Assignment 1

Appendix I : Parmalat Case Study

Parmalat was Italy’s largest food company at that time. Its core business was in dairy
products but it expanded in to TV business, football business and tourism business.
Parmalat’s biggest innovation was that it was the first company to produce milk
through ultra-heat treatment process, which allowed Parmalat’s milk to be stored
without refrigeration for a long time. This was such a mega hit, that by early 2000s,
Parmalat had asset of around €10 billion with over 36,000 employees in 139 plants.
However, it went bankrupt in December 2003. Suddenly, it was discovered that it’s
claimed liquidity of €4 billion cash did not exist and that €8 million in bonds of
investors’ money had disappeared.
Brief Corporate History

Parmalat was founded in 1961 by Calisto Tanzi. In the early years, it focused its
business in dairy products. In 1980s, Tanzi purchased Odeon TV which was sold in
1989 due to a bad result (which generated €45 million loss). In the 1990s, Parmalat
launched many international acquisition campaigns. But such acquisitions, instead of
bringing in profits, started, no later than 2001, to bring in red figures. In the
meantime, Parmalat had diversified into football by buying multiple football teams
such as Parma Calcio, Palmerias and Audax Italiano. Also, Tanzi entered the
tourism business (which generated €2 billion loss).

It kept on doing acquisitions so that by 2002, Parmalat Finanziaria S.p.A., the

holding company of Parmalat had 200 companies spread around 50 countries. While
accumulating losses, and with debts to the banks, Parmalat started to built a network
of offshore mail-box companies, which were used to conceal losses, through a
mirror-game which made them appear as assets or liquidity, while the company
started to issue bonds in order to collect money. The security for such bonds was
provided by the alleged liquidity represented by the offshore schemes.

On Dec. 9, as rumours’ spread that Parmalat's claimed liquidity was not there,
Standard & Poor's finally downgraded Parmalat bonds to junk status, and in the next
few days, Parmalat stocks fell 40%. On Dec. 12, the Parmalat management
somehow found the money to pay the bond. Later in the month, Bank of America,
the bank which Parmalat claimed it deposited €4 billion cash to, declared that it did
not have any outstanding cash from Parmalat and that the account was forged. It
was later found that CFO Tonna had forged the bank account document using a
scanner, scissors and glue. In one shot, the bankruptcy was revealed, and Parmalat
stocks fell an additional 66%. Hundreds of thousands of investors lost their money
and would never recover it. The company officially went bankrupt and Tanzi was
imprisoned, though the Italian government used the legal mean "commissariamento"
to save the trademark.

Calisto Tanzi, CEO

Tanzi was a 22 year-old college dropout when he founded the company. He was
CEO from the inception of the business until the collapse. He was the dominant
figure, the driving force exercising almost complete control over the company,
inserting his own people in every position of power and in positions to oversee those
who held power. Calisto Tanzi engaged the firm in several exotic enterprises, such
as a tourism agency called Parmatour, and the purchase of the local soccer club
Parma. Huge sums were poured into these two enterprises, which have been a loss
from the very beginning. Tanzi’s spending includes the purchase of overpriced
Colombian soccer players, and other extravagances. Tanzi’s son Stefano was the
president of the Parmalat-owned football team. Tanzi’s daughter Francesca
apparently ran Parmatours, one of the family-owned tourism businesses

The Board

Members of Parmalat's board and senior management team owned many related
organisations, outside directorships, management responsibilities and conflicts of
interest involving a host of other firms. The board was composed of 13 members of
whom 5 were non-executive directors .Tanzi was the Chairman of the Board. The
other board members included his brother Giovanni, his son Stefano and his niece
Paola Visconti. It also included the company's CFO Fausto Tonna, who was deeply
involved in the fraud and three other firm managers, Luciano Del Soldato, Alberto
Ferraris and Francesco Giuffredi, all hired by Tanzi. The outside directors were
Tanzi's attorney and two of Tanzi’s close friends.

The role of the external auditing firm

In Italy, the external auditing firm is appointed by the shareholders’ meeting,

although the board of statutory auditors has a voice on the choice of the firm. Its
appointment lasts three years. After three appointments (i.e. nine years) the law
requires the company to rotate its lead audit firm. Italy is the only large economy to
have made auditor rotation compulsory. Grant Thornton S.p.A. served as auditors for
Parmalat Finanziaria from 1990 to 1998, when the company changed auditors to
comply with the mandatory auditor rotation. In 1999 Deloitte & Touche S.p.A. took
over as chief auditors. While Parmalat's auditor Grant Thornton was replaced by
Deloitte after nine years, they continued to audit Parmalat's offshore companies, the
primary dumping grounds for Parmalat's losses, debts and non-performing assets.
This means that Deloitte & Touche had been relying on Grant Thornton’s work to
give their opinion about Parmalat Finanziaria consolidated financial statements. It
seems difficult to argue that auditor rotation contributed to the discovery of the
accounting fraud, since Deloitte & Touche S.p.A. did not discover it during its prior
audits since 1999. In fact, they never claimed any problems regarding the financial
position of Parmalat in any of their reports. Until they issued a review report
(published on 31 October 2003) on the interim financial information for the six
months ended June 2003 in which they claimed to be unable to verify the carrying
value of Parmalat’s investment in the Epicurum Fund, as the fund had available no
published accounts nor any marked to market valuation of its assets (Parmalat
Finanziaria S.p.A., 2003).

Deloitte & Touche always rendered a “nonstandard” report underlying that up to 49

per cent of total assets of the group and 30 per cent of the consolidated revenues
came from subsidiaries which were audited by other auditors. In relation to the
above-mentioned amounts, Deloitte & Touche stated that their opinion was basely
solely upon other auditors’ reports.

Grant Thornton S.p.A. continued as auditor of Parmalat S.p.A.as well as certain

Parmalat off-shore subsidiaries even after 1999. Grant Thornton, specifically two of
their partners who had been auditing companies related to the Tanzi groups since
1980s,audited the Cayman Islands based Bonlat Financing Corporation. Bonlat was
a wholly owned subsidiary, set up in 1998, that held the now well-known fictitious
Bank of America account. This nonexistent bank account raises fundamental
questions about the role of the external auditor. Grant Thornton claimed to have sent
a request to Bank of America in December 2002 asking for confirmation of the bank
account. The latter denied that they had received the request. Grant Thornton
received a reply in March 2003, which was printed on Bank of America letterhead
and signed by a bank employee. It is now believed that this confirmation letter was
forged by Parmalat management. Grant Thornton publicly claimed that its staff acted
correctly, and that the forged document made them a victim of fraud. However, they
acknowledged that the request to Bank of America was done via the Parmalat chief
finance director rather than Grant Thornton auditors were too “involved” in the Bonlat
issues, since the setting up of the latter was allegedly their idea to keep concealed
the Parmalat financial crisis from the eyes of the incoming chief auditor Deloitte &
Touche. Esteban Pedro Villar, an accountant in Deloitte was sceptical about
Parmalat’s accounting and peppered Parmalat’s senior management with questions.
Parmalat CFO Tonna lost his temper and complained to Adolf Mamoli, the main
contact to Parmalat in Deloitte. Thereafter, Mamoli required Villar to report to him
before contacting Parmalat.

Ownership and corporate structure:

Parmalat was at the top of a complicated pyramid ownership structure controlled by

Coloniale S.p.A, the Tanzi holding firm that owned 51 percent of Parmalat (Parmalat
Finanziaria S.p.A) equity. Coloniale S.p.A., the holding company of the group, was
under the control of the Tanzi family, through some Luxembourg-based companies.
Therefore, the Tanzi family was the ultimate shareholder controlling Parmalat
Finanziaria and the whole Parmalat group (the block holder) who is willing and able
to monitor the senior management effectively. Block holders may use their power to
pursue their interests at the expense of minority shareholders, by diverting corporate
resources from the corporation to themselves, either legally or illegally. Tanzi
acknowledged to Italian authorities that Parmalat funnelled about Euro 500 million to
companies owned by the Tanzi family, especially to Parmatour. The latter was not a
subsidiary of Parmalat. It was an unlisted company owned by Nuova Holding; a
Tanzi family investment company. In February 2003, chief financial officer Fausto
Tonna unexpectedly announced a new €300 million bond issue. This came as a
surprise both to the markets and to the CEO, Calisto Tanzi. Tanzi forced Tonna to
resign and replaced him with Alberto Ferraris. Ferraris was surprised to discover`
that, though now CFO, he still did not have access to some of the corporate books,
which were being handled by chief accounting officer Luciano Del Soldato. He began
making some inquiries and began to suspect that the company's total debt was more
than double that on the balance sheet.

Hiding Losses
Parmalat hid losses, overstated assets or recorded non-existent assets, understated
its debt, and diverted company cash to Tanzi family members. In order to hide
losses, Parmalat had used various wholly-owned entities, amongst which the most
significant was Bonlat, the Cayman Island waste basket of the Parmalat in its final 5
years, and the holder of the Bank of America’s false account. Uncollectible
receivables were transferred from the operating companies to these nominee
entities, where their real value was hidden. Fictitious trades and financial
transactions were organised to offset losses of operating subsidiaries and to inflate
assets and incomes. Securitisation schemes based on false trade receivables and
duplicate invoices were recurrently used to finance the group.
Parmalat understated its debt through different fraudulent schemes. It recorded non-
existent repurchases of bonds. It sold receivables falsely described as non recourse,
in order to remove the liabilities from the records. It mischaracterised debt or, simply,
did not record it. Later, it was determined that the debts amounted to €14 billion,
which were almost 8 times the sum originally stated.
Financing
Because Parmalat continued its acquisition strategy and many of Parmalat’s non-
core businesses were generating loss, it had to continuously issue bonds in order to
hold cash. In November 2000, S&P downgraded Parmlat with BBB- grade. In 2002,
though Parmalat had recorded €3.3 billion of cash in the book, it issued bonds of 150
million in October and €200 in December. Some investment banking firms raised
concern with these issuances stating that “the reason is not clear why Parmalat
continues to tap the market for relatively small, yet often quite complex debt issues,
when its cash pile continues to rise” and “these need for re-financing raises
questions as to the underlying cash generation of Parmalat”.

From 1990 to 2003, it appears that Parmalat engaged in a massive borrowing spree
funded in large part by many large global banks and brokerage firms to engage in
widespread acquisitions of overseas businesses and assets. Providers of funds to
Parmalat included Citigroup, J. P. Morgan Chase, Merrill Lynch, Bank of America,
Deutsche Bank, Credit Suisse First Boston, and Morgan Stanley—each of whom
helped the company raise vast sums (in the range of $600 million to $4 billion per
bank). The largest bond placers have been Bank of America, Citicorp, and J.P.
Morgan. These banks, rated Parmalat bonds as sound financial paper, when they
knew, or should have known, that they were worth nothing. While Bank of America
has participated as a partner in some of Parmalat's acquisitions, Citicorp is alleged to
have built up the fraudulent accounting system. In addition, Parmalat also secured
upwards of $6 billion additionally from foreign and Italian banks through direct
lending and the use of complex derivative transactions. A key architect for arranging
this continuous funding was Fausto Tonna, the CFO of Parmalat since the company
went public in 1987.

Tanzi admitted that he helped misrepresent Parmalat’s accounts and personally

siphoned off at least $600 million to fill losses at other family-run companies. Some
of these funds (or other corporate funds) may have been diverted to help the family’s
travel and tourist business, Parmatour, which was run by Tanzi’s daughter. Much of
Parmalat’s funds were used to finance acquisitions, pay off steadily rising interest on
the company’s massive and growing debt load, and to hide ever growing losses all
around the world.

The role of the board of statutory auditors

Italian law required listed (and unlisted) companies to set up a board of statutory
auditors. This board acts as the fundamental monitor inside the company. Its main
tasks and responsibilities include:
 to check the compliance of acts and decisions of the board of directors with
the law and the corporate by-laws and the observance of the so-called
“principles of correct administration” by the executive directors and the board
of directors;
 to review the adequacy of the corporate organisational structure for matters
such as the internal control system, the administrative and accounting system
as well as the reliability of the latter in correctly representing any company’s
transactions;
 to ensure that the instructions given by the company to its subsidiaries
concerning the provision on all the information necessary to comply with the
information requirements established by the law are adequate.

Corporate by-laws shall also ensure that one (or two, when the board is composed of
more than three auditors) of the members of the board of statutory auditors is
appointed by the minority shareholders, so that the composition of the board reflects
the will of all shareholders. Parmalat Finanziaria’s board of statutory auditors was
composed of three members, i.e. the legal minimum requirement. The size of the
board of statutory auditors has a direct influence over the level of protection on
minority shareholders because some powers (e.g. the power to convene a
shareholders’ meeting because of a directors’ decision) may be exercised only by at
least two members of the board jointly. Only when the board of statutory auditors is
composed of more than three members can minority shareholders appoint two
statutory auditors. The Parmalat Finanziaria board of statutory auditors never
reported anything wrong in their reports, nor to courts nor did the statutory auditors
at Parmalat S.p.A. or any of its subsidiaries. Even when, in December 2002, a
minority shareholder (Hermes Focus Asset Management Europe Ltd) filed a claim
(pursuant to clause 2408 of the Italian civil code) regarding, among other issues,
related-parties transactions, the board of statutory auditors answered that “no
irregularity was found either de facto or de jure

Committees and the Other Senior Management

The Executive Committee (EC) was composed of 7 directors including 3 Tanzi family
members. The Internal Control Committee (ICC) was composed of 3 members.
Italy’s report & code of conduct, Preda Code recommends that the majority of the
ICC be independent directors. However, 2 members out of 3 were not. Even that one
independent director was Tanzi’s attorney. Internal control committee members
(Tonna) had been the chief finance director from 1987 until March 2003. He also
held the Chairman position at Coloniale S.p.A., the Tanzi family holding company
which was also the major shareholder of Parmalat Finanziaria. The third member of
the internal control committee, who was also the Chairman of the committee, was
allegedly an independent director. However, further analysis shows that he was the
chartered certified accountant of the Tanzi family (as well as an old personal friend of
Tanzi).

The Parmalat fraud has been mainly implemented in New York, with the active role
of the Zini legal firm and of Citibank," said San Diego lawyer Darren Robbins, a
partner in the firm, which is leading the class-action suit. "We believe that Citigroup,
by creating instruments like the sadly famous 'Buconero,' has played a fundamental
role in helping Parmalat to fake their balance sheets and hide their real financial
situation." Through Zini, firms owned by Parmalat have been sold to certain
American citizens with Italian surnames, only to be purchased again by Parmalat
later. The whole operation was fake: The money for the sale in the first place came
from other entities owned by Parmalat, and it served only to create "liquidity" in the
books. Former CEO Tanzi declared to prosecutors in Parma that the fraudulent
bonds system "was fully the banks' idea." Parmalat's former financial manager,
Fausto Tonna, counterfeited Parmalat's balance sheets in order to provide security
for the bonds, but "it was the banks which proposed it to Tonna," Tanzi declared.

Tanzi's version has been so far confirmed by Luciano Spilingardi, head of Cassa di
Risparmio di Parma and member of the Parmalat board. Bond issues were ordered
by the banks, Splingardi said "that one of the last issues, of 150 million euros, was
presented to the board meeting as an explicit request by a foreign bank, which was
ready to subscribe the entire bond, it was Deutsche Bank." Spilingardi says that he
expressed "perplexity" about the proposal, because a previous bond issue of EU 600
million had failed, in the spring of 2003, causing a 10% fall of Parmalat stocks in one
day. But the request was accepted, and the last Parmalat bond, issued in summer
2003, made its way to the Cayman Islands black hole.

The Parmalat crisis finally broke out on Dec. 8, when the company Parmalat
defaulted on an EU 150 million bonds. The management claims that this was
because a customer, a speculative fund named Epicurum, did not pay its bills.
Allegedly, Parmalat has won a derivatives contract with Epicurum, betting against
the dollar. But it was soon discovered that Epicurum is owned by firms whose
address is the same as some of Parmalat's own offshore entities. In other words,
Epicurum is owned by Parmalat.

This article appeared in the January 16, 2004 issue of Executive Intelligence
review. Appendix I : Parmalat Case Study
Parmalat was Italy’s largest food company at that time. Its core business was in dairy
products but it expanded in to TV business, football business and tourism business.
Parmalat’s biggest innovation was that it was the first company to produce milk
through ultra-heat treatment process, which allowed Parmalat’s milk to be stored
without refrigeration for a long time. This was such a mega hit, that by early 2000s,
Parmalat had asset of around €10 billion with over 36,000 employees in 139 plants.
However, it went bankrupt in December 2003. Suddenly, it was discovered that it’s
claimed liquidity of €4 billion cash did not exist and that €8 million in bonds of
investors’ money had disappeared.
Answer the following questions relating to the case study on Parmalat (Appendix I).

a) Critically evaluate this case study in terms of good corporate governance

b) Were the general accepted accounting principles (GAAP) and financial
reporting standards at fault in this case? [5]
c) How was it possible for each conduct to remain undetected for so long? Where
were the monitors? Which monitoring mechanism failed and to what extent are
these failures due to the weaknesses in governance structures and in unethical
behaviour. [22]
d) How can an ethical climate be established and promoted in an organisation like
Parmalat? [5]
e) Briefly explain the role of Institutional Investors in Corporate Governance [8]