “Outside my office, there was always a line of bankers, asking about new business.” There was only one problem: The profits that Parmalat reported were only an illusion created by a set of accounting manipulations.

ACCOUNTING ISSUES

One of the most interesting aspects of Parmalat’s case is the simplicity of its fraudulent accounting (which was not quite as simple as the scheme suggested in Figure 18.1). The purpose of the fraud was straightforward: to hide operating losses so as not to disappoint investors and creditors. The core of the scheme was double billing to Italian supermarkets and other retailers. By standard accounting procedures, every time product is shipped to a customer, a company records a receivable that it later expects to collect as cash. Because receivables count as sales revenue, Parmalat billed customers twice for each shipment, thus greatly enlarging its sales. The company used these inflated revenues as a means of securing loans from several international banks.

“Off-Balance-Sheet Financing”

By 1995, Parmalat was losing more than $300 million annually in Latin America alone. These continued operating losses caused company executives to search for more complex ways of masking the firm’s true performance. Using a trick called “off-balance-sheet financing,” executives set up three shell companies based in the Caribbean. These firms pretended to sell Parmalat products, and Parmalat would send them fake invoices and charge costs and fees to make the “sales” look legitimate. Then Parmalat would write out a credit note for the amount the subsidiaries supposedly owed it and take that to banks to raise money.

Off-balance-sheet financing was also used to hide debts. The company transferred over half of its liabilities to the books of small subsidiaries based in offshore tax havens such as the Cayman Islands. This allowed Parmalat to present a “healthy” balance sheet and a profitable income statement to investors and creditors by hiding large amounts of debt and overstating sales revenue. In 2002, Parmalat reported liabilities of close to $8 billion on its consolidated balance sheet. In reality, the company had roughly $14 billion in debt.

The Art of Milking Growth

Taking advantage of its image, Parmalat issued bonds in the United States and Europe, which were backed up by falsified assets, especially cash. “It was a reversal of logic,” said the chief investigating magistrate after the scheme was discovered. Usually, companies take on debt to grow. But in Parmalat’s case, “they had to grow to hide the debt.” In other words, the company would obtain loans to pay off previous loans. Investigators report that without the accounting manipulations, the company would have reported operating losses every year between 1990 and 2003.

The circle of hiding operating losses by incurring increasingly larger amounts of debt eventually became hard to sustain. To perpetuate the fraud, Parmalat needed to continue incurring debt, paying interest on old debts with no real cash of its own and finding new ways to create false sales. Alberto Ferraris, who was appointed CFO in March 2003, mentioned that “he couldn’t understand why the company was paying so much to service its debt; the interest payments seemed far higher than warranted for the €5.4 billion in debt on the books.”

By the late 1990s, auditors in Argentina and Brazil raised several red flags that pointed to problems with Parmalat’s accounting. In early December 2003, the company failed to make a €150 million bond payment. This puzzled those familiar with the company because, according to the 2002 financial statements, Parmalat had plenty of cash on hand.

The fraud became public on December 19, 2003, when Grant Thornton, the company’s auditor, made a startling discovery. While auditing Bonlat, a fully owned subsidiary of Parmalat based in the Cayman Islands, the auditors contacted Bank of America to confirm a letter held by Bonlat in which Bank of America allegedly certified that the company had €3.95 billion in cash. Bank of America responded that such an account didn’t exist. This resulted in investigators swooping into Parmalat’s headquarters to confiscate documents and computer hard drives, which uncovered the accounting tricks. On one computer hard drive, prosecutors found clues to the deception: They found “Account 999,” which contained details of secret transactions amounting to more than €8 billion.

THE CONSEQUENCES

Parmalat filed for bankruptcy protection on December 24, 2003. CEO Calisto Tanzi resigned and was detained by Italian authorities three days later and sent to prison. He was subsequently confined to house arrest until September 27, 2004. Also accused of wrongdoing were Fausto Tonna, CFO during most of the period under investigation; Giovanni, Stefano, and Francesca Tanzi, brother, son, and daughter of Calisto Tanzi; and other key employees believed to have been involved in the scheme.

“If Convicted . . .”

Initially, it was thought that misstatements were created only to hide operating losses; however, prosecutors demonstrated that the Tanzi family financially benefited from the fraud. For example, Calisto Tanzi revealed that $638 million was moved to “a family-owned tourism business.” In December 2008, Calisto was finally sentenced to 10 years in jail for market rigging. Others have served or are serving jail time, and Stefano, Calisto’s son, is being tried in Switzerland on fraud and money-laundering charges.

Enrico Bondi was appointed by the government as CEO of Parmalat to direct recovery efforts. As part of his campaign, he has brought lawsuits against Grant Thornton and Deloitte, the auditors, for not performing the audit with proper care and not bringing their suspicions to the attention of management. Grant Thornton cut ties with its Italian practice after Parmalat’s problems surfaced. In addition, Bondi is suing major international banks, such as Bank of America, Credit Suisse First Boston, Citigroup, and Deutsche Bank.

Lawsuits, Rounds I and II

The lawsuits accuse the banks of ignoring the fraud to obtain fees from doing business with Parmalat. As mentioned earlier, these banks were instrumental in helping the company raise capital to fund its international expansion. The banks and the auditors deny any wrongdoing and claim they were victims of the scheme. Citigroup Inc., UBS AG, Deutsche Bank AG, and Morgan Stanley will be involved in the Milan trial for “failing to have procedures that would have prevented crimes that contributed to” Parmalat’s failure. As of mid-June 2007, Bondi has collected almost $900 million in settlements in Italy and the United States, but Parmalat lost its case against Citigroup and actually had to pay them damages.

Parmalat, in turn, has been sued by investors, banks, and other organizations. In the United States, the SEC filed a complaint against Parmalat on December 29, 2003, alleging that the company fraudulently raised money through bonds in the United States by overstating assets and understating liabilities. On July 30, 2004, Parmalat agreed to settle with the SEC without admitting or denying the claims. Parmalat won’t be fined but has agreed to make changes to strengthen its board of directors and improve governance.

Restructuring

Besides the legal battles that have resulted from the fraud, Bondi’s restructuring campaign calls for aggressive changes in Parmalat’s organization. On March 29, 2004, the company announced it would narrow its focus in markets in Italy, Canada, Australia, South Africa, Spain, Portugal, Russia, and Romania and would pull out of other regions. However, in May 2007, “Parmalat . . . agreed to sell its Spanish assets to Lacteos Siglo XXI.” Latin American countries “with strong and profitable positions,” such as Colombia, Nicaragua, and Venezuela, would be retained. In addition, Parmalat would cut its workforce from 32,000 to less than 17,000, slash the number of brands from 120 to 30, and concentrate on “healthy lifestyle” products.

SO, WHAT’S THE BOTTOM LINE?

In Europe, the Parmalat scandal created deep concern among authorities. The European Commission suggested that it would like to strengthen auditing standards by insisting that member countries introduce accounting- oversight boards similar to those in the United States. Many organizations have proposed reforms to prevent another scandal of such magnitude. One of the areas of reform considered was more transparency in the bond market in Europe; in other words, bond-price disclosure. However, “the [European Commission] has indicated that it will allow traders to police themselves instead of requiring the same data about bonds as for stocks.”

From an accounting perspective, Parmalat joined the ranks of other European companies by adopting International Financial Reporting Standards published by the International Accounting Standards Board and adopted by the European Commission for their consolidated financial statements. In addition, Parmalat’s independent auditors are now global auditing firm PricewaterhouseCoopers. The hope is that these two moves will help convince investors that Parmalat is moving in the right direction on the accounting side. After the restructuring, Parmalat has risen from the ashes, is now listed again on the Milan stock exchange, and is Italy’s biggest listed food company. At least it didn’t suffer Enron’s fate.

Plus a Little Corporate Misgovernance

However, even though these accounting moves were taken to help Parmalat recover, they are not enough. Although the fraud was perpetrated through a set of accounting tricks, several issues converged to allow such manipulations to happen. One of the clearest deficiencies at Parmalat was its corporate governance system. As a family-owned business, the company was tightly controlled by insiders, especially Calisto Tanzi, who held the positions of CEO and chairman of the board of directors.

Most of the other board members were family members or managers of Parmalat. This prevented the company from having a strong, independent voice to stop the actions taken by management. In addition, Italian law allowed Parmalat to have two auditors instead of one. Grant Thornton was the main auditor, but Deloitte audited some of the subsidiaries, including Bonlat, where the fraud was uncovered. This arrangement made it more difficult for the auditors to have one clear, coherent picture of Parmalat’s financial condition. As noted, neither of these auditors is used by Parmalat now. Finally, and perhaps most importantly, management integrity failed. In the end, a manager determined to commit fraud will most likely succeed even in a very good governance system.

In the aftermath of Parmalat’s fraud, investigators were left wondering how a few accounting numbers

could fool so many people. One thing, however, was clear: Europe now had its very own Enron.