12.3 Fraudulent behaviour and scandals in nancial markets

and move money around among subsidiaries but the claimed funds sometimes did not

exist. The company led for bankruptcy. Calisto Tanzi was arrested.

In addition, questions were asked about the company’s accounting rm, the US-

based Grant Thornton, which had audited Parmalat’s books until 1999 and had continued

to audit the books of Bonlat, the subsidiary with the missing $4.9bn. Grant Thornton

claimed that it had been the victim of a fraud but the head of the Italian branch of the

company resigned and his partner was suspended after warrants had been issued for

their arrest.

As well as the charges in Italy, the SEC in the US charged Parmalat with fraudulently

offering $100m of unsecured notes to US investors and of inating its assets by at least

$5bn. In late May 2004, Italian prosecutors sought to have thirty-two Parmalat execut-

ives put on trial. Several former executives later pleaded guilty to misleading investors,

received jail sentences and testied in the trial of Calisto Tanzi. The trial was still continuing

in September 2006.

Parmalat was subsequently rebuilt as a company and again listed on the Italian stock

exchange. In 2006, the new management of the company sought to take legal action

against banks whom it believed assisted in the fraud.

Enron, a regional natural gas pipeline company, was formed in 1985 through a

merger between two other companies, Houston Natural Gas and InterNorth. The

chairman and chief executive of the new company, Kenneth Lay, was a long-time

friend of George W Bush, who was to become US President in 2000. The US energy

market was deregulated in the late 1980s and from 1989 Enron began trading natural

gas and electricity allowing users to buy gas or electricity from different producers.

It made its breakthrough via contracts to deliver energy products at future dates. It

also sold nancial instruments designed to protect customers against large swings in

energy prices. It thus effectively moved from being a straightforward energy company

to a derivatives and nancial company. It was frequently recommended by stock

market analysts because of its innovative approach to energy trading. In 1999 Enron

took advantage of the dot.com boom by launching Enron online, the rst global

commodity trading web site.

The company had also expanded during the 1990s by takeovers including, in

1998, the British water company, Wessex Water. It became the US’s seventh biggest

corporation and in 2000 its share price peaked at $90.56. However, Enron had

nanced its takeovers by going heavily into debt, concealing the extent of that debt

by dubious accounting practices including the establishment of complex special

partnerships. Thus, their share price was based on misleading information about the

state of the company.

By early 2001 things were beginning to go wrong. Within Enron’s auditor, Arthur

Andersen (itself the US’s eighth biggest company), worries were beginning to be

expressed about the accounting practices being followed. Nonetheless, it later emerged

that the auditor had sought to protect its client from investigation by destroying

a number of important documents. Jeffrey Skilling, who had taken over from

Kenneth Lay as chief executive in February 2001, resigned from the job in August

2001, the position reverting to Kenneth Lay. Skilling claimed ‘personal reasons’ for

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Chapter 12 • Financial market failure and nancial crises

the resignation but it soon became clear that severe difculties lay ahead. At around

this time, the major gures in the corporation began selling their shares in the com-

pany while the share price was still high. In October 2001 Enron reported a $618m

loss for the previous quarter and disclosed a $1.2bn reduction in shareholder equity,

partly in connection with partnerships run by chief nancial ofcer Andrew Fastow,

who was sacked by the company. Enron shares lost a fth of their value and the

Securities and Exchange Commission (SEC) began an investigation into the account-

ing practices. In November 2001 Enron admitted to having greatly overstated its

prots over the previous four years. Its credit rating was slashed to junk bond status.

This seriously damaged the company because many of Enron’s debt agreements were

dependent on the retention of its investment grade credit rating – the loss of that

rating triggered debt repayments that it could not make.

At the beginning of December 2001 Enron led for bankruptcy. It was at that time

the biggest bankruptcy in US corporate history but was surpassed by the bankruptcy

of WorldCom in the summer of 2002. Four thousand Enron employees lost their

jobs. The pension plans of many Enron employees lost almost all their value because

they held many Enron shares.

In January 2002, the US Justice Department opened a criminal investigation into

Enron and, later the same year, charged Arthur Andersen with the obstruction of

justice. The accounting company collapsed with the loss of 85,000 jobs. Kenneth

Lay resigned as Chairman and Chief Executive and a former deputy chairman com-

mitted suicide. In October 2002, Andrew Fastow was indicted on seventy-eight charges

including conspiracy, fraud and money laundering. In 2003, Fastow’s wife and seven

other executives were charged. At the beginning of 2004, Fastow and his wife pleaded

guilty. Fastow accepted a ten-year prison sentence and became a prosecution witness.

His wife was jailed for one year. Kenneth Lay and Jeffrey Skilling were arrested and

their trial began in January 2005.

In May 2006 Lay was convicted on six counts of wire fraud, securities fraud and

conspiracy. Skilling was found guilty on nineteen counts of conspiracy, securities

fraud, insider trading and making false statements. Sentences were to be announced

in September 2006 but Lay who was facing a prison sentence of up to forty-ve years

died of a heart attack in early July 2006.

We have here added two of the major nancial scandals of recent years to the

several others dealt with in this book. There have been many others – WorldCom,

Allied Irish Banks, the Bank of Commerce and Credit International (BCCI), Daiwa

Bank, Hollinger International...In scandals such as these, jobs are lost, share-

holders lose out, often employees lose savings, high legal costs have to be met and

condence in the equities market and other nancial markets are damaged. Two sets

of questions arise:

l	Are the frauds that often produce these scandals simply the result of a ‘small number of bad apples’? Or do they suggest something seriously wrong with the operation of nancial markets?

l	How do these frauds escape attention for so long? What can be done to reduce their number and importance in the future?

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