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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

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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,

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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)

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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.

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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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