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Case 8-2
Parmalat: Europe’s Enron
After the news broke about the frauds at Enron and WorldCom in the U.S., 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 U.S. started
to take a closer look at the principles-based approach in the European Community that relies less
on bright-line rules to establish standards as is the case in the U.S. but that may have loopholes
making it relative easy to avoid the rules. As discussed in the chapter, a principles-based
approach relies more on objective standards that guide decision-making in the application of
accounting standards, supported by ethical judgment to help implement the principles. The case
of Parmalat illustrates why many question whether the principles-based approach leads to
financial statements that more faithfully represent financial position and results of operations.
Background
Parmalat began as a family-owned entity founded by Calisto Tanzi in 1961. During 2003
Parmalat was the 8th largest company in Italy and had operations in 30 countries. It was a huge
player in the world dairy market and even more influential within the Italian business circles.
They 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%. Tanzi family members also occupied the seats of CEO and
chairman of the board of directors. The structure of Parmalat was primarily characterized by the
Tanzi family and the large amount of control they 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 Bank of America did not exist. The Parmalat situation described below makes it clear that
Europe is not isolated from financial fraud. It also proves that the quality of financial reporting
and financial transparency are issues of global concern. At the end of the day, these issues may
be more important than whether a principles-based or rules-based approach is used.
The Italians Act
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. 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) were found to be
missing from the bank accounts of the multinational dairy group in December, 2003. The
company has since declared bankruptcy and 16 suspects, including Carlos Tanzi, are in jail.
Other suspects include Tanzi’s son Stafano, his brother Giovanni, former Parmalat finance chief
Fausto Tonna and lawyer Liampaolo Zini. Former internal auditors and three former Bank of
America employees also 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. 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 all five continents
through either a direct presence or through license agreements.
Parmalat Diverted Company Cash to Tanzi Family Members
In transactions that might engender pride on the part of Dennis Kozlowski, the former
CEO of Tyco, Parmalat transferred approximately €350 million (approximately $494) to various
businesses owned and operated by Tanzi family members between 1997 and 2003. These family
members did not perform any equivalent services for Parmalat that would warrant such
payments. Further, Parmalat failed to disclose that the transfers were to related-party interests.
US Banks Caught in the Spotlight
Italian magistrates and officials from the SEC examined the role of lenders to Parmalat,
which collapsed into bankruptcy in late December, 2003, following the disclosure of major holes
in the financing of the company. The SEC’s inquiries focused on up to €1.05 billion ($1.5
billion) of notes and bonds issued in private placements with U.S. investors. The banks
investigated include Bank of America, JP Morgan Chase, Merrill Lynch and Morgan Stanley
Dean Witter.
Parmalat’s administrator, Enrico Bondi, helped the authorities to 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.
Accounting Fraud
One of the most notable fraudulent actions was the creation of a completely fictitious
bank account in the U.S. that supposedly contained $5 billion. After media reports exposing the
account surfaced, the financial institution at which the deposit existed (Bank of America) denied
any such account. The company’s management had misled 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.
Parmalat’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 and thus keeping the bad debt expense or write off for the valueless
accounts off of 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 they 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 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 inter-company 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 the establishment of nonexistent foreign nominee companies and hiding liabilities. Calisto
Tanzi and other management were investigated by Italian authorities for manipulating the Milan
stock market. On December 20, 1999 the management of Parmalat made a press release of an
appraisal of the Brazilian unit. While this information release may appear to be a straight forward
action, what Mr. Tanzi and others failed to disclose was facts relating to the appraisal itself. The
appraisal came from an accountant at Deloitte Touche and Tohmatsu (the international name of
Deloitte & Touche) 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 intending to hurt the Parmalat share price.
Financial institutions failed to thoroughly examine the accusations and continued to loan money
to Parmalat due to the supposed strength and power wielded by Parmalat throughout the world.
[Notice the similarity with Enron whereby U.S. banks and financial institutions brought into the
fraud that was Enron and didn’t want to upset the then seventh largest company in the U.S.]. As
Luca Sala, formerly the 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.” This attitude and
similar attitudes at Citibank led both banks as well as many others to write off millions of dollars
of loans after the collapse. Several Bank of America employees where charged in the Parmalat
Fraud, most in connection to the non-existent U.S. bank account but also in relation to lending
practices. Eventually, all of the bank’s employees were acquitted leading the bank to state: “The
crime of market manipulation with respect to BOA was found to be completely groundless”.
Failure of Auditors
Parmalat accused the auditors, Grant Thornton International 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 are highlighted by the firms’ own claim 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 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. 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 which 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 Mr. Tonna or an agent acting on his behalf. The forgery
consisted of creating a confirmation and printing it on Bank of America letterhead then sending it
back to the auditors.
