Milking Investors Through Financial Statement Fraud

Parmalat "a milk-and-cookies conglomerate" seemed at first glance to be above suspicion. But the firm began to implode when the Italian regulatory commission began its investigation, a Parmalat bank account supposedly holding 3.9 billion Euros was found to be fictitious, and Parmalat fired its two chief auditing companies. This one will last for years.

If you've ever traveled or lived in Western Europe, it becomes apparent that any expectations of fresh milk "delivered from local farmers, served in glass containers" are badly dated, naïve dreams. Fresh milk is a rarity in Europe, with sterilized milk in drink box-like cartons or shrink-wrapped plastic bottles being the norm. Dominating this norm is Parmalat Finanziaria, Europe's largest milk producer, generating 2.7 billion Euros in European sales.

Along with milk, Parmalat produces ready-to-eat milk-based sauces, yogurts, tomato products, as well as a selection of food stuffs. Americans may know Parmalat through its holdings of Archway, Mother's, and Salerno brands, with Parmalat coming in as America's third-largest producer of cookies. If classified along the lines of American publicly traded companies, Parmalat would find its place in the rather vanilla Foods category, where, according to its 2003 financial report, it generated approximately 7 billion Euros in worldwide revenue. While an impressive presence in Europe, Parmalat obtains 60 percent of its revenue from its worldwide subsidiaries in the Americas, Asia, Africa, and Australia, employing 36,000 throughout the world.

Signs of Trouble

To begin with, Parmalat was never a particularly lucid example of financial reporting. The conglomerate produced long, complex, and convoluted financial statements, along with bizarre, baroque, and confusing "guidance" from management. Two examples might serve to illustrate the confusing nature of information produced by Parmalat. Pages 51 through 77 of Parmalat's 2003 half-year report provide, in small-fonted, densely presented spreadsheets, a breakdown of related party holdings and transactions. Here one encounters a complex array of intercompany loans, transactions, and holdings. Portuguese food processing companies, for example, provide loans to Ecuadorian finance companies, which in turn provide capital to Brazilian engineering companies "all owned, in part or in whole, directly or indirectly, by Parmalat." Although I haven't performed an exact count of all the holding companies, one can gain a broad perspective from the following consideration: there are 42 countries in which Parmalat has holdings. Smaller countries, where there are, for example, three to four main holdings, are themselves held by on average three to four entities owned directly or indirectly by Parmalat. In the United States and Australia, the number of holdings and entities constructed for the holding of these concerns is considerably larger. Such a list goes on in similar complexity for more than 28 pages. In the end, an astute analyst can do nothing but ask: Why does a food company "a relatively small food company in comparison with U.S. behemoths such as Kraft or Sara Lee" have more complexity than a General Electric (which has an extensive finance arm which might legitimate various intercompany transactions)? Why would a relatively small company have more complexity than a $100 billion affair? How and why on earth would a food company weave such a convoluted web? How bad can taxes possibly be?

Complexity of this sort is designed to hide something. A motivated short seller or conscientious lender had only to dig deeper to determine that something was wrong "that Parmalat was too complex and too fuzzy to merit an investment grade credit rating."

Before we arrive at our next example, it may be helpful to note that investors, as of October 2003, had perhaps priced some of these questions into the valuation of Parmalat. For, while Parmalat generated 7 billion Euros in annual revenues, it had a market capitalization of only 3 billion (relative to an all-time high market capitalization of 4 billion) at that time. In fact, as recently as March 2003, investors had sent Parmalat shares down to a then-low of 1.5 billion Euros in market capitalization, or 21 percent of revenues. In comparison, Kraft, the U.S. food producer, has historically traded at a multiple of between 1.8 to 2.4x revenues. This is no small message from investors: relative to its peers, Parmalat trades at an 11x negative multiple in valuation, or a 1,100 percent discount to similar names.

For our next example, I beg the reader to suffer through the following long passage from a press release dated Nov. 12, 2003. Investors had questioned the nature of a large mutual fund investment Parmalat had made in an off-shore Cayman Islands fund. Upon announcing plans to liquidate its investment, Parmalat made the following statement:

Parmalat Finanziaria complained in different venues, also institutional, and in more occasions the circulation, also instrumental, in different ways, of unfounded and/or seriously defamatory news and assumptions regarding our Group, aimed at fearing new alleged financial scandals or not existent irregular accounting practices. These news and assumptions were taken and inappropriately amplified by various sources and continued in time with worrying rage, such as to consequently originate the sedimentation, much to our regret, of a negative perception and doubts with regard to our financial and economic soundness. This in spite of the positive operating results achieved during 2002 and the current year. These news and assumptions have also negatively influenced the pricing of Parmalat securities and the market sentiment towards us. Parmalat Finanziaria will reserve its action against the instigators and defamation vehicles of the negative news instrumentally used.

I need not point out what may well be the most amusing media release ever created. Shortly after the release of this financial statement, the largest (in absolute terms) financial fraud in European history began. The details are still being uncovered and will be for years but we'll turn to what we known.

Unraveling of Parmalat's Scheme

There is no easy or clear starting point in what is now being called The Parmalat Scandal. According to Jane Fuller of the Financial Times, it might start with the Italian financial system itself, whose accounting and reporting rules are lax, and whose regulatory agencies are replete with conflicts of interest and corruption. Or it might be the very birth of Calisto Tanzi, the ex-Chairman of Parmalat, now under house arrest, who may be addicted to buying loss-making companies and convincing investors to finance his purchases. But November and December 2003 are good starting points, two months in which Parmalat produced 20 media releases (compared with, on average, its normal four to five annual media releases). On November 10, of that year, Parmalat issued its first defense in a series of media releases to answer demands from CONSOB, the Italian equivalent of the Securities and Exchange Commission. CONSAB had apparently made a formal inquiry into (a) the classification of certain current assets, which affect the liquidity of Parmalat and its ability to borrow both short and long term, and (b) the classification of $4 billion worth of debt held in intercompany holdings. Characteristically, Parmalat threw gasoline on the fire by attempting to list and explain its financing activities:

All the bonds issues by consolidated subsidiaries will be reported as "debenture loans", under the liabilities section D in the forthcoming financial statements, rather than "bank debt". Some 360 million Euros (nominal value) of the bonds issued by controlled companies, altogether totaling 550 million Euros and expiring during 2003 and 2004, have been bought back by another company included in the Group consolidation area. Thus, as per 30 September 2003, funds required by Parmalat Group to reimburse debenture expiring within 31 December 2004 amounted to 190 million Euros. We might add to this amount some 246. 4 million Euros plus the relative accrued interests, in the event holders of Parmalat Soparfi SA equity linked bonds 2002/2022 might decide to exercise, as allowed by the regulation governing the debenture loan, the request of early redemption on December 2004. The mentioned debenture loans will be reimbursed using Group's liquidity. This agreement concerns intercompany financing amongst Group companies. One company makes a determined amount of cash available to a financial institution that in return uses this fund to finance another Group's company based in another country. The total value of these intercompany financings amount to USD 819 millions, as per 30 September 2003. The controlled companies using such intercompany financing are the following:

• Parmalat de Mexico
• Parmalat Netherlands BV
• Parmalat Partecipacoes do Brasil LTDA
• Parmalat de Venezuela CA
• Wishaw Trading
• Parmalat Capital Finance Limited
• Bonlat Financing Corporation
• Parmalat Soparfi SA
• Eurofood IFSC Limited

These financial transactions bring advantages to the group at operating level by allowing a more flexible use of credit lines in the different countries where the Group operates.

What was meant to clarify and explain various inquiries on behalf of CONSOB only heightened attention from shareholders, bondholders, creditors, and the financial media. The following day, two additional "clarifications" were released, one affirming the existence of a 496 million-Euro investment in the Epicurum Fund (the Cayman Island fund mentioned on page 30) and the second re-affirming the review of internal controls performed by Grant Thornton, the accounting firm responsible for the audit of certain subsidiaries of Parmalat. On November 12, Parmalat announced its liquidation of its holdings in the Epicurum Fund; on November 21, Parmalat "clarified" intercompany transactions amounting to 590 million Euros; on November 27, Parmalat announced it would receive US$589 million in the liquidation of its holdings in Epicurum, and US$13 million in the liquidation of a currency swap agreement with Epicurum. Twelve days later, on December 12, Parmalat announced that Epicurum "did not liquidate Parmalat's investment in Epicurum by the Dec 4th deadline." According to Parmalat, the fund was so overwhelmed by the liquidation that it required more time to work out the details. Investors, on the other hand, were busy shooting first and asking questions later. For, on the following day, Parmalat, an ostensibly cash-rich company, announced that it potentially wouldn't be able to meet a 150 million Euro interest payment due to the delay of its liquidation of its holdings in Epicurum.

The next day a media release announced "a potential plan for the Group's industrial and financial restructuring." Parmalat's stock began to plummet. The company frantically sent a barrage of media releases in the following days to assuage the fears of investors, but by the time Parmalat announced in one day both its satisfaction of its 150 million Euro interest obligation and the resignation of its chairman, Calisto Tanzi, along with its entire audit board of directors, investors had sent Parmalat's stock to zero. Parmalat was now a worthless company.

Shortly afterwards, Parmalat's board of directors called for an analysis of the company's assets and liabilities. Only this time the board of directors didn't choose Deloitte and Touche, its auditors, for the job; rather, PricewaterhouseCoopers was called in to determine what, if anything, Parmalat was worth. On December 19, the first of a series of media release bombs were dropped: a letter of credit accounting for 3.9 billion Euros of liquid securities from Bank of America was a forgery; the assets didn't exist. The existence of the Epicurum fund "in retrospect, the tip of the proverbial iceberg" was the least of Parmalat's worries. By December 29, Parmalat was placed under extraordinary administration.

On January 7 and 8 of 2004, the extraordinary administration of Parmalat announced that it had fired Grant Thorton and Deloitte and Touche, its two chief auditors. On January 17, Parmalat announced that 7 billion Euros in fixed income securities held in a New York Bank of America account didn't exist. On January 21, Stefano, Giovanni, and Paulo Tanzi (all of the Tanzi family which owned more than 51 percent of Parmalat shares) resigned from their senior positions at Parmalat. On January 26, PricewaterhouseCoopers, in its initial review of assets and liabilities, stated that 2003 Earnings Before Interest, Taxes, and Depreciation was overstated 530 percent, and that liabilities of 1.8 billion Euros were understated "net financial indebtedness was in fact at a staggering 14.3 billion Euros, representing an understatement of 800 percent. In addition, PricewaterhouseCoopers stated that 2002 and 2003 liquid assets "were negligible." Parmalat had been living by the skin of its teeth all along.

Classification of Fraud Scheme

Parmalat allegedly committed financial statement fraud in every conceivable form: asset/revenue overstatements, timing differences, fictitious revenues, concealed liabilities and expenses, improper disclosures, and improper asset valuations. The Tanzi family allegedly was able to create, out of thin air, billions of dollars of financial transactions because it controlled the internal workings of the company of which it was the majority owner. However, what's still unclear is the involvement of Parmalat's two chief auditors, Grant Thornton, and Deloitte and Touche. While Deloitte claims it relied on audits of Parmalat subsidiaries performed by Grant Thornton (in accordance with Italian audit standards), many have claimed that Deloitte and Touche, over a period of 12 years, allegedly was unable to detect and identify intercompany transactions used to hide $8 billion in company debt. According to the Financial Times, a Brazilian auditor at Deloitte and Touche was fired at the request of Parmalat for allegedly raising concerns over intercompany transactions at Parmalat Brazil, transactions that in many cases accounted for 100 percent of revenues and profits for Brazilian subsidiaries and served no economic purpose other than as an ostensible conduit for Parmalat financial shenanigans.

Although there has yet to be a formal report on the exact nature of the fraud committed at Parmalat, the basic theme of the fraud is apparent: Parmalat went on a buying binge over a period of 12 years, purchasing loss-making dairies and, ostensibly, turning them into profit-making ones. In reality, Parmalat allegedly bought loss-making dairies and allegedly did nothing to turn them around, instead hiding the losses in intercompany transactions which its auditors never detected. To obtain cash, and to simulate profits, Parmalat was a regular and eager participant in the equity and debt markets, using prestigious investment banking firms such as Citigroup, Goldman Sachs, Bank of America, Deutsch Bank, and GE Capital to facilitate its cash needs.

Although many documents and computer files were destroyed at Parmalat, one computer hard drive was recovered, which revealed the existence of account number 999, an 8 billion Euro debit to assets which was used as collateral for many of the company's intercompany loans. Chairman Tanzi allegedly personally vouched for many intercompany transactions, something that chairmen rarely do, and something that apparently impressed local auditors enough to take them off the trail of Parmalat's successful 12-year ruse against its auditors.

In addition, allegedly many officials, owners of companies acquired by Parmalat, politicians, and, indeed, Parmalat family members themselves, grew very rich at the expense of Parmalat debt and equity holders. Here, the Financial Times provides an account of financial fraud and kickbacks all too common at Parmalat:

A former Parmalat employee described the acquisition of one Central American company by Parmalat for $25m: "The seller got $5m. The rest went to politicians, middlemen, Parmalat executives. But you had to account for it as $25m even though it was worth $5m."

According to The Wall Street Journal, Enrico Bondi, the special administrator appointed by the Italian government, has asked an Italian judge to seize the assets of every company director and internal auditor since 1990.

In a late-July report compiled for the Italian government, Bondi says Parmalat used about 5.4 billion Euros to go on a global acquisition spree "buying up companies in Canada, the United States, Latin America, and Asia" and to cover up losses around its far-flung empire. The report also says the company spent about 6.5 billion Euros on interest payments and 2.3 billion Euros to people or entities connected with Parmalat. For example, nearly 500 million Euros was diverted to Parmatour SpA, a travel company run by the industrialist's daughter, Francesca.

Bloomberg News reported on July 22 that Parmalat's main banks allowed the company to hide the true state of its finances for more than a decade, according to a report ordered by Milan prosecutors.

An Unpreventable Case?

Given the level of alleged collusion among Tanzi family members, and potential collusion among Parmalat auditors and investment bankers, it may well be the case that the Parmalat scandal was unpreventable. However, as the Financial Times suggests, both creditors, investment bankers, and, most importantly, credit-rating agencies could have performed simple audit work that would have uncovered red flags. Namely, a rudimentary audit of Parmalat subsidiaries would have shown an unusually high proportion of related party transactions. Such a finding would have led to a more detailed audit of related party transactions, which would have led to the tips of one of the many Parmalat icebergs. It appears the accounting firms failed, and many suggest that they were simply afraid of losing Parmalat's business, as if nothing had been learned in the last three years of scandals. If this is true, it serves as additional evidence that auditing firms grow weak and stupid in the midst of profit opportunities.

The reliance on audited statements by various investment bankers, credit rating agencies, and creditors "produced by the accounting firms" seemed reasonable at the time and in line with industry standards. Given the costs of formal audits, the clean bill of health given to Parmalat by its two chief auditors seemed like sufficient evidence to facilitate Parmalat's major shopping spree in the international debt and equity markets. One must ask whether it would have made any sense for Standard and Poors, Bank of America, Citigroup, Goldman Sachs, Deutsch Bank, and GE Capital to question the work of two highly respected accounting firms, and, moreover, target a producer of milk and cookies as a potential for large-scale fraud. Are auditors and creditors taught to look for intangible clues, such as the flamboyant Italian chairman, with a past history of business failures? These aren't quantifiable data points that accountants or auditors are taught to look for. Indeed, an accountant's looking for such intangible qualities might be judged prejudicial and characteristic of unprofessional conduct. Should auditors always be suspicious of complexity? Or is there a point at which financial complexity is warranted? The greater question, perhaps, is whether the capital markets simply failed. Investors are supposed to have the motive to perform their own due diligence, whether conducted in-house or outsourced to specialists. Were investors lazy, or were they fooled by the seemingly innocuous business? Or were investors misled by investment banks, upon whose due diligence they relied? And were investment banks in turn misled by the auditors, upon whose audit opinions they relied? Were auditors misled by Parmalat executives, upon whose information they relied? And perhaps were Parmalat executives misled by an Italian system which practically begged for financial fraud to occur? As we ponder these questions, evidence is being gathered by officials across the globe, Parmalat associates sit in custody in several countries, auditors piece together the pieces of the puzzle using evidence that remains from 12 years of fraud. Meanwhile, 36,000 Parmalat employees continue to produce milk and cookies in every part of the world. But without account 999, what was once known as Parmalat is soon to be gone under a massive equity deficit.

James Rose is a graduate business student in the McCombs School of Business at the University of Texas (UT) at Austin. This article is adapted from a paper he wrote for the UT graduate fraud examination class taught by Joseph T. Wells, CFE, CPA, founder and Chairman of the ACFE.

References

Bloomberg.com. "Parmalat Banks Allowed Food Company to Hide Fraud, Says Report." http://quote.bloomberg.com/apps/news?pid=10000006&sid=9L9T.LNdYS.g&refer=home ( July 21, 2004 )
Fuller, Jane. "A Failure that Should have been Halted by its Victims." Financial Times. ( April 13, 2004 )
Galloni, Alessandra; Reilly, David. The Wall Street Journal Online. http://online.wsj.com/article_print/0,,SB109053963603171779,00.html. ( July 26, 2004 )
Il Sole 24 Ore. "Parmalat Has Registered False Profits Since its Listing, say Prosecutors." ("Bonlat, la ëlavanderia' dei Tanzi."),( April 13, 2004 )
Kapner, Fred. "Eight Billion Reasons to Destroy Parmalat "Account 999.'" www.FT.com. ( April 12, 2004 )
Parker, Andrew. "Big Firms Must Keep to Global Audit Rules." Financial Times. ( April 13, 2004 )
Parmalat media releases available at: www.parmalat.com/en/fset.html?sez=dc
Parmalat financial statements available at: www.parmalat.com/en/fset.html?sez=dc
Plender, John. "Divergence from Italian Best Practice." Financial Times. ( April 13, 2004 )
Parker, Andrew. "Big Firms Must Keep to Global Audit Rules." Financial Times. ( April 13, 2004 )
Reuters. "S&P says had no Early Hint of Parmalat Credit Woes." ( April 5, 2004 )
Wyman, Peter. Letter to the Editor. Financial Times. ( April 14, 2004 )