European corporate governance. The pause after Parmalat

Date: 17/01/04

Europe's Enron calls for a measured, but more determined response

WHEN Enron imploded in 2001, America responded quickly and vigorously to a huge fraud. Politicians used the Enron affair as a wake-up call for American businesses. Tough new rules were introduced, notably the Sarbanes-Oxley act. Managers were told to sharpen up their standards. One of the world's biggest accounting firms disappeared, its reputation shattered by the actions of a few employees. Briefly, the integrity of the entire capitalist system seemed under threat.

The collapse into bankruptcy of Parmalat, an Italian dairy-products group, has become Europe's Enron. Billions of euros are missing. A once-respected firm is in tatters. Thousands of jobs are at risk. This European scandal shares many elements with the American one, from corrupt management and a complacent board of directors to complicated financial dealings in offshore tax havens via big banks, which seem to have been only too willing to underwrite the deals that kept a massive fraud alive for years. As at Enron, at the heart of the fraud lay an accounting and auditing fiasco.

Yet how has Europe responded? So far, with little of America's vigour. In fact, the response has been rather muted. Plenty of observers want to dismiss the affair as a local Italian matter. After all, didn't Silvio Berlusconi's government water down penalties for false accounting? And isn't Italy a model of disregard for rules on corporate governance, a place where the rights of minority shareholders are regularly abused?

Unfortunately, these truths conceal as much as they reveal. As more has emerged about the fraud at Parmalat, it has become clear that the proper context for analysing it is a European one. There is an important Italian dimension, to be sure. By quickly changing its bankruptcy law and proposing a sweeping reform of its regulatory system, Italy has shown that, despite doubts, it may yet be capable of overcoming its normal political torpor. The decision this week by Italy's Constitutional Court to overturn a law which granted Mr Berlusconi legal immunity while in office also shows that the country's judiciary is not supine. And yet while Mr Berlusconi runs the government, any reforms that touch the corporate sector will be tainted by the suspicion that they are designed for his benefit, or at least to do his interests no harm.

The real lessons for Europe are broader. The fraud at Parmalat gulled not only Italians but international investors, banks and credit-rating agencies. Parmalat even had an American listing for some of its securities to add to its air of normalcy. In short, the fraud has exposed how vulnerable the financial system remains when safeguards are perverted, either deliberately or through incompetence. The main aim should be to make frauds easier to detect and harder to perpetrate. Strengthening auditing standards and compliance, as well as the role of truly independent board directors, is essential.

The European Commission has already suggested that it would like to strengthen auditing standards, perhaps by insisting that member countries introduce accounting-oversight boards, like the one required in America by Sarbanes-Oxley, to enforce the implementation of international accounting rules that will become obligatory for all EU companies next year. That seems sensible. In addition, the commission should try to impose more onerous standards on Europe's many securities exchanges. Tougher requirements on firms that want to list shares or sell bonds create a strong incentive for businesses to be open about what they are doing and make it much easier for outsiders to make informed judgments. In the short term, pressure can be exerted locally, by encouraging national exchanges (including Italy's) to adopt stricter rules. Longer term, as markets and exchanges consolidate, such rules should converge on a European-wide benchmark.

Rainbow regulation

Even such modest initiatives as these, however, are difficult. Parmalat is a reminder that Europe still has a long way to go towards the harmonising of either accounting or corporate-governance standards on best practice. Businesses operate amid a patchwork of rules and securities markets, and fraudulent firms can exploit this. Harmonisation need not mean a straitjacket of uniformity. Long-standing cultural differences will justify some variation. Nevertheless, it is in Europe's long-term interests to reduce the sheer intricacy of the current patchwork, especially because EU enlargement will inevitably add some vibrant new colours.

Doing so will require determination and political co-operation. National governments should support any efforts made by the commission to generate better practices and standards, starting with the basic building blocks of corporate auditing and accounting. If that is Europe's response to Parmalat, then Europe's businesses will all be better for it.