The Parmalat situation started out as a fairly standard - if stunningly large - accounting fraud. Managers allegedly used various accounting tricks to avoid disclosing sizeable losses, possibly with the collusion of at least some auditors and lawyers. According to this morning's WSJ, however:
As the probe advances, one of the chief questions remains: Where did the money go? Much of the alleged fakery appears to have been aimed at hiding losses, according to a person familiar with the matter. But prosecutors also say they now suspect that individuals were siphoning off some cash for themselves, this person said. ...
Prosecutors looking into Parmalat are alleging Mr. Tanzi, who stepped down this month, misappropriated at least $600 million from the business over the years, according to a person familiar with the widening probe at the Italian dairy conglomerate.
In other words, the Parmalat problem has expanded from "mere" accounting fraud into a classic example of the corporate governance problems associated with large publicly held corporations. I thought it might be useful to spend a few minutes explaining how the corporate governance problem at Parmalat differs from that at, say, Enron.
My professional career has been devoted to the study of large publicly held corporations. The key governance problem in such firms, of course, is the separation of ownership and control. The firm’s nominal owners, the shareholders, exercise virtually no control over either day to day operations or long-term policy. Instead, control is vested in the hands of professional managers, who typically owned only a small portion of the firm’s shares.
Separation of ownership and control occurs in its purest form in the truly public corporation in which stock ownership is dispersed amongst many shareholders, no one of whom owns enough shares to materially affect the corporation’s management. As Professors Berle and Means famously explained: “The separation of ownership from control produces a condition where the interests of owner and of ultimate manager may, and often do, diverge ....” Adolf A. Berle and Gardiner C. Means, The Modern Corporation and Private Property 6 (1932). Preventing such divergences, or at least minimizing their effects, has been the primary concern of scholars and regulators. Enron stands as a classic example that, despite all our work, unscrupulous managers can still - and always will - use their control over such corporations to benefit themselves at the expense of their shareholders (not to mention creditors, employees, and other stakeholders).
Yet, not all publicly held corporations exhibit a complete separation of ownership and control. Some public corporations have a single shareholder (or a small cohesive group of shareholders acting together) who own a majority of the voting stock of the corporation. Many more have a single shareholder or group who owns less than a majority but nevertheless ows a sufficiently large block to give it effective voting control. (The classic example is John D. Rockefeller, Jr.’s struggle to oust the chairman of the board of Standard Oil of Indiana. Rockefeller controlled only 14.9% of Standard Oil’s stock. After an admittedly long and difficult contest, however, Rockefeller ultimately prevailed in attracting enough support from other shareholders to ust the chairman.)
The presence of a controlling shareholder solves the classic separation of ownership and control agency problem. Managers who pursue their own self-interest will be displaced by the controlling shareholder.
Yet, the presence of a controlling shareholder introduces a new divergence of interest; namely, that between the majority shareholder and the minority shareholders. Precisely because of the power exercised by a controlling shareholder over management, it is very easy for the controlling shareholder to extract non-pro rata benefits for itself at the expense of the minority. At Hollinger, for example, Lord Conrad Black allegedly not only caused the corporation to pay large management fees to companies controlled by hom or his cronies, but also caused the company to spend $8 million of its own money to buy FDR historical papers Black then used in writing his FDR biography. If the prosecutors are right, Parmalat controlling shareholder and CEO Tanzi joined that club sometime ago.
Because of the potshots some European comentators took at Anglo-Saxon capitalism after Enron, it is tempting to make much of the Parmalat scandal (even for me). Yet, in truth, there is no room for jingoism in this context. The problem of majority shareholder abuses is no respecter of national boundaries. In juxtaposition to Parmalat, for example, one could cite the Anglo-US example of Hollinger, or the domestic US example of Adelphia.
There are no easy solutions to the problem of dealing with a controlling shareholder. Forcing a majority shareholder to give up control is no answer, both because of the enfringement on contract and property rights and because it solves one governance problem by restoring the agency problem associated with dispersed ownership. Transparent accounting rules is key, but enforcement is a problem. Accounting fraud will be with us as long as there are unscrupulous businessmen and dishonest or incompetent lawyers and auditors. Attempts to drive out every last residue of fraud are more likely to burden honest corporations with undue regulations than to prevent bad actors from acting badly. Instead, what we should strive for is a cost-effect system of better accounting rules and responsible enforcement that strives only to reduce the problem to manageable proportions.
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