“Three years after the Parmalat scandal, what Italy still lacks is an open market for corporate control and a managerial culture sensitive to the value of corporate governance” says a Conference Board expert in a new study of international convergence of governance standards.
November 14, 2006…The magnitude of the Parmalat collapse has put Italy’s approach to corporate governance under close scrutiny by the international community. To respond to criticism, meet European harmonization requirements, and restore investor confidence, Italy has legislated stringent reforms in corporate and securities laws and regulatory agencies have been given stronger investigative and sanctioning powers. As a result, Italian companies today must comply with governance standards that are comparable to those of other developed financial markets in the world.
“But the recent reforms may provide a false sense of security to the investment community, because for each important advancement in governance legislation, much progress still needs to be made on the enforcement side,” says Matteo Tonello, LL.M., Ph.D., a corporate governance expert at The Conference Board and author of a new major study of international convergence of corporate governance practices. “Without the ability to enforce the law, any new provision remains meaningless.”
Despite the convergence of corporate rules and conduct towards widely accepted international standards, Italian companies still score much lower in terms of governance ratings than their Anglo-American counterparts.
STRENGTHENING THE ENFORCEMENT SYSTEM
The Parmalat story clearly exposed the poor performance of public oversight bodies such as the financial market regulatory agency (CONSOB) and the Bank of Italy. As early as 2002, certain financial analysts had expressed concerns about the reluctance of Parmalat’s management to provide explanations of its financing strategy. Specifically, it was unclear why the company needed to raise capital through complex and expensive bond placements rather than use the large amounts of cash (falsely) reported on its balance sheet. And yet CONSOB did not start to investigate Parmalat until late 2003, when it became evident that market forces were discounting Parmalat stock in reaction to these business practices. The Bank of Italy was at this time also being criticized for failing to share with CONSOB important information on distressed and defaulted debt evident in the central bank records.
“Many of these shortcomings have been corrected by the most recent legislation, which designs new channels of communication among enforcement agencies and carves out specific exceptions to the laws on the protection of privacy and use of privileged information,” Tonello observes. “But the effective cooperation of enforcement activities is the result of protocols and arrangements that are still being developed. Ultimately, what counts is to ensure that monitoring bodies are given the financial and human resources to detect and prevent any wrongdoing before it adversely affects the market.”
The study also points to the need for stronger protection of smaller investors under Italian rules of civil procedure. Where they had the option, many investors chose to sue Parmalat’s lending banks and external auditors in U.S. courts. U.S. courts are perceived to have more expertise in corporate and financial matters, provide more certainty of outcome because of their extensive case law history and to be more likely to provide an expeditious recovery of damages. “The deterrent effect of potential litigation cannot be underestimated,” says Dr. Tonello. “In the United States, class actions can have enormous consequences on corporate and personal assets. Similar litigation tools are simply not available under Italian law or in many other European countries.”
THE STRENUOUS DEFENSE OF CORPORATE CONTROL
Italy’s Parmalat is a notable example of how the need to preserve a controlling position prevailed over a sound long-term strategy and ultimately led to failure for both the defrauded investors and the controlling family. In Parmalat, a controlling shareholder was able to exploit a system that is not tough enough on transparency and accountability. When the scandal broke, on December 19, 2003, Parmalat was already scoring low on the Institutional Shareholder Service’s Global Corporate Governance Quotient. The company appeared at the very bottom of a list of 69 Italian companies rated by the proxy service provider, and was outperforming only 2.8 percent of businesses in the MSCI EAFE index (which comprises a variety of firms listed in major European and Asian exchanges).
Throughout the 1990s, Parmalat appeared to be a successful multi-national company, boasting an array of widely recognizable consumer brands as well as distribution channels in many parts of the globe. Below the surface, however, the company had abandoned a sound expansion strategy for an obscure and misleading financial scheme that preserved the controlling power of the founder’s family. Fraudulent transactions at Parmalat were possible because of affiliations between directors and owners, independent board members’ lack of expertise in finance and risk management, and corrupted entanglements with statutory auditors and the investment banks engaged by the company to place risky debt securities among retail investors. “Through these and other shortcomings in the company’s governance system, the controlling shareholder managed to hide its inability to face the new challenge of a competitive and globalizing market,” commented Dr. Tonello. “Had the company truly participated in an open and transparent market for corporate control, its share value would have reflected such inability and prompted a management change.”
MAKING THE SYSTEM COST-EFFECTIVE
Says Dr. Tonello: “The securities law reform recently passed by the Italian Parliament was clearly influenced by the Sarbanes-Oxley Act and the belief that better corporate practices should result from a more stringent regulatory regime. And yet this view of corporate governance is now being questioned in the country where it has originated from: the United States.”
As a result of the high costs of Sarbanes-Oxley compliance, the U.S. stock market is no longer the market of choice for European companies interested in raising equity capital. According to Dr. Tonello, in drafting the new law, the Italian regulator should have considered such data about the U.S. experience. “Compared with other European markets, the Italian stock market is still very small: what we need is to encourage new IPOs, whereas additional costs may drive away prospective issuers and investors.”
THE ROLE OF ACTIVIST, LONG-TERM INVESTORS
“For the future, it is important for the Italian financial market to fully appreciate the contribution that may be offered by long-term institutional investors to the formation of valuable corporate governance standards,” Dr. Tonello adds. “The success of certain experiences, such as CalPERS’ Focus List in the United States or USS’ Enhanced Analytics Initiative in the U.K., is remarkable. It indicates how outside watchdogs, such as investors and financial analysts, can directly participate in the enhancement of corporate governance. Specifically, they can put pressure on senior executives to invest on what should be considered a fundamental intangible corporate asset, generating enterprise value and competitiveness for the public company. Should this approach become mainstream, even in Italy, the future development of governance practices would be economically efficient and tailored to the needs of each business, without the unnecessary costs of certain rigid regulatory solutions.”
CEDAM, 2006, 826 pages, Euro 85.00 in Italian
The book includes four chapters, which cover, respectively: 1) the debate on international convergence of corporate governance standards; 2) the role of the corporate board and internal controls; 3) external controls (gatekeeping); 4) corporate disclosure. In addition to discussing the effects of the Sarbanes-Oxley Act of 2002 on foreign private issuers and the European Commission’s Action Plan on corporate governance, the book is updated with the recent Italian securities law (No. 262/2005) and the new Italian Code of Best Practices (March 2006).
Foreword by Francesco Galgano, Professor of Law at the University of Bologna, Member of the Government Commission on Corporate Law Reform and President of the Commission of Study on Corporate Transparency.
Dr. Matteo Tonello is Senior Research Associate and Acting Associate Director at The Conference Board Governance Center. He received a Master of Laws degree from Harvard Law School and a J.D. from the University of Bologna. He also earned a Ph.D. in Law from the St. Anna Graduate School of the University of Pisa (Italy). Dr. Tonello was a Visiting Scholar at Yale Law School in 1997 and practiced corporate law at Davis Polk & Wardwell from 1998 to 2004. Recently, he advised the Italian Commission of Study on Corporate Transparency about the effect of the Sarbanes-Oxley Act on foreign private issuers. In Italy, he is a member of the editorial board of Contratto e Impresa and the author of articles and essays for several Italian law journals. His publications include Revisiting Stock Market Short-Termism (The Conference Board, 2006), Emerging Corporate Governance Practices in Enterprise Risk Management (forthcoming), and The Role of U.S. Corporate Boards in Enterprise Risk Management Oversight (with Carolyn K. Brancato and Ellen Hexter, The Conference Board, 2006). He can be reached at +1 212 339 0335 or, via email, at matteo.tonello[at]conference-board.org