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Analysis and Commentary
Parmalat was founded in 1961 as a family-run farm in Northern Italy. In the years that followed, the company grew into one of the largest dairy and food companies in Italy and eventually became a multinational conglomerate. At the time of its crisis in 2003, Parmalat listed 214 subsidiaries in 48 different countries.
Parmalat’s fraud apparently began in 1990 and lasted until 2003. In essence, when the company’s financial performance began to slip in 1990, and rather than resolve its problems, management chose to disguise them through fraud and collusion. During this 13-year period, Parmalat executives used a wide range of unethical techniques to extend the fraud. They inflated revenues by creating fake transactions through a double-billing scheme. They used receivables from these fake sales as collateral to borrow more money from banks. They created fake assets thereby inflating reported assets. In some cases, they took on legitimate debt that they hid from investors (New York Times, 27 January 2004). They also eagerly worked with investment bankers to engage in fianancial engineering which moved debt off balance sheet or disguised it as equity on the balance sheet. They even colluded with third-party auditors and bankers to finance the fraud indefinitely.
So, what happened? How did they do it? Why did they do it? What could a careful investor have observed before the scandal was revealed?
Problems at Parmalat began to emerge publicly in mid-2002. Between July and December of that year, Parmalat’s credit spreads widened by 250 to 300 basis points (depending on the debt issue). Tightening credit conditions in Latin America and the default of food industry rival Cirio in 2002 drove the rising spreads.
By December 2002, Merrill Lynch analysts Joanna Speed and Nic Sochovsky became concerned about the company’s ability and willingness to issue debt in the public markets. They published a report titled “The Straw That Breaks the Camel’s Back,” which downgraded Parmalat to a “sell” rating, citing the company’s ongoing reliance on funding from the debt markets despite having considerable cash on the balance sheet — a full year before the scandal broke.
In fact, this sort of common-sense perspective is about all a professional investor can use to identify that something is awry. Specifically, the analysts argued that holding large cash balances that paid little interest while also holding substantial sums of debt that required higher interest payments represented “inefficient balance sheet management.” They didn’t even know how right they were. It was later revealed that the company’s reported cash balances were fraudulently inflated (among other issues) and its debts were massively understated.
Nevertheless, the investment community largely missed the fraud. Of the 29 analyst reports issued on Parmalat in 2002, 21 issued a “buy” rating, 7 issued a “hold” rating, and only the Merrill Lynch team issued a “sell” rating (Gabioneta, Prakash and Greenwood, 2013). In all fairness, one of the reports rating Parmalat a “buy” also expressed concerns about the company’s debts. The analyst was from Unicredit Banca Mobiliare. In December 2002, he noted, “As for the debt refinancing issue, we argue that, post Cirio and owing to the higher risk perception following the instability in South America, refinancing expiring debt at a reasonable cost has become harder. Moreover, the group has shown no intention to use its Euro 3.3 billion cash pile. This point would need to be accurately assessed with the management, which, however, continues to remain unapproachable” (ibid). Equally importantly, most other analysts remained unconcerned about possible improprieties at Parmalat and maintained their buy ratings. Nevertheless, the market’s suspicions about Parmalat grew as the stock price fell by roughly 40% between November 2002 and February 2003.
Just as the ink was drying on the December 2002 Merrill Lynch report, one of Parmalat’s auditors requested verification of the Bonlat bank account in the Cayman Islands. Meanwhile, the scope of the hole in Parmalat’s finances continued to widen, putting more and more pressure on the company to elevate its fraud. In January 2003, CFO Fausto Tonna announced a €300 million bond issuance. Parmalat founder and CEO Calisto Tanzi was not informed of the move, however, and shortly thereafter fired Tonna, replacing him with Alberto Ferraris and withdrawing the bond offering. Naturally, the withdrawn offering spooked markets, and Parmalat’s stock price experienced a swift 30% decline (part of the aforementioned 40% decline ending in February of 2003). Interestingly, Mr. Ferraris picked up right where Mr. Tonna left off. There was apparently no shortage of people willing to swindle the public.
While the company mulled over its response to the Bonlat verification request, management decided to go on the offensive. On 20 March 2003, CEO Tanzi brazenly went to Italian financial markets regulator Consob with a 34-page complaint alleging that the major banks sought to slander Parmalat (by suggesting that its financials had “accounting irregularities”) in order to make speculative gains on its shares. Of course, we now know there were deep “irregularities,” but this fact did not stop the company from attacking others. According to Consob spokesman Alberto Aghemo, Tanzi accused Lehman Brothers in particular of falsely suggesting Parmalat was engaged in improper accounting. In effect, Tanzi tried to pre-empt the “rumors” in the court of public opinion. When Consob investigated the complaint, it found that Parmalat’s stock had fallen in response to the withdrawal of the €300 million bond issue. “In reality, nobody had spoken of accounting irregularities. There was no evidence of manipulation,” Aghemo said (New York Times, 14 January 2004).
Also in March 2003, Parmalat produced a (forged) verification letter on Bank of America letterhead “validating” the account and submitted this letter to the requesting auditor. On one front, the company was attacking Wall Street firms for allegedly suggesting it had accounting irregularities, while on the other front, it was forging documents to “verify” a false account statement for a phantom €4 billion in cash. That is world-class brass. Parmalat even went so far as to forge the signature of an actual Bank of America employee. How the auditor sought and allowed this document to be produced by Parmalat itself remains a mystery. A basic function of auditors is to independently verify accounts, and the auditors very clearly shirked this responsibility. We may never know whether this particular shortcoming was intentional. Nevertheless, the forged letter ultimately became the center of controversy when Bank of America revealed on 19 December 2003 that the Bonlat account did not exist. At this time, a former auditor with Deloitte quipped, “What is the one line item in an audited balance sheet that no one questions? Answer: the cash and other short-term assets. And that is precisely where this fraud was directed.”
The next fracture in the Parmalat story occurred on 11 November 2003, when Deloitte & Touche refused to sign off on Parmalat’s half-year financial statements (Jones, 2010). Specifically, Deloitte said it was unable to confirm a €135 million gain Parmalat said it made on a derivatives contract owned by its Cayman Islands–based hedge fund subsidiary, Epicurum.
Then, in December 2003, the twisted scam began to unravel. On 8 December 2003, despite having reported €4 billion in cash and short-term assets on its balance sheet, Parmalat defaulted on a €150 million eurobond payment. Parmalat claimed a customer had not paid its bills (it was later revealed that the “customer” was owned by Parmalat). On 9 December 2003, Parmalat’s bond rating was downgraded to junk by S&P, and the stock price fell an additional 40% in subsequent days (see Figure 1). That same day, Tanzi stepped down as CEO and the Parmalat board hired turnaround expert Enrico Bondi to resolve the crisis. On 16 December, Bondi engaged PWC to review Parmalat’s finances. That same day, Bank of America’s New York branch notified existing auditor Grant Thornton that the company’s Bonlat account did not exist. On 19 December, Parmalat publicly announced that €3.95 billion in cash was missing, sending the Parmalat stock price near zero (see Figure 1). Parmalat executives subsequently went on a binge, destroying computers and shredding documents related to these off-balance-sheet transactions. On 27 December 2003, Parmalat was officially declared insolvent, and CEO Calisto Tanzi was indicted for fraud and arrested.
Figure 1. Parmalat Stock Price, January 2002 to May 2004
Sources: Bloomberg, CFA Institute
So, how exactly did all this happen?
After completing its review of the company’s books, PWC determined that Parmalat’s financial statements had been misstated since at least 1990. Parmalat reported positive and growing earnings every year from 1990 through 2002. After properly restating its financials, however, PWC revealed that Parmalat had actually lost money in 12 of those 13 years. PWC concluded that Parmalat’s fraud began in 1990 as an attempt to cover losses at a South American subsidiary.
The Parmalat fraud is not unusual in how it began. Many frauds, whether at investment firms (e.g., Nick Leeson at Barings PLC), banks (e.g., Daiwa Bank), or corporations in other industries (such as Parmalat), start as a desperate attempt to hide losses. The very process of trying to “save” a company through illicit means transforms it from a legitimate business into an illegitimate one. The individuals involved are typically trying to “save face” to avoid reporting substantial losses to superiors, boards, investors, or family. Rather than deal with the difficult work of correcting the organization’s problems, or perhaps admitting that the challenges are simply too great, many succumb to the temptation to conceal losses through fraud, risky behavior, or both. In the case of Parmalat, executives Tanzi and Tonna deployed a wide range of deceitful tactics to bring in extra cash and to disguise these actions from the outside world. Such actions are almost always a direct result of pride, and that certainly appears to have been the case here.
In one example, Tonna devised a double-billing scheme to inflate Parmalat’s revenue and assets. For accounts sold on credit to a supermarket or retailer, Parmalat accountants would selectively duplicate invoices (typically in the name of the shipping company that delivered the milk), generating fake sales. These duplicate invoices would increase reported revenues and accounts receivable. Parmalat would then take the fake receivables to banks and use them as collateral to obtain loans. The loans, in turn, increased the company’s liabilities and, of course, cash.
Such a tactic, however, only escalates the original problems over time. If a company reports revenues of $100 but in reality has revenues of $90, it might still have costs of $92. So, although it may report an $8 profit margin, it has actually generated a $2 loss. If the company then takes on $10 in debt to fill the gap, it can feign profitability so long as it can continue to pay off the debt. In the case of a chronically unprofitable company such as Parmalat, the problems introduced by taking on too much debt must ultimately meet their day of reckoning. Then, the accounting ruse eventually reflects the company’s underlying economics. This scenario illustrates why Parmalat’s case first manifested itself as a debt crisis and was only later revealed as a fraud.
The company also took on debt disguised as equity through complex transactions with Wall Street. For instance, in a deal with Deutsche Bank, Parmalat entered into a collared swap agreement that in effect allowed the firm to borrow money and to record those funds as equity on its balance sheet. In the deal, Deutsche Bank paid Parmalat €20 million in exchange for 7 million shares of Parmalat stock (Glater 2004). Deutsche Bank also bought a call option that gave it the right to purchase Parmalat stock, and Parmalat bought a similar put option giving Parmalat the right to sell Parmalat stock. At some future date, one of the two options would be “in the money,” and the “winning party” would be contractually obligated to reimburse the “losing party” for the gain. In other words, if Parmalat’s stock price went down, Parmalat would realize a substantial gain on the put contract and be contractually obligated to return the gain to Deutsche Bank, thereby securing Deutsche Bank’s interest. The contract set a date in the future when the deal would be reversed — Parmalat would get the shares back and return the €20 million. Meanwhile, Parmalat paid Deutsche Bank an annual fee for making the arrangement. Although not disclosed, this fee was likely equivalent to a market rate of interest on a commensurate amount of “debt.” Although it is not entirely clear what information was available to investors at that time, it is clear that derivative contracts should be examined for this sort of gimmickry. A third-party investor should investigate reported gains and losses on derivatives contracts for just this sort of transformation of debt into equity.
As an example of how widespread the fraud was, in 2002, Parmalat’s Brazilian unit, Parmalat Administracao e Participacoes do Brasil Ltda., issued a €500 million convertible bond that was automatically convertible into Parmalat company shares (Wall Street Journal, 29 January 2004). The security paid interest of 10.45% and was backed by promissory notes from the parent company and a long-term purchase agreement for the shares. It was widely believed that the buyer of these convertible notes was yet another unit of Parmalat — meaning that the activity was a ruse to lift reported equity on the parent company balance sheet. In effect, Parmalat issued a bond that was treated as equity on the balance sheet.
A fraud of Parmalat’s scale almost always involves contributions from many parties. According to Parmalat employee Claudio Pessina, “as many as 300 employees were aware of the company’s double-billing scheme.” This statement illustrates yet another powerful example of authority mis-influence. When a person in a position of power pushes a firm to do something unethical, many employees cooperate in the wrongdoing, primarily because they project blame onto the authority for their own participation in unethical activity. This phenomenon was made famous in a series of experiments now known as the Milgram experiments, in which subjects were asked to administer electric shocks to “participants” (actually actors) when they answered questions incorrectly. The actors would simulate severe pain, even to the point of death, yet many of the test subjects continued to administer the shocks despite believing they were delivering life-threatening pain to the actors. Indeed, the willingness of otherwise honest employees to participate in a fraud is staggering.
Participation in a fraud is not strictly confined to a company’s employees. In 1997, Parmalat’s lead auditor Grant Thornton International (GTI) noted a “hole” in Parmalat’s books amounting to €5 billion. When GTI allegedly asked CEO Tanzi about the large gap, he said that it would be filled within three years. In fact, GTI conspired with management to hide the fraud from the firm’s new lead auditor, Deloitte & Touche, when it took over in 1999. Additionally, Bank of America’s head of corporate credit in Italy, Luca Sala, admitted to misappropriating $27 million from Parmalat. Sala told investigators that he would help organize bond placements for Parmalat in which he would use an outside broker who managed risks such as currency fluctuations. This outside broker would then split fees with Sala so that Parmalat would always turn to that broker for business. In other words, Parmalat executives colluded with many people to bring in the capital they needed.
How Parmalat accounted for all this nefarious activity is a separate matter. According to Italian law at the time, companies were required to switch auditors every nine years. Even though Parmalat brought in Deloitte & Touche in 1999 as its primary auditor, it retained its previous auditor, GTI, to audit its offshore affiliates, thereby dodging the spirit, if not the letter, of Italian law. In later testimony, GTI auditor Maurizio Bianchi admitted that GTI worked with CFO Tonna to find a way to hide the company’s problems from Deloitte & Touche. Likewise, Tonna testified that GTI was not only aware of the fraud but also actively helped Parmalat to execute it, including helping the company to create a bogus sale of €300 million in powdered milk to the Cuban government.
One of the easiest ways for companies to fabricate results is to create fake sales. From an accounting standpoint, the sales account is credited while accounts receivable and the “cash” account (if any) are debited, increasing reported assets on the balance sheet. GTI stayed on as secondary auditor for Parmalat and lead auditor for Parmalat’s special-purpose entities (SPEs). As of December 2002, Parmalat reported total debt of €1.8 billion on its balance sheet. When PWC concluded its investigation after Parmalat’s collapse, it discovered that Parmalat actually had €17 billion in debt. So, some €15 billion in debt was hidden off balance sheet.
The public prosecutor of the Parmalat case highlighted that in 2002, the company derived only 15% of reported EBITDA from the principal operating company Parmalat SpA, whereas the Bonlat subsidiary accounted for a much higher percentage (undisclosed). In many ways, the Parmalat story is also about a failure of the gatekeepers, both within the company and within the financial supply chain (commercial banks, investment banks, auditors, etc.), who were in a position to act. Investors who rely on the veracity of reported information always risk such a failure.
Another red flag centered on the following questions: How can a low-margin dairy business report such high margins (about twice the industry average? How can a low-growth dairy business generate meaningful revenue growth? By focusing on the return structure of a business, one can better gauge a company’s ability to produce such results and identify characteristics that should be observed but are not. It is, of course, possible for a company to thrive in a low-margin business (e.g., Wal-Mart), but the company must also have an attendant competitive advantage by way of cost, brand, or something else materially important to the marketplace. Did Parmalat have better-tasting milk, for example? Lower-cost processes? Superior distribution? Did it have any defining characteristics that separated it from the competition? It appears there was no compelling reason for the company to enjoy superior economics.
Naturally, this analysis requires an investor to do the hard work necessary to make this judgment. Without a compelling and rational explanation for superior returns, the questions then turn toward collusion and fraud. How could this company report margins twice the industry average without a competitive advantage? How could it have gone to the debt markets so much without having built up so much debt? How could any of this be possible without some form of hidden debt or overstatement of assets or misstatement of expenses? For a company to be an attractive investment, the financials must tie in with the story of the business.
So, how did Parmalat manage to “misplace” so much money without anyone knowing? Think of it as a shell game. Parmalat created and exploited a complex ownership structure that relied on SPEs to create illicit transactions, to disguise these transactions for reporting purposes, and to hide debt. And it paid co-conspirators to perpetrate the fraudulent scheme.
Once the scandal became public, prosecuting attorneys in Milan obtained critical testimony from a number of Parmalat employees. Former CFO Tonna testified that he signed bank transfers on behalf of CEO Tanzi up until 2001. At this point, Tonna grew uncomfortable funneling the cash, so Tanzi himself began doing the transfers even though it would compromise his ability to later deny knowledge of any wrongdoing. “Tanzi was not only aware of all the problems in the group but was also the person who decided to hide them.” (Wall Street Journal, 2 January 2004) According to another employee, “Tanzi was desperate, and when you’re desperate, you’ll do anything.” According to his own lawyer, Tanzi testified, with tears in his eyes, “This is the company I built —and now it’s no longer mine. I’ve lost everything.” In some instances, Tanzi’s testimony tried to direct blame towards others, but the testimony of his employees nearly universally pointed back to Tanzi (Wall Street Journal, 2 January 2004).
The company’s apparent acquisition strategy also afforded it the opportunity to pick and choose how to consolidate expenses. Parmalat created SPEs in the Cayman Islands, Dutch Antilles, and Malta, and it even created one called Bucenero (meaning “black hole” in Italian) and used it to store fictitious assets and hide debt. For instance, the company transferred uncollectible receivables from consolidated subsidiaries to these SPEs. It created fictitious trades at subsidiaries that were generating losses in order to inflate revenue and income. It recorded non-existent repurchases of bonds. It sold receivables falsely labeled non-recourse, meaning that the buyers could put the receivables back to Parmalat, so they still bore the risk of ownership. In total, the company hid €12 billion ($15.2 billion) of debt and kept it off balance sheet.
Ultimately, it was discovered that Tanzi and 16 other executives had collectively misappropriated over €1 billion for personal gain. The post-bankruptcy Parmalat CEO Bondi filed suit against 45 banks with which the company had done business, alleging that these banks helped Parmalat hide losses from investors. In June 2008, Parmalat reached a settlement with UBS and Swiss Bank for a total of €357 million. Neither bank acknowledged any wrongdoing. The rest of the suits were dismissed in Italian courts.
The corruption was so widespread and long lasting that multiple red flags should have appeared for multiple people both inside and outside of Parmalat. Nevertheless, as an outside investor, there is no ‘magic bullet’ to avoid this sort of scam in the future. Effective due diligence always has a limit. Only vigilance by all interested parties will bring about swifter discovery than in Parmalat’s case. Of course, awareness of how other companies perpetrated their scams can provide a good starting point.
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