Post on 21-Apr-2022
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Analyses of Corporate Scandals and Fraud in Europe: Environmental,
Market and Corporate Characteristics
ABSTRACT
This study analyzes the processes that lead companies to sink into fraud in the European context
at the institutional, corporate and firm levels. Using an extended theoretical framework, the study
examines the six most significant European financial scandals: BCCI (UK), Gescartera (Spain),
Parmalat (Italy), Royal Ahold (Netherlands), Skandia (Sweden) and Vivendi Universal (France).
This research supports the shortcomings in the regulations at the European institutional and
national levels with respect to business ethics, corporate functioning and governance. It also
sheds light on the conditions of the bubble economy and the spirals created by increased pressure
from the market during the period preceding the corporate scandals.
Beyond the similarities of the major causes of failures in these companies, the analyzes provide
insights into unethical behaviour, ineffective boards/governance, dominant CEOs and family
shareholders/blockholders, the alignment of incentives of management and major shareholders,
accounting irregularities, inefficient internal controls and the failure of auditors.
Key words: European Corporate Scandals, Failing Regulations, Bubble Economy,
Family Ownership, Ineffective Board/Governance, Management Incentives
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1. Introduction
There has been growing criticism of the functioning of the capital market economy, particularly
with regard to management misconduct and unethical corporate behaviour, the lack of high-
quality accounting and financial reporting, the inefficient role of intermediary parties (auditors
and financial analysts) and ineffective corporate governance and control mechanisms. The
numerous cases of corporate deviance and high-profile financial scandals in the last decade in the
United States (e.g., Enron, WorldCom, HealthSouth, Adelphai, Delphi and Halliburton) provide
some insights into the ‘dark side’ of the capital market economy and show that without resolving
several central corporate issues and bottlenecks – some of which are related to the structural
nature of the capital market economy – it is highly unlikely that the market can run smoothly in
the future.
In addition to the ‘big financial scandals’ in the US, Europe has also experienced its share
of corporate frauds, and was in the throes of several significant high-profile cases during the
same period, caused by management misconduct and wide-ranging corporate deviance. However,
for several reasons regarding institutional, cultural and regulatory factors as well as the role of the
media, the US cases have been largely publicized. A few of the cases have received particular
attention in the academic literature (Enron and WorldCom), especially from the viewpoint of
management misconduct and the problems associated with accounting, auditing and corporate
governance, despite the fact that the reasons for corporate deviance and financial scandals extend
much further than these shortcomings.
Glancing at the European environment, there has been very limited media coverage and
few research publications in the academic literature, compared with the US context. In this study,
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we approach corporate fraud issues from a different angle and in a much broader context than
accounting, auditing and unethical corporate and managerial topics, which are used in most
previous studies conducted in the US. Furthermore, we conduct an in-depth analysis of corporate
fraud and financial scandals in the European context at three interrelated levels – institutional and
regulatory, financial market and firm – of six major financial scandals and cases of corporate
deviance (BCCI, Gescartera, Parmalat, Royal Ahold, Skandia and Vivendi Universal),
respectively, in six different marketplaces in Europe (the UK, Spain, Italy, the Netherlands,
Sweden and France).
In line with the above-defined scope, we set up a theoretical framework including the
aforementioned issues in which we then examine three research questions. The first deals with
the European environment, in which six selected cases of high-profile financial scandals
occurred. This contributes to a better understanding of the catalyzer effect of the environmental
factors that may provide favorable conditions for corporate fraud. The second question examines
the role of the bubble economy and market pressure, which may affect management behavior in
committing fraud. Questions 1 and 2 are interrelated, particularly because the European capital
market, similarly to the American context, operates under the law and regulatory frameworks and
the key issue is that the market conditions, whether favourable or unfavorable, should affect the
policy makers. The third research question attempts to provide insights into the firm-specific
characteristics of the six selected high-profile European corporate failures, particularly with
respect to the shareholder structure, the alignment between executive compensation packages and
shareholders’ interests, an ethical climate and control environment, governance and control
mechanisms and the role of external auditors.
The present study differs in several respects from the previous papers. First, it concerns
corporate fraud in the European environment, which has not, compared with the US context, been
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sufficiently debated in the academic literature. Second, in contrast to most published papers
relevant to American corporate fraud cases, which mainly deal with accounting irregularities,
auditing and unethical management behaviour, the current paper examines corporate fraud and
financial scandals at a deeper level within the company and the environment in which it operates.
Indeed, this research study considers the environmental factors and market conditions that may
be determinant in creating a favorable climate for organizations and those who are in command to
sink into fraud. The third major contribution is that the paper sheds light on the process of
corporate fraud from a board range of multidisciplinary perspectives, including the influence of
the shareholder structure (e.g., family ownership and shareholders’ concentration), a poor ethical
climate, creative accounting and fraudulent financial reporting, ineffective corporate governance
and control mechanisms and market-based management compensation. Rather than looking
solely at the causes of corporate failures and scandals, we believe that the research approach of
this study, which is based on analyses of the processes that lead companies and managers to sink
into fraud, provides better insights into corporate and management fraudulent actions.
The paper is organized as follows. After discussing the research motivation and its
contributions, we shall begin with an introduction to the theoretical framework for our study.
This includes a literature review regarding the main theoretical topics that will be discussed in the
paper. The third section presents the research design, the procedure for selecting and analysis of
the sample companies and the research questions. Subsequently, we present the results of our
analyses by referring to the three research questions. The concluding remarks of the study will be
provided in the final section.
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2. Research Motivation and Contribution
The issue of corporate fraud has been extensively analyzed, particularly in the last decade, with
an increasing number of high-profile financial failures. However, most previous research papers
examine corporate fraud scandals in a general manner and particularly in the US context with
respect to accounting irregularities, financial statement fraud, auditors’ failures and management
misconduct (e.g. Baker and Hayes 2004; Brody et al. 2003; Craig and Amernic 2004; Cullinan
2004; Ferrel and Ferrell 2011; Hogan et al. 2008; Lee et al. 2008; Morrison 2004; O’Connell
2004; Rezaee 2005; Reinstein and McMillan 2004; Rockness and Rockness 2005; and Unerman
and O’Dwyer 2004).
Besides the scope limitation of the above research studies and the point that most of them
were oriented towards accounting, financial reporting and auditing issues, they were exclusively
related to the US financial markets, whereas there has been a significant number of corporate
fraud cases in recent years in other parts of the world. In the European context, apart from the
case of the UK-based BCCI, which, due to the size and importance of the fraud as well as its
political implications, received substantial publicity in the media and was subject to several
special reports by political institutions (e.g., UK House of Commons 1991 and 1992a and b; U.S.
Senate Committee on Foreign Relations 1992 a and b) and several research studies (e.g., Mitchell
et al. 2001; Lee et al. 2008), the other European cases have been examined only in a few research
documents (e.g., Soltani and Soltani 2008; Cohen et al. 2011; Soltani 2005, 2013).
This paper is particularly interested in the environmental conditions within which
corporate frauds and financial scandals occur as well as in a broad range of firm-specific
characteristics. The main objective of this paper is to examine corporate scandals and financial
fraud within the European context by using a broad theoretical framework and by taking into
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consideration the factors associated with the European regulatory framework (laws and
regulations) and financial market. Although we acknowledge that financial and corporate fraud
is, in most cases, intentional, the study aims to provide an insight into the processes that lead
publicly listed companies and top management to sink into fraud. For this reason, the discussions
and analyses in this study are presented at three interrelated levels: the institutional and
regulatory framework, the financial market and firm-specific characteristics. Despite the fact that
there may be other reasons beyond these three key factor drivers, such as tough competitive
market conditions in terms of the product and sector of activities and the willingness of
companies to keep their leadership positions, we believe that the analyses presented in this paper
shed light, to a great extent, on the sources, conditions and causes of recent corporate fraud and
financial scandals.
For the purpose of this study, we select the six most significant, high-profile and
publicized cases of corporate deviance occurring during the 1990s and at the beginning of the
2000s in six influential European financial markets. These include the UK-based Bank of Credit
and Commerce International (BCCI), the stock broking firm Gescartera, the biggest business
scandal in Spain, the Italian dairy and foods giant group Parmalat, the Dutch group of the
supermarket chain Royal Ahold, the Swedish insurance company Skandia, the oldest company on
the Stockholm Stock Exchange, and Vivendi Universal, the French multinational group.
The criteria for selecting the above six corporate fraud cases are based on several factors,
such as the diversity of the marketplace, the large scale of the fraud committed and the volume of
their activities (assets, sales, revenue and profit) before their collapse. All six cases were among
the leaders in their respective sectors of activity and either were listed simultaneously on their
local markets and the New York Stock Exchange (Royal Ahold and Vivendi Universal) or had a
relatively large volume of activities in the US (BCCI, Parmalat and Skandia). Several of the
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selected cases (BCCI, Parmalat, Royal Ahold and Vivendi) were quite comparable to well-known
cases of fraud at the international level, such as Enron and WorldCom in the United States. In our
choice, we also consider the multiplicity of types of frauds and deviances committed as we did
not want to analyse only the cases of fraudulent financial reporting, auditing and governance
similarly to most studies conducted in the US context.
The current research paper has three specific characteristics that substantially differentiate
it from previous studies. Firstly, to understand the root causes of financial failures and scandals,
the paper focuses on the European corporate context in which, to our knowledge, there are
serious deficiencies from the viewpoint of academic publications and media coverage. This may
be due to a lack of sufficient public disclosure and poor transparency around corporate affairs in
the European media and business community. The paper emphasizes the importance of
environmental factors (institutional, law and regulatory framework and financial market) in the
European context, which differs substantially from the US context. The European context is
unique at the worldwide level with its particularities in political institutions, law-making process
and diversities within the member states (political systems, cultural, social and economic factors).
The European Union currently consists of 28 member states, which are sovereign with regard to
their political system and institution but in many respects depend on the decisions of the
European Parliament, its council and the nominated commissioners.
There are indeed several differences between Europe and the US, particularly with respect
to the regulatory framework (e.g., according to Coffee 2005, stronger public and private
enforcement and intensity of laws exist in the US compared with Europe), the characteristics of
the financial market (more family ownership and greater shareholder concentration in European
public companies than in US corporations) and the corporate governance rules (they are set up in
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Europe in two forms: the laws, directives and recommendations of the European Commission and
the national laws of the member states, in contrast to the mandatory nature of SEC regulations).
The second motivation of the paper is to examine the impact of the bubble economy and
the pressure that the financial market may exercise on corporations and management to meet its
expectations. This is an interesting issue for discussion, particularly in the European context,
because European public companies involve more family ownership and strong shareholder
concentration than US corporations (Coffee 2005); hence, this may facilitate the alignment
between the incentives of major shareholders and the market-based management compensation.
Indeed, it would be interesting to examine the link between the conditions of the bubble economy
and the expectation of the financial market in terms of earnings management with what Desai
called the “giant financial-incentive bubble” (Desai 2012, p. 124), referring to the large sum of
money that certain board members have assigned to themselves in the form of salary, bonuses
and stock options.
The third main feature of the paper is to investigate corporate fraud by using a broad
theoretical framework, which, although it includes the topics that are usually examined in
previous papers (accounting irregularities and fraudulent financial reporting, auditing and
unethical management behavior), it also considers other important issues, such as the influence of
the shareholders’ structure, the link between the major shareholders’ interest and the management
compensation package and incentives, an organizational ethical climate and control environment,
and corporate governance and control mechanisms. The paper advocates that although accounting
irregularities, fraudulent financial reporting and auditing matters are among the essential causes
of corporate fraud, they are not the main sources of corporate deviance and financial scandals.
We believe that a thorough analysis of high-profile financial fraud and scandals should be
undertaken within a broad range of factors at the institutional, financial market, corporate and
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managerial levels. This argument is based on the grounds that accounting and financial reporting
do not operate in a vacuum. While the six selected European cases in this study have been
described by the media, regulatory bodies and some academics and professionals as ‘accounting
scandals’, accounting and auditing irregularities are part of a long chain of unethical behavior
involving various actors inside and outside corporations.
We believe that the aforementioned specific characteristics and multidisciplinary
approach used in this study by considering the environmental factors (e.g., laws, regulations and
financial market conditions) as well as employing an extended theoretical framework provide
potential contributions to a better understanding of the processes and the root causes of corporate
fraud and financial failures. Finally, due to the wide variety of topics covered in the paper and the
discussion on relevant studies, this research may contribute to the academic literature on
corporate financial fraud and scandals, forensic accounting and corporate governance and provide
practical implications in related areas.
3. The theoretical Framework of Corporate Fraud: Institutional, Market and
Firm-Specific Characteristics
In this paper, we build a theoretical framework upon a three-legged stool consisting of
institutional and regulatory, financial market and company-specific characteristics. This
framework, which will be used in the definition of three research questions and the examination
of six selected cases of corporate fraud and financial failure, is based on our conceptual analysis
and the review of a wide range of published literature and documents relevant to this research.
We believe that this framework and its interrelated components provide a solid basis for our
discussions regarding the process and the root causes of corporate fraud and financial scandals.
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Although we examine this framework in the European context with its specific financial market
characteristics and institutional and regulatory patterns, in our opinion, because of the common
features, the framework can be extended to other environments, such as the US.
In the first part of this framework, the paper aims to discuss the existence and the
sufficiency of the laws, regulations and codes released by the European Commission and the
national bodies in the related areas. The second part of the framework discusses the importance
of the bubble economy and market expectations in exerting pressure on companies and
management, which seek to align their interests with the market by releasing optimistic and
favorable earnings that may eventually lead to fraudulent financial reporting. The third part of the
framework provides an insight into essential firm characteristics – as outlined below – which may
be determinant in corporate fraud and financial scandals.
- Shareholders’ structure: family ownership and shareholders’ concentration;
- Alignment of shareholder interests and management compensation packages and incentives;
- Organizational ethical climate;
- Creative accounting, fraudulent financial reporting and auditors’ failures;
- Corporate governance and control mechanisms;
We provide in the following sections an overview of the components of our theoretical
framework.
3.1 The European institutional and regulatory framework
The European Unioni was created in the aftermath of the Second World War with the objective of
reinforcing economic cooperation within Europe. In line with this objective, the European
Economic Community (EEC) was created in 1958 with the aim of increasing the economic
cooperation between six countries: Belgium, Germany, France, Italy, Luxembourg and the
Netherlands. What began as a purely economic union has evolved into an organization spanning
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policy areas, from development aid to the environment. A name change from the EEC to the
European Union (EU) in 1993 reflected this. Currently, the EU is a unique economic and political
partnership between 28 European countries that together cover much of the continent.
Harmonization of the rules and regulations relating to company law and corporate
governance, as well as to accounting and auditing, has been an essential objective for creating a
single market for financial services and products in the EU. However, the objectives set out by
the European institutional bodies in these areas are very much market-oriented. This interest has
gained considerable momentum since the late 1990s with the increasing size of the capital market
and the number of companies in Europe.
With respect to the transposition of the European Commission regulations, the member
states of the EU (of which there are currently 28) can use different legal instruments (law and
code) in order bring into force the provisions necessary to comply with the regulations. With
respect to corporate issues, the distribution of corporate governance-related principles between
law and code in each member state depends on a number of factors, including legal tradition, the
ownership structure and the extent of development in such areas. Three of the selected countries
in this study (France, Italy and the Netherlands) joined the European Union in 1952 and two
others (the UK and Sweden) in 1973 and 1995, respectively; all have a relatively long
background in regulating the financial market, company laws, corporate governance and
accounting and related issues, particularly the UK, which heads the list with an outstanding
position at the global level. In the six selected countries, some matters are traditionally regulated
by law in accordance with European legislation, including general board organization, procedural
shareholder rights, audit committees and statutory auditing. Other issues, such as board members’
independence, remuneration and nomination committees, or internal control and risk
management, are more often covered by codes. Although the European Union is based on the rule
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of law, the EU’s decision making and legal procedure are extremely complex due to diversities
among the member states in the areas of political structure, cultural values and social and
economic systems.
3.2 Literature review of the European corporate governance studies
To our knowledge, very few research papers (Ball et al. 2000; Collier and Zaman 2005; La Porta
et al. 1998 and 2000; Mintz 2005; Soltani 2005; Nowland 2008; Soltani and Maupetit 2013;
Vander Bauwhede and Willekens 2008; and Sheridan et al. 2006) have been conducted on the
basis of cross-country analysis in the European context, particularly from the perspective of the
European directives, regulations and codes and the characteristics of corporate governance.
Based on a comparative analysis regarding 49 countries, including those used in our
study, La Porta et al. (1998) examine legal rules and their origins covering the protection of
corporate shareholders and creditors. Although there have been significant changes in the
European financial markets since the 1990s, the paper shows that common-law countries, such as
the UK and the US, have the strongest legal protection of investors, in contrast to civil-law
countries such as France and Germany. In line with this paper, La Porta et al. (2000) describe the
differences in laws and the effectiveness of their enforcement across countries. By showing the
possible origins of these differences and their consequences, the authors attempt to assess the
potential strategies of corporate governance reform. They argue that the legal approach is better
for understanding corporate governance and its reforms than the market-centered financial or
bank-centered systems.
The study by Soltani (2005) highlights significant differences between the US context and
four European countries (France, Germany, the Netherlands and the UK), particularly in terms of
the characteristics of corporate governance, audit committees, sanction and disciplinary policies,
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oversight bodies and control mechanisms. Using content analysis of the European codes, Soltani
and Maupetit (2013) examine the extent to which the European codes and regulations,
particularly those issued after 2002 and 2007, consider several important issues, such as ethics
and corporate behaviour, shareholder rights and board accountability. The analyses show that
there are severe shortcomings in the European corporate governance codes regarding the
importance given to ethical values, integrity of management and accountability mechanisms.
Vander Bauwhede and Willekens (2008) examine the determinants of the quality of
corporate governance disclosure policies among European listed companies in the time preceding
the adoption of the European Union recommendations and Action Plan (European Commission
2003). The authors find that the level of disclosure is lower for companies with high ownership
concentration and higher for companies from common-law countries, and it increases with the
level of working capital accruals. Ball et al. (2000) attempt to characterize the ‘shareholder’
model of common-law countries (Australia, Canada, UK and USA) with the ‘stakeholder’
approach to corporate governance of code-law countries (France, Germany and Japan) as a way
of resolving information asymmetry by public disclosure and private communication. They
showed that “common-law accounting income exhibits significantly greater timeliness than code-
law accounting income, but that this is due entirely to greater sensitivity to economic losses
(income conservatism)” (1999, p. 26).
From the viewpoint of the effect of corporate governance codes on voluntary company
disclosure practices, two papers by Nowland (2008) and Sheridan et al. (2006) provide
contradictory analyses. On one hand, the study by Nowland (2008) concludes that a regulatory
approach to improving disclosure practices is not always necessary since voluntary national
governance codes have a significant direct and indirect effect on company disclosure practices.
On the other hand, Sheridan et al. (2006) indicate that the introduction of the UK codes of
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Cadbury, Greenbury and Hampel relating to corporate governance were accompanied by a
significant increase in the number of news announcements.
Several other papers examine specific aspects of corporate governance in the European
context. Collier and Zaman (2005) analyse recent corporate governance codes issued by twenty
countries for evidence of convergence in the corporate governance systems in Europe, suggesting
that there has been a degree of convergence towards an Anglo-Saxon model as the audit
committee is widely accepted in countries with both unitary and two-tier governance systems. By
considering the corporate governance systems in the UK and the US, two examples of strong
shareholder ownership patterns of financing, and Germany, a country with a tradition of strong
credit financing, the study by Mintz (2005) emphasizes the importance of an ethical tone at the
top and high-quality internal control in voluntary codes of governance.
In summary, the above studies highlight the absence of a significant effect of the
European Commission codes and regulations on companies’ disclosure policies, which are
influenced more by voluntary national governance codes than by the regulations imposed by the
Commission. This also supports the shortcomings of the European Commission directives and
regulations, which may result from the comply or explain concept.
3.3 The bubble economy, market expectation and earnings management
Based on our research framework, the second pillar of theoretical discussion concerns the effect
of a bubble economy and market expectations on high-profile corporate fraud. The relationship
between a bubble economy and corporate scandals is an important issue that has not been
sufficiently debated in the accounting and finance literature, whilst it has been discussed in the
law literature. Coffee (2005) states that “conventional wisdom explains a sudden concentration of
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corporate financial scandals as the consequence of a stock market bubble. When the bubble burst,
scandals follow, and eventually, new regulation” (2005, p. 1).
Several research studies provide evidence that high-profile corporate scandals are, to a
great extent, associated with fraudulent financial reporting and management efforts to manipulate
accounting information (e.g., Soltani, 2013; Cohen et al. 2010). There has also been strong
concern about the relationship between a bubble economy and the use of financial market-based
compensation in a capital market economy. This concern is legitimate because, as highlighted by
Soltani (2013), when there is a strong relationship between the incentives and rewards of top
management and major investors on one hand and the factors such as corporate performance, the
appetite for risk and excess returns on the other, this would have an unfavorable effect on the
company’s risk management policy as well as on the smooth running of corporations and the
financial market. Desai (2012) argues that “when risk is repeatedly mispriced because investors
enjoy skewed incentive schemes, financial capital is being misallocated. When managers
undertake unwise investments or mergers in order to meet expectations that will trigger large
compensation packages, real capital is being misallocated” (p. 133).
Besides the management’s personal incentives, several factors, such as responding to the
demand of major shareholders and the pressure exercised by the financial market, can be
considered as determinant factors in corporate fraud. These could occur when, due to pressures to
meet market expectations or a desire to maximize their salary and bonuses, top management
intentionally take positions that lead to fraudulent financial reporting by materially misstating the
financial statements.
Additionally, other reasons such as the increasing number of public companies, the
expansion of the financial market and the high valuations of equity securities, have put
tremendous pressure on the management to achieve high earnings or other performance targets.
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In a capital market oriented towards profit maximization, certain existing or potential
shareholders seek short-term profit from their investment, and some securities analysts may have
a tendency to respond to these expectations. The expectations of shareholders with regard to
companies’ financial performance may affect the perception of top management when making
investment and financing decisions. The failure or incapacity of the management to meet
earnings targets can result in significant declines in a company’s market capitalization and this in
turn negatively affects the financial-market-based compensation of corporate managers, whose
income largely depends on achieving earnings or stock-price targets.
Although the bubble economy and the market expectation for high earnings growth are
not the only cause of financial scandals, they are considered as the determinant factors by several
authors. Ball (2009) seeks to explain the reasons that lead to the occurrence of a large number of
cases in such a short period from 2001 to 2002. Based on the premise that the longest boom in
US history ended in March 2001, he describes the economic cycle that produces the strong
effects of such a boom on financial scandals. He argues that “in an extended boom, high growth
becomes built into performance expectations: into earnings and revenue forecasts, budgets, share
prices, option values, investment decisions, and debt commitments” (2009, p. 283). Based on
Ball’s hypothesis, “the boom ‘busts’, growth suddenly falters, and around the same time many
managers are unable to meet expectations” (2009, p. 283). This is the starting point of a sequence
of cycle-related events including the pressure exercised by the market on managers to deliver
strong earnings growth and share market performance and their attempts to disguise their
faltering performance by either faking transactions or adopting unaccepted accounting methods.
This process may result in the company’s financial failure, which is either detected in time or
passed through as not all such cases have become known to the public.
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The bubble economy may also push managers to adopt different policies in terms of
earnings management. Rather than adopting a policy of strong earnings growth announcement,
managers may use a smooth earnings disclosure policy. In a disordered market economy, share
prices may tend to be lower for companies with erratic earnings patterns because such companies
are perceived by the market to be riskier. Managers are therefore motivated to manage earnings
to achieve a smooth pattern for the purposes of a higher share price (Brennan, 2003, p. 7).
Similarly, as Warren Buffett acknowledges, “smooth earnings growth looks pretty, and it makes
Wall Street happy, but it is a profoundly unnatural condition. Business is cyclical. The economy
is cyclical. Pretty earnings are generally a sign that there is an artist at work in the accounting
department” (2006, p. 1).
Apart from the consequences of the bubble economy for earnings management, the
unusual market conditions may provide misleading signals to market participants seeking to
invest in companies. It also reduces the credibility of the financial statements of companies
because of significant differences between the market and the book value. Soltani (2007) points
out that as share prices soared in the bubble economy, people pointed to the growing gap between
the book value of companies (appearing in their accounts) and their market capitalization (valued
on stock exchanges) as evidence of the irrelevance of accounts (2007, p. 580).
The bubble economy may also have a misleading effect on regulators and intermediary
parties who are responsible for protecting the public interest. As stated by Ball (2009), the bubble
economy contributes to the risk of “falling asleep at the switch because corporate monitors
(boards, internal and external auditors, analysts, rating agencies, the press and regulators) come to
accept high growth as normal” (2009, p. 283). There is also a serious concern about the negative
effect of the bubble economy on the performance and independence of corporate governance and
audit committees, which may not be able to give a warning signal in time to take immediate
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preventive measures in the case of fraud. “As the bubble economy encouraged corporate
management to adopt increasingly creative accounting practices to deliver the kind of predictable
and robust earnings and revenue growth demanded by investors, governance fell by the wayside.
All too often, those whose mandate was to act as a gatekeeper were tempted by misguided
compensation polices to forfeit their autonomy and independence” (American Assembly Report
2003, p. 5).
3.4 Firm-specific characteristics
The third pillar of our theoretical framework in this study is related to company-specific
characteristics. In this section, we discuss the key points of these characteristics, which will be
used in the analysis of the six European corporate fraud cases.
3.4.1 The shareholder structure: family ownership and concentrated shareholdings
The shareholder structure may have a substantial effect on a company’s activities in the areas of
investment, financing and dividend policies. The existence of a concentrated and family
ownership structure in the European context compared with dispersed shareholdings in the US is
highlighted by several authors (Ball 2001, 2009; Ball et al. 2000; Coffee 2005).
The presence of large shareholders addresses the agency problem as they have both a
significant interest in profit maximization and enough control over the assets of the firm to attain
their objectives. This presence may have some unfavourable effects on the company’s affairs
because, as pointed out by Shleifer and Vishny (1997), “although large investors can be very
effective in solving the agency problem, they may also inefficiently redistribute wealth from
other investors to themselves” (p. 774). The blockholders may also put significant pressure on the
management in exercising their power, or perhaps even oust the management through a proxy
fight or a takeover (Shleifer and Vishny 1986).
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The effect of shareholder structure on corporate fraud and financial failures may be a
central issue in this discussion. Based on Coffee (2005), the structure of share ownership is likely
to determine the nature of the fraud across different legal regimes. This structure also influences
the effectiveness of corporate governance and control mechanisms within a corporation.
Comparing dispersed ownership (US) with concentrated shareholdings (Europe), Coffee (2005)
states that “private benefits of control can be misappropriated in a US public company, and recent
illustrations include the Adelphia scandal, where a controlling family diverted assets of over $3
billion to itself in much the same way as did the controlling shareholders at Parmalat” (2005, pp.
208–209).
Ball (2009) compares the European and the US system of shareholder structure and argues
that the existence of controlling shareholders in Europe does not contribute to the effectiveness of
corporate governance and independence and the performance of external auditors. Based on his
arguments, “increased politicization of corporate governance and financial reporting places the
(US) historically successful ‘shareholder’ governance system at risk of degenerating into a
‘stakeholder’ governance system, with representation of major political blocs in writing the rules
and in running corporations” (2009, p. 317). In line with this argument, Ball et el. (2000) state
that the stakeholder approach is the system that produced the ultraconservative, low-quality
financial reporting that is mostly observed in continental Europe.
In contrast to Ball’s arguments (2001 and 2009) and that of Ball et al. (2000), Coffee
(2005) argues that “dispersed ownership systems of governance are prone to the forms of
earnings management that erupted in the USA, but concentrated ownership systems are much less
vulnerable. Instead, the characteristic scandal in such systems is the appropriation of private
benefits of control” (2005, p. 198). Coffee concludes that “the bottom line for regulators is this:
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show us the structure of share ownership, and we can predict the likely scenario for fraud and
abuse” (2005, p. 209).
The issue of shareholder structure in the European context and its impact on several
financial scandals has been highlighted as one of the key sources of market failures. Comparing
the shareholder model, as in the US/UK system with highly dispersed ownership, with the
stakeholder model that allows concentrated ownership of shares, or ‘blockholding which is more
common in Europe, Maddaloni and Pain (2004) find that it is difficult to assess a priori the effect
of ownership structures on financial market dynamics. The authors argue that “prices and
quantities could become volatile if large blockholders pursue policies that ultimately make firms
more vulnerable. However, such investors may equally be more active shareholders, keeping in
close contact with firms’ management to exercise control of their behavior and promoting good
corporate governance. In doing so, they may be able to prevent companies taking on
inappropriate amounts of risk” (2004, p. 34). Based on Maddaloni and Pain (2004), the European
market has a highly concentrated ownership structure dominated by a single blockholder or an
individual investor or group because in 50 per cent of non-financial listed companies in Belgium,
Germany, Italy and Austria, a single blockholder controls more than 50 per cent of the voting
rights. The percentages for Dutch, Spanish and Swedish companies are roughly 44 per cent, 34
per cent and 35 per cent, respectively (Maddaloni and Pain 2004, p. 32). The importance of a
highly concentrated shareholder structure along with the presence of a single blockholder in most
European countries is well demonstrated when compared with a relatively dispersed market like
that of the UK and the US, where the median blockholders account for around 10 per cent (UK),
9 per cent (NASDAQ) and 5 per cent (NYSE).
3.4.2 Alignment between executive compensation packages and shareholders’ interests
21
The relationship between the interests of major shareholders and financial incentives of senior
management are important issues in the discussion on corporate deviance and financial scandals.
This importance is mainly related to the link between, on one hand, the company’s performance,
particularly from the financial market perspective, and, on the other, the compensation packages
of senior executives as well as the company’s dividend policy.
As pointed out by Soltani (2013), corporate financial failure raises the question of whether
the substantial remuneration of CEOs or board members is based on criteria such as performance,
merit, skill and competence or whether it is a product of ‘give-and-take’ and arm’s-length
negotiation between management and major financiers at the expense of other stakeholders’
interests. Similarly, it is argued that “a financial markets-based compensation seeks to align the
interests of managers with those of shareholders and to reward the former in a way that is
commensurate with their performance” (Desai 2012, pp. 126–127). Similarly, the direct
relationship between the dividend policy based on the company’s market performance and the
management compensation package may harm the interests of other stakeholder groups.
Several papers (Coffee 2005; Denis et al. 2005; Desai 2012; Harris and Bromiley 2007;
O’Connor et al. 2006; Persons 2012; and Sen 2007) examine the influence of executive
compensation on corporate fraud and financial misrepresentation. Focusing on fraudulent
financial reporting, Desai (2012) argues that the financial-incentive bubble is an integrated part of
the capital market economy and is also one of the causes of a bubble economy. He states that “in
1990 the equity-based share of total compensation for senior managers of US corporations was
20%. By 2007 it had risen to 70%” (2012, p. 124).
Persons (2012) reports that companies may want to compensate their independent
directors with cash and stock ownership, rather than options, to achieve better alignment of
22
directors’ long-term interests with those of shareholders. With regard to the companies’ choices
for cash payment or stock attribution to senior management, Coffee (2005) states that “executive
compensation abruptly shifted in the United States during the 1990s, moving from a cash-based
system to an equity-based system” (2005, p. 202). This has also been the case of the European
market for the last two decades. The allocation of a significant number of stock options to top
management increases the managers’ equity ownership, and this in turn may affect their
incentives to undertake highly risky projects. The ‘dark side’ of the option-based compensation
for senior executives is that this produces both more efforts to inflate earnings to prevent a stock
price decline and increased sales by managers in advance of any earnings decline.
Harris and Bromiley (2007) provide empirical support for the simultaneous impact of top
management incentive compensation and poor organizational performance on leading firms,
inducing them to act unethically and increasing the likelihood of financial misrepresentation.
Denis et al. (2005) find a significant positive relationship between a firm’s use of option-based
compensation and securities fraud allegations being levelled against the firm because these
options may increase the incentive to engage in fraudulent financial reporting, and this incentive
is exacerbated by institutional and block ownership. The study by Sen (2007) states that increased
ownership of management may not necessarily reduce the propensity to commit fraud. The
author advocates that “what is more likely to be successful is the certainty of determination and
application of the penalty rather than its size” (2007, p. 1123). O’Connor et al. (2006) contrast the
conventional view that CEO stock options aid corporate governance by reducing moral hazard
with the proposal that CEO stock options may subvert sound corporate governance. The authors
report that ‘large CEO stock option grants were sometimes associated with a lower incidence of
fraudulent reporting and sometimes with a greater incidence, depending upon whether CEO
duality was present and whether directors also held stock options’ (2006, p. 483).
23
Several papers discuss management incentives from the viewpoint of ethical
considerations (Angel and McCabe 2008; Kolb 2011; Micewski and Troy 2007 and Moriarty
2009 and 2011). There is also a relationship between executive compensation, earnings
management and fraud (Persons, 2006; Jones and Wu 2010). The importance of these issues
becomes more significant since “there may be a missing link between corporate performance
measurement systems and CEO incentive and compensation plans” (Dossi et al., 2010).
Is the use of financial market-based compensation, which has a direct relationship with
earnings management and the quality of earnings, the best rewarding policy in public companies?
This question is closely linked with the temptations to manage earnings and aggressive earning
management in relationship with market expectations. Incentives to manipulate earnings for the
purpose of enhancing earnings-based compensation are important issues in the corporate
governance and accounting literature (Huson et al. 2012). In the capital market economy, the
good performance and successful outcome of corporations depends, quite naturally, on achieving
earnings targets. As stated by Micewski and Troy (2007), “on the one hand, earnings targets
should motivate management to conduct business affairs so that earnings goals can be achieved.
On the other hand, reaching earnings targets at all costs can result in behavior where the use of
any means anticipated to help in achieving this goal is considered to be justified” (p. 18).
However, there is a significant difference between the US and Europe in terms of
managerial compensation policy. As stated by Coffee (2005), these differences involve both the
scale of compensation and its composition. In 2004, CEO compensation as a multiple of average
employee compensation was estimated to be 531:1 in the USA, but only 16:1 in France, 11:1 in
Germany, 10:1 in Japan and 21:1 in nearby Canada. Even Great Britain, with the system of
corporate governance most similar to that of the US, had only a 25:1 ratio (2005, p. 203).
3.4.3 Organizational ethical climate
24
Following high-profile financial scandals, such as the six cases discussed in this study, there has
been an explosion of interest in ethical behavior with regard to the role of key actors in financial
markets, including the CEO, board members, influential shareholders, auditors and financial
analysts. In our discussion, we will take an interest in the overall ethical climate and the
aggregated perceptions of organizational norms that have been implemented within corporations
in terms of ethics and the code of conduct, the management and subordinate relationship,
management perceptions of leadership and exercise of power and the dysfunctional behavior of
managers. It would be interesting to debate the extent to which normative systems of ethics have
been institutionalized in organizations.
These scandals, which have damaged the reputation of top management, brought to the
surface the unethical behavior, moral debacles and abuse of power by senior management
(Stevens 2004; Andreoli and Lefkowitz 2008). Although the personal characteristics of senior
management are significant antecedents of misconduct in corporate scandals, the central issue is
the formal organizational compliance practices and the ethical climate as the independent
predictors of misconduct within an organization (Andreoli and Lefkowitz 2008, p. 309).
The discussion on corporate wrongdoings and management misconduct can be extended
to the organizational ethical climate as a multidimensional construct concerning the ethical
culture, ethical leadership and control environment. Schneider (1975) defines the climate in an
organization as perceptions of organizational practices and procedures that are shared among
members. Several authors discuss the concept of an ethical climate within the theory of an ethical
work climate (Arnaud 2006; Martin and Cullen 2006; Victor and Cullen 1987, 1988; Wimbush et
al. 1997). Victor and Cullen (1988) state that “the prevailing perceptions of typical organizational
practices and procedures that have ethical content constitute the ethical work climate” (1988 p.
101). The ethical climate is one component of the organizational culture (Cullen et al. 1989) and
25
it is understood as a group of prescriptive climates reflecting the organizational procedures,
policies and practices with moral consequences (1989, p. 177). The ethical climate affects a broad
range of management decisions and because of its multidimensional characteristics it would be
hard to identify a single type of work climate or specific criteria for its evaluation. Crutchley et
al. (2007) find that “the corporate environment most likely to lead to an accounting scandal is
characterized by rapid growth, with high earnings smoothing, fewer outsiders on the audit
committee, and outsider directors that seemed overcommitted” (2007, p. 53).
Several authors discuss the importance of an ethical climate in the context of fraudulent
actions, particularly with regard to organizational leadership (Shin 2012), management
motivation, the pressure exercised by the management on subordinates and the way in which they
rationalize this (Murphy et al. 2012), and family ownership (Duh et al. 2010). Duh et al. (2010)
emphasize a stronger presence of clan cultureii characteristics in family than in non-family
enterprises.
3.4.4 Creative accounting, fraudulent financial reporting and auditors’ failures
Almost all the cases of high-profile corporate scandals, including those selected for the
discussion in this study, involve accounting fraud and fraudulent financial reporting, the use of
inappropriate accounting standards as well as the auditors’ inability to detect fraud. Accounting
and financial statement fraud has cost investors more than $500 billion during the past several
years (Rezaee 2002; Cotton 2002). In such cases, the management has incentives to indulge in
creative accounting techniques, which, in most cases, lead to material misstatements and
significant financial fraud. As defined by Jones (2011), “the managers set the creative accounting
agenda. They wish to portray the accounts in a light favorable to themselves. This may be to
increase profits or increase net assets. The flexibility in accounting allows them to select
accounting techniques which can deliver the profit figure that serves their interests” (2011, p. 21).
26
The management is in charge of the preparation of financial statements and has full
responsibility for implementing effective measures for the prevention and detection of fraud. It
has a dominant position in the company’s structure and possesses a unique ability to perpetrate
fraud because it is frequently in a position to manipulate accounting records directly or indirectly
and present fraudulent financial information. According to Shapiro (2011), traditional accounting
fraud is the intentional misrepresentation of financial statements, punishable criminally or civilly,
in order to obtain an advantage wrongfully, retain a benefit or avoid a detriment (2011 p. 61). In
describing the sequence of cycle-related events that led to the longest boom in US history, ending
in March 2001, Ball (2009) states that “some managers resort to either faking transactions or
adopting unaccepted accounting methods to disguise their faltering performance” (2009, p. 283).
In discussing the factors that may increase the likelihood of financial statement fraud,
Rezaee (2005) states that “cooking the books causes financial statement fraud and results in a
crime” (p. 278). He argues that economic incentives are common in financial statement fraud
cases, even though there are other types of motives, such as psychotic, egocentric or ideological
motives (2005 p. 283). Several papers analyzed the cases of corporate scandals from the fraud
triangle perspective, which involves incentive or pressure to commit fraud, a perceived
opportunity to do so and some rationalization of the act, which are commonly referred to as
‘means, motives and opportunity’iii
Cohen et al. (2010) analyzed the corporate fraud cases
released in the press by including the theory of planned behavior in the notion of the fraud
triangle. The authors emphasize the importance of personality traits in corporate fraud and
suggest that auditors should take a strong interest in the behavior and attitudes of managers when
assessing risk and detecting fraud. However, Soltani (2013) states that the fraud triangle
framework has several major deficiencies and proposes that this framework should consider the
characteristics of the control environment, regulatory context and organizational ethical climate.
27
In line with this discussion, Dorminey et al. (2010) argue that the fraud triangle alone is not an
adequate tool for deterring, preventing and detecting fraud because two of the characteristics of
pressure and rationalization cannot be observed: “All the predator seeks is an opportunity. The
predator requires no pressure and needs no rationalization” (2010, pp. 20–21). Similarly,
Ramamoorti (2008) states that fraud is a human endeavor, and it is important to understand the
psychological factors, including personality, that might influence the fraud offender’s behavior.
Littman (2010) criticizes auditors’ evaluation process of the risks associated with the company’s
activities and financial statements and the framework of the fraud triangle used by them.
The role of internal and external auditors in the prevention, detection and disclosure of
fraud is also important. Many aspects of the recent corporate failures raise concerns about the
nomination/retention of external auditors, the quality of their performance and auditing practices,
their independence and the effectiveness of the oversight mechanisms in auditing. The question
of an auditor’s duties to report fraud to shareholders and the governance structure within the
organization as well as to market regulators has long been an issue of concern in the capital
market economy. Above all, beyond these responsibilities, based on the current auditing
standards and regulations, the external auditors do not owe a ‘duty of care’ to various groups of
stakeholders, such as minority shareholders, employees and clients. External auditors are also
themselves economic agents who try to maximize their revenues and this may in some cases
jeopardize their independence and affect the quality of their performance.
3.4.5. Ineffective corporate governance and control mechanisms
The financial crisis of recent years highlights the strong dissatisfaction with the effectiveness of
accountability, corporate governance and control mechanisms. The significant amount of
corporate deviance and financial fraud in the last two decades provides evidence of serious
concerns and shortcomings in the smooth functioning of control mechanisms both in the US and
28
in the European financial markets. Indeed as pointed out by Coffee (2005), different kinds of
scandals characterize different systems of corporate governance (2005, p. 198).
The investor community distrusts members of corporate management, who are widely felt
to have abused their position at shareholders’ expense. Based on Soltani (2007), “conventional
wisdom suggests that corporate management must be held accountable to ownership, that the
directors and officers must be responsible to the shareholders and that this accountability system
sufficiently limits corporate power so as to make it tolerable in a capital market economy” (2007,
p. 76). The effectiveness of accountability mechanisms depends, to a great extent, on the
management’s willingness to implement formal and informal control mechanisms within an
organization. “After all, it is only accountability that legitimizes the exercise of any power;
because it is the only way to ensure that the power which has been delegated is not abused, that
any conflicts of interest that arise between those who delegate the power and those who exercise
it are properly resolved” (Monks 1993, p. 167).
Referring to the US and European corporate governance systems, Coffee (2005) considers
that high-profile corporate fraud is also a “story of ‘gatekeeper failure’ in that the professional
agents of corporate governance did not adequately serve investors” (2005, p. 204). The poor
governance policy reinforces the idea that corporate executives should not be allowed to make
arbitrary decisions to use other people’s wealth for their own interests. Shareholders need to have
effective accountability and control mechanisms in place for challenging the management when
they believe that the management is not acting in their own interests or is performing poorly. As
stated by Rezaee (2005), “The opportunity to engage in financial statement fraud increases as the
firm’s control structure weakens, its corporate governance becomes less effective, and the quality
of its audit functions deteriorates” (2005, p. 295).
29
Ball (2009), among several other authors, criticizes the increasing regulation of corporate
governance in financial market on the grounds that “increased politicization of corporate
governance and financial reporting places the historically successful ‘shareholder’ governance
system at risk of degenerating into a ‘stakeholder’ governance system, with representation of
major political blocs in writing the rules and in running corporations” (2009, p. 317). Although
Ball (2009) acknowledges the governance failure and ineffective control mechanisms in several
high-profile financial scandals in the US, he does not propose other more effective alternative
means of oversight mechanisms that may substitute the increasing level of regulations.
4. Research Methodology
Figure 1 below demonstrates the three components of our theoretical framework (institutional,
market and company-specific characteristics) in which three research questions are posed. The
discussion on the third level (firm-specific characteristics) includes five major topics (Figure 2).
We selected six high-profile financial failures in six European countries for the purpose of the
study. A brief story of these cases is presented below. The analysis of these cases was based on
reading the press releases and the relevant research papers, professional articles, books’ chapters
and reports of regulatory bodies (the SEC and national regulators).
Insert Figure 1 about Here
Insert Figure 2 about Here
30
4.1 Research questions
Based on the objectives outlined in the motivation of the paper and our theoretical framework, we
will examine the following three research questions (RQs). The first two questions (RQ1 and
RQ2) provide insights into the environmental factors that may cause high-profile financial fraud
from the perspectives of the European regulations and the financial market. RQ3 examines the
firm-specific characteristics of the six selected cases on the basis of five core topics.
RQ1. To what extent did the environmental conditions, particularly with regard to the regulatory
framework at the European and national levels, contribute to the financial failures of the six
groups?
RQ2. To what extent did the conditions of the bubble economy in the six selected financial
markets (France, Italy, the Netherlands, Spain, Sweden and the UK) contribute to the financial
scandals of the six groups?
RQ3. What are the main company-specific characteristics of the six high-profile financial failures
from the viewpoints of shareholders’ structure, alignment of shareholder interests and
management compensation incentives, ethical values, creative accounting, fraudulent financial
reporting, auditors’ failures, and ineffective governance and control mechanisms?
4.2 Sample companies and criteria for selection
We selected six high-profile corporate scandals in six large financial markets in member states of
the EU. The companies were among the most important at the national and European levels and
several of them were also significant on the worldwide scene (BCCI, Parmalat, Royal Ahold and
Vivendi Universal). Above all, the selected cases are not limited to fraudulent financial
accounting and reporting and involve several other types of fraud and parties (e.g., management,
31
major shareholders and family owners, regulatory bodies, external auditors, financial analysts and
politics).
4.3 The brief story of six high-profile European financial failures
Before providing the analysis of the six financial scandals in accordance with our theoretical
framework, we present below the major spotlights and a brief introduction of the cases.
4.3.1 Bank of Credit and Commerce International (BCCI in the UK – 1991)
The BCCI case is one of the biggest banking failures and highly debated financial frauds of the
twentieth century, involving the regulators, particularly the Bank of England. Several articles in
the literature (Adams and Frantz 1993; Arnold and Sikka 2001; Beaty and Gwynne 1993; Kerry
and Brown 1992; and Mitchell et al. 2001) provide an extensive historical analysis of the
bankruptcy of BCCI. From its origins as a small family-owned bank in pre-independence India
and later Pakistan, BCCI’s founder, Agha Hassan Abedi, built an international banking empire
that he envisioned as a Third-World bank capable of competing with Western banks. By 1977,
BCCI was the world’s fastest-growing bank, operating from 146 branches in 43 countries. By the
mid-1980s, it was operating from 73 countries and had some 1.4 million depositors with balance
sheet assets of around $25 billion (Gwilliam and Jackson 2011, p. 383; Mitchell et al. 2001).
On 5 July 1991, upon the receipt of a report from Price Waterhouse concerning the
massive accounting fraud and irregularities as well as non-compliance with banking regulations,
the Bank of England decided to close down the operations of BCCI around the world. The losses
were estimated to be more than $10 billion (Mitchell et al. 2001, p. 2). The U.S. Senate
Investigations (1992, p. 53) showed that BCCI had manipulated accounts, created fictitious
profits and bogus loans, misappropriated deposits and failed to record deposit liabilities.
4.3.2 Gescartera Brokerage House (Spain – 2001)
32
The Gescartera scandal, in 2001, is considered as the most important scandal and story of
corruption that has shaken up the Spanish financial community. Founded in 1992 by Antonio
Rafael Camacho, Gescartera, a brokerage house, was supposed to be a successful stockbroking
operation until the Spanish National Stock Market Commission discovered the $100 million
shortfall at the company. Before its collapse, Gescartera lured around 2,000 investors with
promises of return as high as 10 per cent per month (Gutierrez 2001).
The scandal of Gescartera highlights “… a complex tale of greed, nepotism and fraud that
cast a vivid light on Spain’s traditional old-boy network in business” (The Economist 2001). The
case primarily provides evidence of misconduct, swindles, scams and the use of company assets
by its founder. Besides that, it involves multiple aspects of fraud, corruption and negligence,
including the manipulation of the company’s accounting and financial information, serious legal
flaws in financial regulations, illegal political and business links, and the auditor’s failure. The
Spanish High Court trial took place in 2007 with a total of 14 people accused of embezzlement,
including the founder (Camacho), who was sentenced to 11 years’ imprisonment.
4.3.3 Skandia (Sweden – 2000)
Incorporated in 1855, Skandia, Sweden’s biggest insurer and the oldest listed insurance company
on the Stockholm Stock Exchange, was rocked by a number of scandals in 2000. Before the
discovery of fraud, Skandia was one of the greatest success stories in Europe with outstanding
financial performance in the 1990s. As reported by Rimmel and Jonäll (2011), the “total turnover
grew from €6.96 billion in 1996 to €23.41 billion in 2000. The company’s largest markets were
the US (57 per cent of total sales) and the UK (28 per cent of total sales)” (2011, p. 369).
Rydbeck and Tidström (2003) submitted an extensive investigation report on different
frauds committed in Skandia. The case of Skandia mainly involves fraudulent accounting and
33
reporting information (e.g., embedded value accounting to value the insurance contracts
portfolio), management abuse of power regarding generous contracts including salary, bonus,
option-based incentive schemes and other personal benefits, and ineffective control mechanisms.
When various parts of Skandia were sold off, in transactions of dubious legitimacy, 15,000
pension savers brought a class action suit against the company (Jones 2011, p. 533).
4.3.4 Parmalat (Italy – 2003)
The US regulator described the Parmalat affair as “one of the largest and most brazen corporate
financial frauds in history” (SEC 2003a). The roots of Parmalat as family ownership as well as
Italy’s eighth-largest industrial group before its collapse in 2003 can be traced back to 1961,
when Calisto Tanzi inherited a family food processing business that was started by his
grandfather, ‘Tanzi Calisto e Figli – Salumi e Conserve’ (Tanzi Calisto & Sons – Cold Cuts and
Preserves). The group had diversified its activities and expanded internationally in the 1980s and
1990s to become a giant in the world market for dairy and food products. In 2002, Parmalat was a
corporate giant composed of more than 200 companies operating in 50 countries and employing
more than 36,000 people in more than 140 plants around the world.
Parmalat’s fraud surfaced in December 2003 with the discovery of a ‘black hole’
(Buconero, the Italian equivalent) concerning a bank account in which the company said it had
€3.9 billion (approximately $4.9 billion), but which did not exist (Soltani and Soltani 2008). On
27 December 2003, Parmalat was declared insolvent by the court of Parma and placed into
extraordinary administration by Italian legislative decree. According to the SEC (2003a),
Parmalat, by overstating its assets and understating its liabilities by approximately €14.5 billion
($18.1 billion) from 1997 to 2003, perpetrated a bigger fraud on investors than those of
WorldCom and Enron combined.
34
4.3.5 Royal Ahold (The Netherlands – 2003)
Royal Ahold NV began as a family company – belonging to its founder Albert Heijn – in 1887 in
the Netherlands and evolved from a single grocery store to a big food company in the 1980s and
then became one of the largest multinational groups. The company decided to go public and
listed in Amsterdam in 1948. However, the Heijn family kept its control of the company with the
Heijn’s two sons, Gerrit and Jan, holding 50 per cent of the shares as ‘founder’ shares.
Before its spectacular collapse, Royal Ahold was the third-largest retail grocery and food
services group at the worldwide level and had been listed on the Amsterdam Euronext market and
the NYSE since 1993. In 2002, Ahold reported consolidated net sales of €62.7 billion from
around 5,606 stores in 27 countries, but with a consolidated loss of €1.2 billion (Ahold annual
report 2002). The following year, Ahold revealed more than $880 million in accounting
irregularities at its Columbia-based US Foodservice unit. Ahold also discovered potentially
illegal transactions in its Argentine subsidiary (Disco) and its Scandinavian joint venture. Ahold’s
capital worth continued to erode and in a few days $7 billion of shareholders’ money had
disappeared.
4.3.6 Vivendi Universal (France – 2002)
The history of Vivendi Universal can be traced to 1853, when the Compagnie Générale des Eaux
(CGE) was established as a joint stock company by the French Government to operate in civil
engineering and utilities. In 2000, Vivendi became a media and environmental services
conglomerate with securities traded on the Paris Euronext and NYSE. In 1999, the company
employed 275,000 people around the world with consolidated net sales of €41.6 billion and €2.3
billion operating income.iv
The firm had grown almost entirely through buyouts. Jean Marie
Messier, the company’s chairman and chief executive officer, spent more than €60 billion on
35
acquisitions in 2000 and 2001, using different types of borrowings, including the issuance of
bonds convertible into common shares (Soltani and Soltani 2008).
In March 2002, Vivendi Universal revealed a net loss for 2001 of a staggering €13.6
billion ($17 billion), chiefly due to goodwill charges arising from the collapse in the value of
acquisitions made during boom times. The case of Vivendi involves mismanagement, big bath
behavior and false announcements of earnings, concealed risks and management abuse of power
in terms of compensation packages and financial incentives.
5. Results of the Research Analysis
In line with the research objectives and questions outlined above, we present below our analyses
at the institutional, market and firm levels.
5.1 RQ 1. To what extent did the environmental conditions, particularly with regard to the
regulatory framework at the European and national levels, contribute to the financial
failures of the six groups?
Our analysis of RQ1 is based on the examination and review of directives, regulations, codes and
recommendations issued by institutional and professional bodies at the European (Council and
Commission) and national (six selected countries) levels. This review should mainly be
conducted for the period preceding the major financial scandals. Although it is not the main
objective of the study, we also conduct this analysis for the period post-financial scandals.
Our review of the European directives and regulations shows that before the financial
failures and corporate scandals of the beginning of the 2000s, virtually no directives and
regulations were issued by the European Council or the European Commission in the areas of
market functioning and corporate behavior. The directives issued in the areas of accounting and
36
financial reporting (Fourth Council Directive 1978 and Seventh Council Directive 1983) and the
statutory audits (Eighth Council Directive 1984) did not make any reference to corporate and
managerial issues within publicly listed companies.
At the national level, although there has been significant evolution since the 1990s with
regard to corporate governance issues in European countries, the major initiatives have been in
the form of recommendations without any mandatory obligation, with some exceptions in the UK
context. In the area of governance, from 1991 to 1997, more than ten codes were issued in EU
member states, six of them in the UK. In 1998, interest in governance code development
exploded across the European Union, with seven codes issued in that year alone. Another seven
codes were issued in 1999, six in 2000 and six more in 2001. There were more new codes and
recommendations in 2002–2003. The Cadbury Report (1992) was issued in the UK just after the
high-profile scandal of BCCI. This was the first and most important code issued in the 1990s in
the European context. The main problem with the Cadbury Report was related to its narrow scope
because it was mainly oriented towards accounting, auditing and, to some extent, the composition
of the board and very little was said about other important corporate issues. The most important
recommendations issued in selected countries for this study were the Viénot Reports I and II
(1995 and 1999) in France, Preda Code (1999) in Italy, Peter Code (1997) in the Netherlands and
Código de Buen Gobierno (the Governance of Listed Companies 1998) in Spain. There was no
code of corporate governance in Sweden before 2000 and Corporate Governance Policy (2001)
was the first recommendation issued by the Swedish Shareholders’ Association almost a year
after the financial scandal of Skandia. Besides the point that these codes are essentially presented
in the form of recommendations and are not mandatory for public companies, the results of our
analyses that we cannot present in this paper due to space limitations show that these codes do
not cover, or at least not sufficiently, the critical issues such as management misconduct and
37
abuse of power, earnings management and fraudulent financial reporting, ethical principles, risk
management, shareholders’ rights and the criteria according to which management compensation
can be determined.
Following the financial scandals of the beginning of the twentieth century, the European
Commission launched the vast Action Plan (EC 2003) to reinforce the control mechanisms and
quality of financial reporting within European publicly listed companies. These initiatives led to
the release of several directives, recommendations and legal texts concerning the modernization
of company law and the reinforcement of corporate governance (Directive 2006/46/EC and
Communication COM/2003/0284), shareholder rights (Directive 2007/36), the role of non-
executive or supervisory directors (Commission recommendation 2005/162/EC) and directors’
remuneration (Commission recommendations 2009/385/EC and 2004/913/EC). Directive
2006/46/EC is an important guideline in the areas of accounting, financial reporting and auditing,
but it does not sufficiently cover corporate governance issues. Regarding corporate governance,
the Directive mainly requires companies to disclose an annual corporate governance statement as
a specific and clearly identifiable section of the annual report, but it does not cover the ethical
principles, risk management and issues relating to the conditions that may lead to fraudulent
actions within corporations. In the area of corporate governance, the Green Paper of 2011 (EC
2011) provides the important initiatives of the Commission on this issue.
With regard to market functioning and companies’ requirements, the Directive on insider
dealing and market manipulation (Market Abuse Directive – MAD-2003/6/EC) was among the
major initiatives of the European Commission. It was aimed at reinforcing market integrity by
addressing the issues of price manipulation and the dissemination of misleading information. The
Commission acknowledges that ‘insider dealing and market manipulation prevent full and proper
market transparency’ (Art. 21). However, this Directive, similarly to several others, lacks an in-
38
depth analysis of the conditions (e.g., the reasons for shares’ trading undertaken by members of
top management and those representing major shareholders) as well as the sanction and
disciplinary policies that may be determinant factors in such operations.
In summary, the results of our analyses regarding RQ1 provide evidence of failing regulation
and this prompts two particular comments. Firstly, there were serious shortcomings in the
regulatory framework in the period preceding the financial scandals of 2000s in the European
context (European institutional and national levels), particularly with respect to important topics
including ethics and corporate behavior, accountability and control mechanisms, potential
conflicts of interest regarding management activities, fair treatment of shareholders, effective
oversight frameworks, independence of board members and risk management. Indeed, most of
these regulations and codes are oriented towards financial accounting and auditing. Secondly, the
concept of comply or explain (Directive 2006), according to which listed companies should
comply with the regulations or otherwise disclose and explain to the shareholders (e.g., in the
annual report) the reasons for non-compliance, does not fully contribute to the effectiveness and
the quality of corporate governance. Despite the flexibility of comply or explain concept, there
are serious shortcomings in applying this principle in the sense that it reduces the efficiency of
the EU’s corporate governance frameworks and limits the system’s usefulness. The Green Paper
(European Commission 2011a) reveals that “over 60 per cent of cases where companies choose
not to apply recommendations, they did not provide sufficient explanation” (p. 18). They either
simply stated that they had departed from a recommendation without any further explanation or
provided only a general or limited explanation. The other major weakness of comply or explain
concept is that there is no sanction for those who do not comply. As highlighted, “if explanation
rather than compliance is chosen by enough listed companies, it will become the norm not to
39
comply, and companies will be less inclined to make the effort to comply” (Norton Rose 2003, p.
6).
5.2 RQ2. To what extent did the conditions of the bubble economy in the six selected
financial markets (France, Italy, the Netherlands, Spain, Sweden and the UK) contribute to
the financial scandals of the six groups?
In the capital market economy, the market performance of companies is an important indicator in
evaluating their global performance. This performance, however, is closely associated with a
number of factors, such as the overall market conditions, the way in which the management may
react to various market indicators and the extent to which this may affect the management’s
judgement when reporting on company’s activities. Similarly, the discussion on these issues
should be conducted in conjunction with topics such as top executives’ compensation packages
and incentives and earnings management because of the possible link between these two and
companies’ market performance. For these reasons, the favorable or unfavorable financial market
conditions should be considered in the analyses of corporate behavior in general and particularly
in the processes that lead companies and managers to sink into fraud.
RQ2 aims to provide insights into the market conditions preceding the cases of corporate
fraud and financial scandals in Europe. In line with this objective, we analyze the general trend of
stock prices during the last two decades by using the data of the World Bank, which show the
market value as the percentage of the gross domestic product (GDP) on a yearly basis from 1988
to 2012 for each country. We collected this information manually on a yearly basis and calculated
the average market capitalization over the GDP for the periods 1988–1992, 1993–1997, 1998–
2002 and 2003–2007.
Table 1 below indicates the average market capitalization as percentage of GDP for each
five-year interval and for the six selected countries where the cases of the financial scandals
40
occurred (the figures are rounded to two decimals). For comparative analysis, we also indicate
the relevant figures for 2008, the period of economic crisis (last column), as well as for the
United States.
Insert Table 1 about Here
The overall observation is that there is a significant increase in the market values of listed
companies in the European markets selected in this study. As Table 1 indicates, there is a sharp
increase from 1988 for each five-year interval until 2002, the year just before the news on
financial scandals was disclosed for five of the selected companies (Vivendi, Parmalat, Royal
Ahold, Gescartera and Skandia) listed respectively on financial markets in France, Italy, the
Netherlands, Spain and Sweden. This increase is particularly substantial for the period between
1988 and 2002 preceding the high-profile corporate frauds discussed here. When the average
market values as percentage of GDP for the five-year interval of 1998–2002 were compared with
the figures for 2008, there is clear evidence of a significant increase for all six selected countries.
For the case of the UK-based BCCI, which occurred in 1991, there was an increase in
market values from 1988 onwards, although this increase was not substantial. This may be due to
the specificities of the reasons for its failure which are more related to management misconduct, a
lack of effective banking regulations and control mechanisms than earnings management policy
and management’s positive responses to market expectations. Although it is smaller in terms of
capitalization and the number of listed companies, the market values in the UK in several periods
are even larger than those in the US market.
41
Taking into account the substantial increase in stock values during a relatively long period
of time, there is evidence of a bubble economy in the 1990s. Evidently, five of the selected
companies in this study (Vivendi, Parmalat, Royal Ahold, Gescartera and Skandia) benefited
substantially from favorable market conditions during this period. More importantly, these
corporate frauds coincided with the stock bubble of the late twentieth century and the puncturing
of that bubble in 2000.
Our analyses also advocate that the bubble economy and the spirals resulting from
increased pressure from the market and financial analysts may affect the earnings management
policies of companies, particularly at the time of earnings announcements. This argument is in
line with the general observation that companies may inflate their earnings in order to satisfy the
market expectations because there is a fierce battle in the financial market by many top
executives of public companies to meet investors’ demands in terms of ever-increasing earnings
per share.
5.3. RQ3. What are the main company-specific characteristics of the six high-profile
financial failures from the viewpoints of shareholders’ structure, alignment of shareholder
interests and management compensation incentives, ethics, creative accounting, fraudulent
financial reporting, auditors’ failures, and ineffective governance and control mechanisms?
Despite the importance of environmental conditions regarding the lax and flexible regulatory
framework and favorable market indicators as a force driver affecting the corporate and
management behavior, the companies and their senior management have a big part of the
responsibility for corporate deviance and financial failures. RQ3 provides insights into specific
characteristics of the six selected cases of corporate scandals in several important areas, which
are explained below.
42
5.3.1 Shareholder structure: family ownership and concentrated shareholdings
In contrast to the US financial market with highly dispersed ownership, the shareholder structure
in Europe is characterized mainly by concentrated ownership in the form of family ownership or
blockholders. The analysis of the six groups selected in this study is the best indication of such a
system. Several of these groups were founded by an individual or a family. For instance, BCCI
(UK) was founded in 1958 by the family of Agha Hassan Abedi first under the name of United
Bank in Pakistan. In the 1970s, as much as 50 per cent of BCCI’s assets came from Abu Dhabi
and the family of the ruler of this oil-rich state (U.S. Senate 1992b) as well as from the
participation of the Bank of America (25 per cent) (Mitchell et al. 2001 p. 25). Antonio Rafael
Camacho was the founder of Gescartera in 1990 in Spain. Royal Ahold was founded by Albert
Heijn in 1887 in the Netherlands. The family of Calisto Tanzi founded Parmalat in 1961 in Italy.
The two other companies had founding shareholders (Compagnie Générale des Eaux (CGE) as
the founder of Vivendi in 1850 in France and Skandia incorporated in 1855 in Sweden.
The main issue is that all these corporations, some of them with more than 150 years
historical background (e.g., Skandia and Vivendi), had continued their activities over the years
under the same umbrella even when they went public and were listed on the European financial
markets. For instance, from its foundation as a small family company to a rapidly growing and
complex group running as a large network of companies on a pyramidal structure, Parmalat was
controlled by Tanzi surrounded by a small number of family members (father, sons and daughter)
and friends. Although the company decided to list on the Milan Stock Exchange in the 1990s to
raise funds, the family retained 52 per cent ownership. Similarly, in the case of Royal Ahold,
despite going public in 1948 and being listed on the Amsterdam Stock Exchange, the family of
Albert Heijn, the founder, kept the control of the company by holding 50 per cent of the shares in
the hands of his two sons, Gerrit Jan and Ab. The control of the family over the company was
43
reinforced during the following decades particularly by the attribution of ‘founder’ or ‘priority’
shares in the subsequent public offerings.
5.3.2 The alignment of shareholder interests and management compensation packages
and incentives
Taking into account the concentrated shareholder structure and keeping control in the hands of
family or blockholders, there is clear evidence of the alignment of interests between shareholders
and management in the six selected companies in this study.
In the case of BCCI (UK), the family of the founder (Agha Hassan Abedi) had largely
benefited from the bank’s funds for their personal interests. Several official reports (e.g., Kerry
and Brown 1992-the US Senate Inquiry) provide numerous examples of using the bank’s money
to indulge the personal whims of the CEO and his family, using corruption and greed and
unlawfully diverting millions of dollars to them.
As the main shareholder and CEO of Gescartera, a Spanish brokerage house, Antonio
Rafael Camacho used the clients’ money for his own interests. Based on the SEC report (2003a),
Parmalat (Italy) unlawfully diverted about $400 million to members of the Tanzi family. The
company concealed these payments by recording them as receivables to unrelated third parties.
Parmalat reportedly funnelled money through companies in Luxembourg to pay CFO Fausto
Tonna a €3 million bonus. “Another €500 million was injected by Parmalat top management into
private companies solely owned by Tanzi family, such as Parmatour, the tourist agency” (Soltani
and Soltani 2008, p. 226).
By holding the majority of voting rights and full control of the Ahold Group (the
Netherlands), the Heijn family benefited from favorable option-based incentive schemes and the
company’s money to indulge the personal whims of the CEO. Due to holding ‘founder’ or
‘priority’ shares, the Heijn family also benefited from a higher amount of dividends. De Jong et
44
al. reported that ‘in 2002, the management board held about 2 million options; Van der Hoeven
(CEO) had about half of those options. However, some members of group’s management owned
very few shares, 188,000, and Van der Hoeven ranked a distant third among board with 34,000
shares’ (De Jong et al. 2005, p. 24).
In the case of Vivendi Universal (France), the CEO, Jean-Marie Messier, was nominated
by the major shareholders and was acting in line with their interests. He had also greatly
benefited from different types of compensation schemes and bonuses. For instance, a golden
parachute is a clause in an executive’s employment contract specifying that an executive
management member will receive a significant sum of money in the event that the executive’s
employment is terminated or if the company is acquired. This clause was approved by the
group’s major shareholders. In addition to his salary of €5.1 million and possession of around
600,000 company shares, several months before the collapse of the Vivendi group, Messier had
received €5.6 million in 2002 as a golden parachute. He also claimed more than €21 million as a
severance package, which included back pay and bonuses for half of 2002. However, after being
subject to a civil fraud action by the SEC, Messier was obliged to give back the €21 million in
addition to a $1 million fine. The company financed the purchase of a luxury apartment on Park
Avenue in New York for the sum of $17.5 million, which was often used by Messier and his
family.
Similarly, in Skandia (Sweden), the incentive programs provided to the senior management,
particularly under the title of ‘Sharetracker 1997–1999’, ‘Wealthbuilder 1998–1999’ and Stock
Option Program 2000–2002’, as well as the granting of rental apartments to them, were so
significant that this matter became the subject of investigation among several other topics by an
independent investigative group. The report of this group (Setterwalls and
45
PriceWaterhouseCoopers 2003) highlights the existence of ‘the unapproved portion of the
incentive programs’ and ‘not duly authorized’ payments (2003, p. 10).
5.3.3 Organizational ethical climate
The examples of unethical corporate and management behavior in the six selected companies are
numerous. ‘The scope and variety of BCCI’s criminality, and the issues raised by that criminality,
are immense, and beyond the scope of any single investigation or report’ (Kerry and Brown
1992; The US Senate inquiry–Introduction of Summary). Major shareholders and senior
management of BCCI (UK) decided to operate in loosely regulated places, such as the ‘Grand
Cayman Islands’. They also acted unethically by becoming involved in an arm’s deal, corruption,
money laundering and illegal political connections.
Although Parmalat (Italy) was listed on the Milan Stock Exchange and operated as a
multinational company, the Tanzi family as the founder and major shareholder had been in
command of the group for over four decades (1960–2002) and held practically all the power.
Given the strong position of the family in the group, Parmalat existed as an extension of the
family exclusively for the benefit of its members and a small circle of people who as a clan
formed the management team. These benefits included using the company’s money to indulge the
personal whims of the CEO and his family, maintaining an extravagant lifestyle, greed and
unlawfully diverting millions of dollars to them.
The Heijn family, by holding the majority of ‘founder’ shares in Royal Ahold
(Netherlands) and almost the full control over the group, did not leave any room for the respect of
ethical principles, particularly with the presence of an inefficient control environment and
corporate governance, weak internal control and the strong relationship between board members.
Jean Marie Messier, the CEO of Vivendi Universal (France), described himself in his
book JMm.com 2000 ‘Moi-Même Maître de Monde (Myself Master of the World)’ as ‘a man who
46
tried to buy the world’ (Johnson and Orange 2003). This perception of leadership and
authoritative attitude of the CEO was a determinant factor in creating a poor ethical climate in the
group.
The CEO of Skandia (Sweden) acted unethically by attributing bonuses to senior
management without the permission of the board of directors. Stockholm’s public prosecutor
launched a criminal investigation into these payments (Economist 2003). The company’s finance
director committed tax fraud by transferring the funds of Skandia’s subsidiary in Switzerland to a
company he owned in the tax haven of Guernsey (The Local 2005). Other examples include
suspected insider trading, breach of trust after misusing the company’s corporate assets and
renovating the luxury apartments acquired by the CFO (Ulf Spaaang) and the director of
Skandia’s Life Insurance (Ola Ramstedt) through the company’s funds (Europe Intelligence Wire
2004).
Bribery, corruption and the existence of ‘an aristocratic network of cronyism’ (Beauty
2008) at Gescartera (Spain) were part of the main characteristics of the company’s functioning,
which finally ended up with a total of 14 people accused of embezzlement and several
resignations among the high-ranking members of business, political and regulatory institutions
(Beauty 2008).
5.3.4 Creative accounting, fraudulent financial reporting and auditors’ failures
Fraudulent accounting operations and financial reporting as well as auditors’ failures are the
major features of the selected corporate scandals. For instance, by managing the $10 billion pool
of cash in its international network, BCCI (UK) used the fraudulent technique by “selling large
quantities of ‘options’ to purchase currency or securities at a set price at a later date. The
proceeds of these sales were shown in the books as profits. As liabilities materialized, BCCI was
47
forced to sell more contracts to keep the cash flow and profit running. The value of its
outstanding contracts in 1985 was estimated to be $11 billion” (Mitchell et al. 2001, p. 27).
Mitchell et al. (2001) also present an extensive analysis of the role of the auditors under
the title of ‘the BCCI Cover-UP’. Indeed, the auditors’ perceptions played a critical role in
assuring depositors and savers of the bank’s financial integrity and solvency. As stated, “by the
end of 1987, given Price Waterhouse (UK’s) knowledge about the inadequacies of BCCI’s
records, it had ample reason to recognize that there could be no adequate basis for certifying that
it had examined BCCI’s books and records and that its picture of those records (show) indeed a
‘true and fair view ‘of BCCI’s financial state of affairs” (Mitchell et al. 2001, p. 5). Price
Waterhouse was hit with fines and costs of £975,000 (Accountancy 2006).
Fraudulent accounting operations were significant reasons for Parmalat’s downfall in
Italy. “At last count, at least €10 billion ($13 billion, £7 billion) was estimated to be missing from
the balance sheet of Parmalat. Behind that figure is a kaleidoscopic range of fantastic financial
dealings: myriad opaque subsidiaries from Liechtenstein to the Cayman Islands, including one
called Buconero, or ‘black hole’; false billings in dozens of countries for millions of dollars; and
a now infamous fake bank account supposedly containing €3.95bn” (Financial Times 2006). A
crude forgery and the black hole ‘Buconero’ in Parmalat is an astonishing example of accounting
frauds in the history of financial scandals. At the end of 2002, the Parmalat group in a
memorandum claimed that “liquidity is high with significant cash and marketable securities
balances …” (SEC 2003). The group also claimed that it was holding €3.95 billion
(approximately $4.9 billion) in an account at the Bank of America in New York City in the name
of Parmalat’s Cayman Islands subsidiary, Bonlat Financing Corporation. The €3.95 billion was in
turn included in Parmalat’s 2002 and 2003 consolidated financial statements. ‘The problem was
there was no €3.95 billion. The Bank of America confirmation letter had been forged, apparently
48
by a Parmalat executive using a scanner and a fax machine” (Soltani and Soltani 2006, p. 228). In
large-scale fraud such as that committed in Parmalat, the auditors had part of the responsibility.
Parmalat’s auditors were Italian auditors Hodgson Landau Brands in the 1980s, and then Grant
Thornton from 1990 to 1998, followed by Deloitte & Touche as the principal auditor, supported
by Grant Thornton, until 2002. No one knew or no one blew the whistle.
The massive fraud at Royal Ahold (Netherlands) included “overstating net sales by
approximately €4.8 billion for fiscal year 1999, and then €12.2 billion for 2001. For the same
period Ahold materially overstated operating income by approximately €222 million for 1999 to
€485 million for 2001” (Soltani and Soltani 2008, p. 242). The group’s auditors (Deloitte &
Touche) did not detect these in time and they only decided to suspend the 2002 fiscal year audit
at the time that another Big Four, PricewaterhouseCoopers (PWC), undertook an investigation
into the group’s accounting and reporting. PWC discovered extensive irregularities in the internal
control system of the group and significant intentional accounting irregularities at US
FoodService, which was acquired in 2000 by Royal Ahold.
During 2001 and 2002, the management of the Vivendi group (France) released several
misstated earnings announcements and undertook various ‘aggressive’ and ‘creative’ accounting
methods that flattered earnings projections in order to portray a smooth record of profit growth.
One of these improper practices was called ‘stretching’, which aimed to give the investors a false
impression of the company’s financial condition by announcing earnings before interest, taxes,
depreciation and amortization, which produced a rosier picture than the reality. “The company
also improperly adjusted certain reserve accounts of subsidiaries, and made other accounting
entries without supporting documentation and not in conformity with French and US accounting
standards. Certain inconvenient obligations and contingencies were simply left out of the
accounts” (Soltani and Soltani 2008, p. 254).
49
Gescartera (Spain) was supposed to be a successful stockbroking operation until the
Spanish National Stock Market Commission found – during a routine inspection in June 2001 –
bogus certificates purporting to show some $95 million at two of Spain’s largest savings banks
(UPI–United Press International 2001). To show its outstanding financial performance,
Gescartera used to place large buy-and-sell orders from one stock with different brokers on the
same day, although it only had to settle the difference between the buy-and-sell orders. The
Spanish authorities imposed a financial sanction of €540,000 ($473,000) on Deloitte & Touche
for their failure to detect substantial holes in Gescartera’s accounts of 2000. In proportion to
Deloitte’s total revenues in Spain, this was the most severe fine ever imposed on a Big Five
auditing firm in the country (The New York Times 2002).
In the case of Skandia (Sweden), the report of Setterwalls and PriceWaterhouseCoopers
(2003) concludes that the use of embedded value led to the presentation of accounts for which it
is difficult to obtain a clear overview (2003, p. 5).
5.3.5 Ineffective corporate governance and control mechanisms
Taking into consideration the large scale of fraud, corruption, greed and scams at BCCI (UK),
there is clear evidence of ineffective control mechanisms. The first UK corporate governance
code (Cadbury Report 1992) was issued just after the high-profile scandal of BCCI. Similarly, the
absence of effective control mechanisms and abuse of power of the CEO and several members of
the board of directors at Scandia (Spain) were the main reasons for introducing the corporate
governance policy by the Swedish Shareholders’ Association (2001). The introduction of a new
financial law in 2003 in Spain was partially due to the Gescartera financial scandal in order to
reinforce control mechanisms and privileged information.
Italy adopted the voluntary Preda Code of best corporate governance practices in 1999.
However, having around 52 per cent of the shares, the Tanzi family had the entire control of
50
Pamalat. Calisto Tanzi (the founder, chairman and managing director) and two of his sons
(Giovanni and Stefano) were executive members of the board and his daughter (Stefanio) in
charge of subsidiaries in tourism; they also controlled the corporate governance structure (Soltani
and Soltani 2008, p. 225). One of the minutes of the company’s general meetings stated that “we
believe that the Group’s existing structure is already sufficiently well-organized to manage so-
called internal audit procedures and that the existing internal procedures, are, in line with the
needs of the Group, capable of guaranteeing healthy and sufficient management, adequate to
identify, prevent and manage risks of a financial and operational nature and fraudulent behavior
that may damage the company” (Parmalat company meeting minutes, 2001).
Similarly, taking into account the flexibility of Dutch corporate governance, which is based
on a two-tier system in which a supervisory board exists alongside the management board, the
Heijn family was able to run the Ahold group without effective governance mechanisms (De
Jong et al. 2005). “Several members of the supervisory board were previous members of the
Group and had been nominated internally. The group suffered from a 50 percent board member
turnover between 1998 and 2002” (Soltani and Soltani 2008, p. 240).
In the case of Vivendi Universal (France), although the board of directors and corporate
governance included some of the big names of French business, for example Bernard Arnault (the
president of LVMH)v and Marc Viénot
vi (the author of the French codes of governance acting as
a chairman of the audit committee), these structures were ineffective and did not act in the
interests of the company, particularly in preventing the CEO, Jean-Marie Messier, from making
irrational acquisitions and cooking the books.
51
6 Concluding remarks
This study examines the six most significant European high-profile cases of corporate deviance
and financial scandals at three levels (institutional, financial market and firm): firstly, by looking
at the European regulatory environment in which they occurred, secondly, by considering the
financial market and bubble economy conditions in the periods preceding the financial scandals
and thirdly, by examining the attitudes and actions of corporations and management from the
perspective of firm-specific characteristics. Using an extended theoretical framework, this
research attempts to shed light on the process and root causes of corporate fraud from a broad
range of multidisciplinary perspectives, including institutional and market factors, influence of
the shareholder structure and alignment of management incentives and shareholders’ interests,
the ethical climate, creative accounting and financial reporting, governance and control
mechanisms, and the performance of external auditors. Due to its extended scope as well as the
wide range of issues including environmental conditions examined here, the study is much
broader than previous research papers conducted in the US, which are mainly oriented towards
accounting, auditing and to less extent the corporate and managerial topics.
The analyses and discussions in the paper support the failure of regulations and ineffective
oversight bodies and show that the directives and recommendations (at the European institutional
and national levels) do not sufficiently consider the ethical issues and effective governance and
control mechanisms within public companies. This lack of interest also concerns the most recent
directives and guidelines issued by the European Commission, which should have brought
concrete proposals, particularly in the light of several accounting and high-profile scandals
occurring since 2003 similar to the cases discussed in this paper. Besides that, the voluntary
52
nature of these guidelines for member states does not contribute to the successful implementation
of high-quality codes of ethics and efficient governance and control mechanisms in Europe.
By providing insights into the European financial market conditions preceding the
corporate fraud and financial scandals, the study supports that the conditions of the bubble
economy and the spirals created by increased pressure from the market and financial analysts are
the important factors affecting corporate and management behavior, particularly with respect to
the earnings management policies of companies at the time of earnings announcements.
The analyses of the six selected European corporate scandals shed light on the similarities
in the major causes of failure in these companies. These analyses demonstrate that the corporate
fraud and financial scandals are not incidental and hazardous. They are best explained by
including multiple internal and external factors in a process within which the ethical dilemma has
been coupled with ineffective boards, dominant CEOs with greed and a desire for power and the
lack of a sound ‘ethical tone at the top’ policy, the alignment of senior management incentives
and major shareholders’ interest, accounting irregularities, inefficient corporate governance and
internal controls and the failure of internal and external auditors, which does not permit the
detection of the factors of fraud risk in time.
Both from the academic perspective and practical implications for regulators and standard
setters, this study presents an innovative approach by providing an anatomy of the root causes of
corporate fraud and by taking into consideration the environmental factors at the institutional and
market levels as well as the company-specific characteristics.
53
TABLE 1. The average market capitalization as percentage of GDP for each
five-year interval and for the six selected countries and the US*
Country 1988–1992 1993–1997 1998–2002 2003–2007 2008
France 27.8 37.3 86.5 89.8 52.7
Italy 14.2 19.6 52.5 47.2 22.6
Netherlands 47.8 86.6 138.2 101.8 44.5
Spain 23.9 35.3 73.7 97.8 59.4
Sweden 43.7 76.1 112.4 116.2 51.9
UK 73.2 127.4 159.2 137.1 69.9
US 62.7 98.1 145.1 138.2 82.5
* The data indicated in the above table are based on the calculations of the average GDP for each
five-year interval. The yearly GDP figures are extracted from the World Bank report available at
http://data.worldbank.org/indicator/CM.MKT.LCAP.GD.ZS?page=4.
Figure 1: Theoretical Framework used in this study
Corporate
Fraud and
Financial
Failures
Bubble Economy and Market
Expectations
Company-Specific Characteristics
European Directives, Codes and
Recommendations (at European
Commission and National levels)
54
Figure 2. Components of Company-Specific Characteristics
Firm Specific
Characteristics
Shareholders’
structure
Shareholder Interest/Management
Compensation
Ineffective Governance and
Control
Mechanisms
Creative
Accounting,
Fraudulent Reporting & Audit
failure
Corporate Ethics and
Management
Misconduct
55
i The full information on the historical background of the European Union (EU), its institutions
and its functioning is available on the website http://europa.eu/about-eu/index_en.htm.
ii The emphases are ours.
iii The emphases are ours.
iv The major part of the information was extracted from the annual reports and Form-20 F.
v In 2011, Bernard Arnault was ranked as the richest man in France with €22.24 billion wealth
(the magazine Challenges) and fourth at the worldwide level according to Forbes.
vi Marc Viénot was honorary chairman (chairman and executive director from 1973 to 1997) of
Société Générale, a leading French bank. He was the author of two French corporate governance
codes in 1994 and 1999, entitled Viénot I and Viénot II.
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