European corporate governance: Turning sour

Date: 03/01/04

Europe's businesses have much to learn from the unfolding disaster at Italy's Parmalat

SINCE the Enron scandal, American companies have operated in a new and more demanding climate. Reported financial results are being more carefully scrutinised by investors and regulators. New rules, most notably the Sarbanes-Oxley act, have been adopted to strengthen corporate governance and increase transparency. As America struggled to clean up the mess left by Enron and other corporate scandals, Europeans congratulated themselves for mostly avoiding such wretched excesses. Now, in Parmalat, an Italian food and milk-products company, Europe has a corporate scandal of truly Enronesque proportions. If the integrity of European business is to be restored, and public confidence in the continent's capital markets is to be sustained, Europe's response will have to be as determined and sweeping as America's.

Precisely what that response should be, though, is still unclear because the critical details of the Parmalat case themselves remain obscure. There is no doubt that the company has become a massive financial disaster. Until a few months ago Parmalat was an apparently healthy firm, the product of decades of entrepreneurial endeavour which had turned a tiny ham merchant in Parma into a global giant. Its shares were freely traded and it had no trouble issuing large amounts of bonds. Banks were happy to lend and credit-rating agencies gave it a clean bill of health. But in just a few weeks, Parmalat has gone from being one of Europe's brightest success stories to its biggest corporate fraud. Billions of euros are missing. The duration, extent and purpose of the huge swindle at Parmalat remain to be determined.

It is possible, however, to draw some tentative lessons from the affair. The initial response in Italy has been encouraging. Faced with a crisis, the government rushed through long-overdue laws to allow a streamlined form of bankruptcy protection similar to America's Chapter 11. That will allow Parmalat's new managers some breathing space while they try to salvage something from the wreckage. Helpfully, it also brings Italy more into line with other parts of Europe.

Yet that merely throws into relief broader Italian and European problems raised by the scandal. It has been tempting for international investors to think of Europe as a single investment space. The reality is that harmonisation of Europe's industrial and financial markets still has a long way to go. Local practices matter, never more so than when things go wrong.

Consider, for example, the well-known fact that Italy has a feeble stockmarket regulator. In Silvio Berlusconi it also has a prime minister who himself runs a complex and shadowy business empire, and who recently introduced laws to make false accounting a civil rather than a criminal offence. The danger to honest Italian businesses could not be clearer: their cost of capital will rise if investors begin to discriminate against a country that had been trying to shake off a reputation for dark dealings. In fact, this is precisely what international investors should now do. The sheer scale of the Parmalat scandal raises serious questions about Italian business practices which only a thorough, and very un-Italian, clean-up can now dispel.

Finally, in the light of Parmalat and Enron, investors everywhere should also apply a discount to any companies which engage in complex and opaque financial engineering. Only a few observers of Parmalat appear to have asked why, if all was well, a perfectly straightforward food firm needed complex offshore structures or a cash pile supposedly worth billions. But the warning signs were there. Multiple transactions were poorly explained, or simply not declared. In future, fund managers and banks owe it to their own customers to place much tougher burdens of proof on firms with a taste for elaborate, unfathomable financial deals which seem to have little to do with their mainstream business.

Italy's businesses have much to learn from the unfolding disaster at Italy's Parmalat.