Corporate Governance and Risk Management - Case Study Example

Corporate Governance Content Page 1. Introduction 2 2.1 Company Background 3 2.2 Analysis of Parmalat Scandal. 3 2.3 Evaluation of the role of those charged with governance. 8 2.3.1 Identity of those people involved 9 2.3.2 Discuss their actions/inactions 9 2.3. 3 Best practices of Corporate Governance vs. Company practices 10 4. References 14 Appendix A 15 1. Introduction Corporate governance is defined by the Cadbury Report in 1992 as the system, which is used by companies to direct and control their goals (Chartered Accountants of Ireland, 2013). The same system may contain a series of policies and internal control mechanisms by which an organization is effectively and prudently controlled, directed and managed to ensure its long-term success. Such policies and control mechanisms may entail the presence of checks and balances in the structure and functions in the organization to prevent abuse by those who have powers while allowing the taking advantage of opportunities to accomplish corporate goals and objectives. The enforcement mechanism of the said corporate governance could be rule-based or principle-based. A rule-based system assumes a standard for all companies and therefore is legally binding and enforceable in law. There is also limited scope for interpretation under this system. A principle-based system, on the hand, allows self-regulation and there is flexibility as it can be used to suit any size, situation and stage of development. The rest of the paper will attempt to look at the Parmalat scandal and determine the applicability or inapplicability of which type of corporate governance - whether rule-based or principle-based. Using the evidence that will be provided from the analysis of the scandal and other available evidence from the company’s website, this paper will make a determination for the purpose. 2.1 Company Background Parmalat, founded in 1961 in Parma (Parmalat, 2012a), is an Italian company engaged in the production and distribution of food and beverages (Reuters, 2014a). Its product range comprises three product segments: Milk, Dairy Products, and Fruit Beverages (Reuters, 2014a). The Milk segment includes Ultra High Temperature (UHT), pasteurized, condensed, powdered, and flavoured, cream and béchamel (Reuters, 2014a). The Dairy product segment includes fermented milk, desserts, cheese, butter, encompasses yogurt and probiotic products while fruit juices, nectars and tea are part of its fruit beverage portfolio (Reuters, 2014a). By operating through numerous subsidiaries, the company’s presence extends to Portugal, South Africa, Russia, Cuba and Australia among others (Reuters, 2014a). 2.2 Analysis of Parmalat Scandal. The corporate scandal came out in 2003 when the investing public came to know about the deliberate hiding of liabilities and when there was misstatement of liabilities by understating the same about eight times more than the actual amount. The deliberate hiding of liabilities was in effect a fraud committed against the stockholders and investors of the company since it would mean that the latter were made to believe that the company had been that healthy when in fact it was already insolvent or unable to pay its debts to pay its creditors. To aggravate the situation, the fraud happened with the knowledge and connivance of the gatekeepers or auditors for the past years prior to 2002, which caused decision makers to overvalue the company’s stocks and only to find presence of big amount of liabilities that must have been made known to them. Upon discovery of the correct status of the company nr the existence of liabilities as fact, the company’s stocks in the stock market naturally experienced a deep plunge as could be seen in Appendix A for the past years starting in 2003 as year of scandal. The fall ended in 2005 when fixing of corporate governance practice at Parmalat started (Reuters, 2014b). In December 2003, the company was put into order under a Restructuring Plan. A new management was therefore introduced in the company as a way of rebuilding trust to customers, investors and other stakeholders. Despite the fall that happened because of the fraud committed by Mr. Tanzi and others, the company rose again under the name of Parmalat S.p.A. starting in 2005. It was only in 2005 that the new Parmalat had its stocks listed at the Italian Stock Exchange (Parmalat, 2012a). . Presenting the events with sense of chronology would make the analysis easier to understand as shown below. Sixties and Seventies In 1961, Mr. Calisto Tanzi as the heir of dynasty of food traders of based in Parma started Parmalat by opening a small pasteurization plant . At the latter part of this period, Mr. Tanzi decided to enter the milk market while taking advantage of the continuous packaging process developed by Tetra pack. Afterwards, Parmalat started its expansion into the dairy industry (Ferrarini, and Giudici, 2005). The seventies witnessed Parmalat trademark becoming very popular with its sponsorship of high-profile events in the world of sport. During the same period, Parmalat started penetrating of Latin American markets (Ferrarini, and Giudici, 2005). Eighties and Nineties Further expansion characterized the eighties as at this time Parmalat consolidated its position as a world leader in the daily market. This period allowed further extension into other food markets, such as, tomato sauces, bakery products and fruit juices (Ferrarini, and Giudici, 2005). Capitalizing his company’s growth, Mr. Tanzi could not just stop his becoming well known with Catholic fervour and his connections to high-level politicians at that time including that one with Christian Democrats leaders. Ciriaco De Mita, the then powerful leader of the ruling Christian Democrat, became Mr. Tanzi’s close friend. The relationship allowed Parmalat to make one of its factories in Nusco, with the principal claim to fame being Mr. De Mita's home town (Ferrarini, and Giudici, 2005). Political influence from politician could explain Mr. Tanzi venture into the TV market during this period. This brought the acquisition of Odeon TV via a family friend but only to be sold in 1989 after bad results (Ferrarini, and Giudici, 2005). Such bad decision had its necessary effects. Political connection when abused becomes cronyism and could lead many wrong decisions. The collapse of Parmalat is believed to have its origin from this point as revealed in criminal investigation later that the money used was actually provided by Parmalat (Ferrarini, and Giudici, 2005). Imagine what will happen if Parmalat money was used to cover Mr. Tanzi's debts in other business areas, which put the company into big debts that would be hidden (Ferrarini, and Giudici, 2005). The obvious unfettered power of Mr. Tanzi was very clear, essentially controlling the decision making. A more independent board of directors could have screened this type of decision under ordinary principles of corporate governance. Tanzi was able to make acquisitions and big financial transactions using Tanzi a family company holding Parmalat shares, thus, enabling the latter to get controlling interest of about more than 50% per cent in Parmalat Finanziaria. The later entity latter turned into the listed holding company of Parmalat group, consisting of 58 companies, almost half of which or are based outside Italy. At this point, the total turnover of around reached Euros 560 million. From this group of companies Parmalat was the most significant (Ferrarini, and Giudici, 2005) In the nineties, the Parmalat Group (or “Parmalat") international acquisition campaign came about , with total turnover reaching Euros 2.4 billion in 1995 and Euros 2.8 billion in 1996 with about half of the turnover coming from Latin America (Ferrarini, and Giudici, 2005). As then a multinational group of companies, becoming an active player of capital market became easy with the help of investment banks, like Chase Manhattan Bank . This allowed the company to use bonds in sourcing capitalization from the Euromarkets. This period coincided with sponsorship of well-known sport events and diversification by Parmalat into sports-related industries (Ferrarini, and Giudici, 2005). The reliability of financial reports as early as 1995 could be inferred doubtful at this point, as auditors were not completely independent. Before 1995 Mr. Maurizio Bianchi and Lorenzo Penca were auditing subsidiaries of Parmalat but in 1995, said auditors joined Grant Thornton, which became principal auditor in 1990 (Ferrarini, and Giudici, 2005). By 1999, Grant Thornton was replaced by Deloitte since under Italian law, rotation of auditors was required every nine years. Yet evidence appeared that Bianchi and Penca were aware of the frauds as early as 1995 and there were accused of helping the creation of Bonlat as waste basket for the fake transactions of Parmalat as group (Ferrarini, and Giudici, 2005). Since Bonlat, a subsidiary of Parmalat, was audited by Grant Thornton, the effect of falsity at Bonlat got extended to Parmalat as group of companies, essentially fooling the investors who were supposed to have the right to know the real financial status of the company at every point in time. The new Millennium The trend continued at the start of new millennium, including continuously issuing bonds. With the downgrading of its bonds in November 2000 by Standard and Poor's rating with BBB-grade, Parmalat’ problems got more evident and with the default of the fellow food manufacturer Cirio in November 2002, it was pushed harder with its increased cost of capital (Ferrarini, and Giudici, 2005). For a company to expand further by resorting to more borrowings, while having excessive cash based on its balance sheet is a questionable strategy. Something must be very wrong. This was what exactly happened to Parmalat (Ferrarini, and Giudici, 2005). Imagine a group of company with more than 200 companies spread around 50 countries by 2002 while being known as group leader in the markets of milk and dairy products and beverage. Imagine the same company operated more a hundred of industrial plants while employing less than 38,000 employees with consolidated turnover of Euros 7.6 billion. Such was Parmalat at that point with stocks listed for public to buy (Ferrarini, and Giudici, 2005). A big company appears generally to show stability but in the case of Parmalat, something was wrong on how corporate governance was practiced before the 2003 scandal. The principal auditor of the company when the scandal happened in 2003 was Deloitte, which replaced Grant Thornton at about the middle of 1999 (Ferrarini, and Giudici, 2005). The presence and work of the auditors were supposed to ensure corporate governance. However in the case of Parmalat, it could be observed that they were part of problem. External auditors, through their opinions, are theoretically part of corporate governance as they are supposed to make the financial statements, which include the balance sheet, income statement and cash flow statement of the companies they audit, conform to the international financial accounting standards (IFRS) (Solomon, 2011). Compliance with IFRS means that financial statements are reliable and relevant. False statements on actual liabilities categorically depart from the requirements of reliable financial statements (Kieso et al, 2007). The accounting and finance officer under the control of Tanzi virtually cooperated with latter in committing the acts detrimental to the interest of the Parmalat’s shareholders and other stakeholders. The Grant Thornton , as external auditor, helped and consented with the scheme. Tanzi's chief financial officer Fausto Tonna, made a surprise announcement of new Euros 500 million bond issue. The surprise disturbed the markets and Mr. Tanzi, forcing Fausto Tonna to resign and was replaced by Alberto Ferrairs. It was Ferrairs as the second financial officer, who began inquiries about the problem of Parmalat since he was not allowed access yet to some of the corporate records as the books were with the chief accounting officer Luciano Del Soldato. Ferrairs’ instinct turned out to be correct that real debts were higher than what the balances sheet reported. The discovery of hidden debt caused the dropping of the Euros 300 million fundraising and when it got published, it necessarily and severely affected the stock price of the company as show in Appendix A. 2.3 Evaluation of the role of those charged with governance. The latter part of section will explain the reason why those persons involved in the scandal acted in the way that happened. In other words, what were the reasons that drive them to make false report? 2.3.1 Identity of those people involved The people involved in the scandal include the directors, who are part of the executive officers and the auditors of the companies who opted to keep the secret. Some of those were actually prosecuted for fraud and Mr. Tanzi got convicted in court. Mr. Tanzi was the main character of the scandal as he was the chairman and chief executive officer of Parmalat at that time. The other persons include Tanzi's chief financial officer Fausto Tonna, who replaced by Alberto Ferraris, Luciano Del Soldado, chief accounting officer and auditors Grant Thornton, auditor from 1990 to middle of 1999 and later replaced by Deloitte. 2.3.2 Discuss their actions/inactions The actions of Mr. Tanzi were evidently intentional as he was found to have privately admitted that the financial reports were false after investigations on suspected huge under- declaration or non-reporting of company debts were conducted. His actions could speak of an insatiable greed for more money and power without realizing that the decision to continuously hide the truth could no longer hold because the natural law of supply and demand had set in. Since Mr. Tanzi controlled the board with the majority of the latter as executive directors. It was Mr. Tanzi who caused his finance officer and accounting officers to have fake financial reports with understated liabilities until discovery in 2003, thereby misleading stockholders and creditors. The unfettered powers of Mr. Tanzi brought problems. It is easy to understand that the company was technically one-man board by the person of Mr. Tanzi, who controlled almost everything (Ferrarini, and Giudici, 2005). Out of the 13 directors from the board, 8 were executive directors, leaving only 5 non-executive or independent directors. This structure of the board essentially gave the control to Mr. Tanzi, who virtually shared power with eight executive directors especially with the fact on the composition of audit committee. The committee was supposed to be composed of non-executive directors, was found to have two executive directors and only one non-executive director as members (Ferrarini, and Giudici, 2005). Technically, there was dictatorship on the part of Mr. Tanzi. From a behavioural aspect, the executive directors officers they could have been motivated by preserving their stay in the company while Mr. Tanzi was their at the top, in addition to possible financial or non-financial rewards that may come their way via the action of Mr. Tanzi and other executive directors. The auditors who are supposed to be gatekeepers and independent from the companies they audit, were found lacking the motivation to do maintain good reputation. Deloitte was also found to be providing non-audit services to Parmalat, allowing the former to have fees that may contradict with the nature of an audit service, which should be independent. This created a very lax attitude on the auditor’s part since Parmalat under Mr. Tanzi could be using a carrot-and-stick strategy (Ferrarini, and Giudici, 2005). In other words, the relationship between the auditor and Parmalat before and during the scandal was not purely professional; it was transactional or tainted with corruption. 2.3. 3 Best practices of Corporate Governance vs. Company practices Good practice of corporate governance requires accountability. The UK Code provides: "The board should present a fair, balanced and understandable assessment of the company’s position and prospects" (Financial Reporting Council, 2012, p. 17). In the case of Parmalat, the fact that company was able to hide debts by under-declaring the same for a long time is a proof that the board is not presenting a fair, balance and understandable assessment of the company. Good leadership is also part of best practices for corporate governance. Section A of UK Code prohibits one individual to “have unfettered powers of decision.” (Financial Reporting Council, 2012, p.6). In the case of Parmalat, this was not followed correctly as there was no clear division of responsibilities between those running the business from those who were just there to make an oversight function or to make policies. Mr. Tanzi was able to manipulate things at the company because of his unfettered powers. He virtually could do what he wanted with much power. No wonder he was criminally convicted after trial and got ten years in prison to account for such an unfettered power (BBC, 2008). Part of its 2005 report on corporate governance provides that Parmalat has its Internal Control and Corporate Governance Committee, consisting of three independent directors, and one of its functions is to ensure "that the rules of corporate governance are complied with" (Parmalat, 2012b, p. 7) and to update these rules. The same was almost maintained in its 2012 Corporate Governance report, except for some modifications of the functions (Parmalat, 2012c), thereby providing proof of adapting to changing situations as it self-regulates. Self-regulation proves the use of principle-based corporate governance. Both the 2005 and 2012 Parmalat’s Reports on Corporate governance were prepared in accordance with the Corporate Governance Code of Borsa Italiana (Parmalat, 2012b, 2012c). 3. Conclusion Corporate governance was found to be useful in the case of Parmalat, which has undergone a scandal brought by the dishonesty of its officers in connivance with the auditors. These officers and directors, headed by Mr. Tanzi, were able to hide liabilities in prior years but its discovery caused a dive in the company’s stock price. To fix the company, good corporate governance practices were needed. A comparison of the company practices with those of best practices under the UK Code, revealed violations, indicative of changes to be made necessary in the case of Parmalat starting 2005. As evidence of rising up from the scandal of 2003 and realization of the need to have good corporate governance, Parmalat’s own reports in corporate governance in 2005 and 2012 declared the use of corporate governance to guide and control the company towards its long-term direction. Its subscription to Code published by Borsa Italiana, in addition to the changing requirements and contents of its reports on governance from 2005 and 2012 as a way of adapting to rules suitable to its needs and situations prove that corporate governance enforcement used by the company must be principle-based. As to whether principle-based corporate governance worked well in Italy, the answer can be yes or no. There was already Corporate Governance Code of Borsa Italiana before the 2003 Parmalat scandal, which was principle-based, yet the said scandal happened. It would seem than having law or code is different from actually enforcing the same. When the new management of Parmalat came in after the scandal, the principle-based system was working, because people in charge choose to enforce the same after the lesson of failure to enforce in the past. 4. References BBC (2008). Italian dairy boss gets 10 years. Retrieved 23 February 2014 from Bloomberg (2009). Bloomberg’s Morning Report on Trials and Other Litigation News. Retrieved 7 March 2014from Chartered Accountants of Ireland (2013). UK Corporate Governance Code. Retrieved 26 February 2014 from Ferrarini, G. and Giudici, P. (2005). Financial Scandals and the Role of Private Enforcement: The Parmalat Case. Retrieved 26 February 2014 from < http://web.efzg.hr/dok/pra/hhorak/ferrarini,guidici%20the%20parmalat%20case.pdf> Financial Reporting Council (2012). The UK Corporate Governance Code. Retrieved 23 February 2014 from Kieso, et al (2007). Intermediate Accounting. New Jersey: John Wiley and Sons Parmalat (2012a). Company Website. Retrieved 25 Feb 2014 from Parmalat (2012b). 2005 Corporate Governance Report. Retrieved 23 February 2014 from Parmalat (2012c). 2012 Corporate Governance Report. Retrieved 23 February 2014 from Reuters (2014a). Company Profile. Retrieved 23 February 2014 from Reuters (2014b). Stock Price Graph of Parmalat. Retrieved 23 February 2014 from Solomon, J (2011). Corporate Governance and Accountability. New Jersey: John Wiley & Sons Appendix A Stock Price Graph of Parmalat (Reuters, 2014b) Read More