Discussion 1 655

Discussion #1 – Governance Failures

11

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Many of the regulations discussed in section 1.3 (Information Security Governance by Brotby) are the result of scandals that are indicative of failures in governance.

For this discussion:

· Provide a

summary
of the article

· Answer the

question
: How could proper governance have prevented this event?

European Scientific Journal June 2016 edition vol.12, No.16 ISSN: 1857 – 7881 (Print) e – ISSN 1857- 7431

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Corporate Governance Failure: The Case Of Enron
And Parmalat

Rezart Dibra, PhD
Albania Professional Business Academy, Tirana, Albania

doi: 10.19044/esj.2016.v12n16p283 URL:http://dx.doi.org/10.19044/esj.2016.v12n16p283

Abstract
Corporate governance is a central and dynamic aspect of business.
The term governance is derived from the latin word gubernare, meaning to
steer. It usually applies to the steering of a ship. Thus, this implies that
corporate governance involves the function of direction rather than control.
Corporate governance has come to the forefront of academic research due to
the vital role it plays in the overall health of economic systems. Corporate
governance was long ignored as a matter of potential importance for the
development of a nation’s economy. The wave of U.S. corporate fraud in the
1990s was attributed to deficiencies in corporate governance. The recent
2008-2009 global financial crisis, triggered by the unprecedented failure of
Lehman Brothers and the subprime mortgage problems, renewed interest on
the role of corporate governance in the financial sector. The development of
a strong corporate governance framework is important to protect
stakeholders, maintain investor confidence in the transition countries, and
attract foreign direct investment. This paper looks at the collapse of Enron
and the Parmalat, which was a particular Italian scandal. Parmalat, Enron,
and other American firms such as Tyco and WorldCom all have a number of
fudging at their core – efforts to make the companies look healthier than they
were. Parmalat’s collapse began in November when its auditor raised
questions about a $135 million derivatives profit. After additional evidence
of accounting misstatements, the company’s chief executive and founder,
Calisto Tanzi, resigned on the 15th of December. Four days later, the
company disclosed the fake Bank of America letter. On the 23rd of
December, Italian investigators stated that the company had used dozens of
offshore companies to report non-existent assets to offset themselves. This
was as much as $11 billion in liabilities. Also, this is in addition to the fact
that Parmalat might have been falsifying its accounting figures for as long as
15 years.

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http://dx.doi.org/10.19044/esj.2016.v12n16p283

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Keywords: Corporate governance, transition countries, emerging economies

Introduction
Corporate governance is a central and dynamic aspect of business.
The importance of corporate governance for corporate success as well as for
social welfare cannot be overstated. Examples of massive corporate collapses
resulting from weak systems of corporate governance have highlighted the
need to improve and reform corporate governance at the international level.
In the wake of Enron, Parmalat and other similar cases, countries around the
world have reacted quickly by pre-empting similar events domestically. As a
speedy response to these corporate failures, the USA issued the Sarbanes
Oxley Act in July 2002. In January 2003, the Higgs Report and the Smith
Report were published in the UK. This publication again was in response to
the recent corporate governance failures.
Consequently, corporate governance has become one of the most
commonly used phrases in the current global business vocabulary. The
notorious collapse of Enron 2001, one of America’s largest companies, has
focused international attention on company failures. In addition, it also
presents the role that strong corporate governance play in preventing these
failures.
“Corporate governance” comprises of a country’s private and public
institutions, both formal and informal, which together govern the relationship
between the people who manage corporations (corporate insiders) and all
others who invest resources in various corporations in the country.
Therefore, corporate governance generally refers to the set of rule-
based processes of laws, policies, and accountability that governs the
relationship between the investor (stockholder of a company) and the
investee (management). Corporate governance attracts a great deal of
attention in the aftermath of the Asian financial crisis of 1997-1998 and the
early 2000s U.S. corporate scandals, like Enron and WorldCom. However,
after the threat of global contagion financial crises passed, corporate
governance was relegated to the back of academic research.
Therefore, the focus of this paper is to analyze the challenges that
transition countries faces when moving from a politically-based relationship
to a relationship that is rule-based. Furthermore, it also analyses the role of
corporate governance as a major factor in the unprecedented transformation
of transition countries to a market economy.

The Collapse of Enron
In 2001, Enron became a household name – and probably in most
households in most countries around the world.

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On the 2nd of December 2001, Enron became one of the 10 largest
companies in the USA. In the following months, more and more evidence
emerged about the weaknesses and fraudulent activity of corporate
governance. However, countries across the world have been unsettled and
disturbed by the shock of this event and are now examining their own
corporate governance systems in micro-detail. This they do by looking for
similar weaknesses and potential like Enrons. Enronitis has spread across the
globe like a lethal virus, infecting every company and every shareholding
institutions. In addition, it also had a significant effect on worrying even by
the smallest shareholder and unnerving the financial markets.
Enron was a Huston-based energy company founded by a brilliant
entrepreneur, Kenneth Lay. The company was created in 1985 by a merger
of two American gas pipeline companies. Within a period of 16 years, the
company was transformed from a relatively small concern, involved in gas
pipelines, and oil and gas exploration, to the world’s largest energy trading
company (The Economist, 28 November 2002). Enron, the champion of
energy deregulation that grew into one of the nation’s 10 largest companies,
collapsed yesterday. This collapse occurred after a rival backed out of a deal
to buy Enron, and after many big trading partners stopped doing business
with the company.
Enron, based in Houston, has been widely expected to seek
bankruptcy protection. With $62 billion in assets as of September 30, it
would be the biggest American company ever to go bankrupt. Hence, this
company dwarfs the filing by Texaco in 1987. Late in the day, Enron’s chief
financial officer, Jeff McMahon, stated that the company was still talking to
banks about a restructuring and a consideration of other options.
The role of a company’s board of directors is to oversee corporate
management in order to protect the interests of shareholders. However, in
1999, Enron’s board waived conflict of interest rules to allow chief financial
officer, Andrew Fastow, to create private partnerships to do business with
the firm. These partnerships appear to have concealed debts and liabilities
that would have had a significant impact on Enron’s reported profits.
Subsequently, Enron’s collapse raises the issue of how to reinforce the
directors’ capability and will to challenge questionable dealings through
corporate managers.
Several corporate governance problems have emerged due to Enron’s
wreckage. Unfettered power in the hand of the chief executive is an obvious
problem, and is one that characterized Enron’s management. Also, there
were numerous illustrations of unethical activity within the Enron
organization that continued to come to light long after its downfall. For
example, in May 2002, it became clear from the documents released by the
Federal Energy Regulatory Commission that Enron’s energy traders

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developed and used strategies or tricks to manipulate the markets where
Califonia bought electricity.
Overall, corporate governance in Enron was weak in almost all
aspects. Thus, the board of directors is composed of a number of people who
lacks moral character. Also, they are often willing to engage themselves in
fraudulent activity. This was the genuine root of the company’s corporate
governance failure.
There has been a proliferation of books on the downfall of Enron,
seeking to explain why events transpired as they did. As we have seen, the
USA and the UK strong reaction to Enron’s collapse and corporate
governance has been hurled to the centre stage. This occurs as a result of the
weaknesses at the heart of Enron’s corporate governance system. The long-
term effects of Enron will hopeful be a cleaner and more ethical corporate
environment across the globe. Furthermore, the continuous updating of
corporate governance codes of practice and systematic review of corporate
governance checks and balances are necessary to avoid other Enrons in the
future.
Clearly, corporate governance check and balances can only serve to
detect, not cure, unethical practices. A complicating factor in issues of fraud
and ethical breakdown is the intangible nature of fraud. In addition, there is a
grey area surrounding what is right or wrong, good or bad in human
behaviour. Some comments made by Sheldon Zenner, an American white-
collar criminal and civil lawyer, when speaking of the Enron trial, helped to
illuminate this issue.

Corporate Governance Failure in Parmalat
Separation of ownership and control in a large stock corporation
would be of no particular consequence if the interests of owners and
managers coincided. Corporate governance is concerned with overcoming
the problems of the monitoring and controlling of managerial performance.
This occurs whenever corporate ownership and corporate control are
separated as a result of dispersed share ownership. The primary function of
corporate governance is to ensure that companies are runned based on the
interests of corporate shareholders. However, these shareholders provide
financial resources in running them. In the UK and US, owners of typical
corporation are many, and their shares are small relative to the size of the
corporation.
The collapse of Enron during 2001 has brought about a focused
attention on the effectiveness of the non-executive director function. The
corporate board, with its mix of expertise, independence, and legal power, is
a potentially powerful governance mechanism.

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Parmalat Finanziara, the Italian dairy and food giant, is fast joining
Enron and WorldCom as a household name for corporate scandal. The
alleged financial fraud at Parmalat spans more than a decade. Also, it
involves sums whose estimates have ballooned from EUR 4 billion to more
than EUR 8 billion. Founder, chairman, and chief executive Calisto Tanzi
has been ousted from the company and board and is under arrest. Enrico
Bondi, who replaced Tanzi in December, has been given new authority to act
as the sole administrator of Parmalat. Therefore, he has 180 days to save
what he can of the company.
While Bondi races against time to unearth the sources of the scandal,
some corporate governance experts are already drawing lessons.
The media have termed parmalat, a particular Italian scandal, and
have suggested that the situation was more likely to arise in a country like
Italy than elsewhere (Mulligan & Munchau, 2003; Melis, 2005). Given the
criticisms of Italian corporate governance in the literature, this is not
surprising (Melings, 2005; La Porta et al., 1997).
Parmalat was owned by a complex group of companies. In addition,
it is controlled by one strong blockholder (the founding Tanzi family)
through pyramidal structure (see Melis 2005). Indeed, Melis (1999)
explained that such ownership structures with opaque patterns of ownership
and control are not uncommon in Italian companies. Furthermore, Melis
(2000) stated that the weaknesses of Anglo Saxon systems of corporate
governance were traditionally strong managers: strong blockholders and
unprotected minority shareholders. The case of Parmalat was typical of this
form of corporate governance. This is with controlling Tanzi shareholders
channeling corporate resources illegally to themselves, at the expense of
minority shareholders (Melis, 2005).
Although Italian corporate governance is characterized by monitors,
namely the statutory auditors and the external auditing firm, this was not able
to protect the company from self-destruction. A direct analogy may be drawn
between the cases of Enron and Parmalat, in terms of fraudulent activities
and the companies’ audit firms. However, for Enron to exist, Parmalat has
survived its ordeal and has turned on the auditors in order to recover funds.
Another difference is in the way that the auditing firms involved with
Parmalat managed to extricate themselves from the crisis. However, Arthur
Andersen was destroyed in the aftermath of Enron.
Melis (2005) highlighted a series of other serious corporate
governance failures which led to the parmalat’s crisis. Firstly, one of the
non-executive directors in Parmalat was not independent as he had been
working in Parmalat as a senior manager since 1963. Secondly, the chairman
and chief executive position were not separated as was recommended by
corporate governance codes of practice in Parmalat Finanziaria. Hence, both

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positions were held by Tanzi. Thirdly, the Preda corporate governance code
in Italy specified that where a group of shareholders controls a company, it is
even more important for some directors to be independent from the
controlling shareholders. This was certainly not upheld by Parmalat. Also,
there was no adequate explanation given by the company for this lack of
compliance.
As in the case of Enron, the failure of Parmalat to establish careful
checking and monitoring structures within the company’s governance
framework laid it bare to the abuse of power and fraudulent activity. Unless
these devices for detecting fraud and misconduct are in place, it is relatively
easy for Enron-like situation to arise.
Therefore, corporate governance in Italy was in sixth place as we can
see in the graph below.

(source: http://www.economist.com/node/2349958)

The Parmalat case may seem to differ in terms of the simplicity of its
fraud. The audited statements from Bonlat were used to show cash balances
that were reported by the parent company. Thus, it used in offsetting high
levels of debt on its balance sheet. Each quarter with a set of forged
documents would show purported cash holdings at Bonlat that matched the
head office’s requirements. Furthermore, Deloitte seems to have accepted
Grant Thornton’s audits unquestioningly. On the other hand, bankers and
investors took the audited group figures as reassurance that, although
complex, the group’s finances were essentially sound. In addition, they failed

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to ask why a company with so much cash needed to borrow so much.
(http://www.economist.com/node/2349958)

Conclusion
Corporate governance is the organizational arrangement by which a
company represents and serves the interests of its investors. It encompasses
anything from the company’s boards to executive compensation schemes to
bankruptcy laws.
Like the American cases, the Parmalat scandal has raised questions
about how the company could fudge its numbers for so long without any
help from outside. The auditors, says Mittelstaedt, should have least spoken
to Bank of America to verify that they held the $4.9 billion Parmalat
claimed.
The system of checks and balances that support corporate governance
needs to function effectively. Consequently, both Enron and Parmalat
highlight the essential functions of non-executive directors, audit and
disclosure, as well as ethicality of management. Corporate governance
mechanisms cannot prevent unethical activity by top management. However,
they can at least act as a means of detecting such activity by top management
before it is too late. When an apple is rotten, it has no cure. Nevertheless, the
rotten apple can be removed before the infection spreads and infects the
whole barrel. Therefore, an analysis of the Enron and Parmalat cases shows
that both the US and corporate governance systems are so different in
character. Additionally, they can be vulnerable to abuse and corporate
governance weaknesses which are similar in nature. This is really what
effective corporate governance is all about. Therefore, this study aims to
explore the various checks and balances, and mechanisms by which good
corporate governance ensures successful business and social welfare
maximization.

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Aguilera & Jackson (2011). Comparative and International Corporate
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Anderson, Melanson & Maly (2007). The Evolution of Corporate
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Agyei & Owusu (2014). The Effect of Ownership Structure and Corporate
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http://economics/

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