12.3 Fraudulent behaviour and scandals in nancial markets

Even if the ‘few bad apples’ theory were correct, we are still left with the question

of why entities are able to hide their frauds for as long as they do. In many cases, in

the long period of concealment, companies become much larger and the fall, when

it comes, is very much greater.

Among the groups of people charged with ensuring that nancial markets and

institutions operate honestly and openly, we have:

lthe boards of directors of companies including non-executive directors;

lcompany shareholders;

lcompany auditors;

lcredit-rating agencies;

lother nancial analysts;

lnancial market regulators.

As both Enron and Parmalat showed, boards of directors can be dominated by a

small number of powerful executives who can relatively easily conceal their actions

from the board. We saw in the case of Barings (Box 9.5) that the board had little

knowledge of what its principal trader was doing on the company’s behalf. It is also

interesting that the chief executive and other senior executives charged with fraud

often claim that they did not know the fraud was being committed.

Non-executive directors may have little knowledge of the operations of the com-

pany and frequently hold many positions, making it difcult for them to follow

closely what is happening in the company. They seldom appear to ask awkward

questions and, at least on occasion, appear interested mainly in collecting their

non-executive director’s fee.

Given the complexity of modern nancial arrangements, small shareholders are

seldom able to understand company operations. Where large nancial institutions

(such as pension funds) are shareholders, there should be scope for the board to

keep some sort of check on the actions of company executives and traders. However,

shareholders are not likely to ask searching questions while the company is doing

well and the share price is rising.

In both the Enron and Parmalat cases, the auditors have been blamed for failing to

carry out their task adequately and have been seen as complicit in the fraud. Another

example of an auditing failure is provided in Box 13.3 in the Maxwell pension fund

case. There is clearly a potential problem when auditing rms themselves are large

and are stock-exchange-listed companies needing to keep prots high to keep their

own shareholders happy. Auditing companies may have a strong interest in not

offending the executives of their clients.

Credit-rating agencies have also been strongly criticised for their failure to notice

problems in the Enron and Parmalat cases. In both instances, the credit ratings of

the rms were kept high until a few days before the companies were forced to le

for bankruptcy. Following the Enron affair, the major credit-rating agencies in the

US claimed that they had made changes to their procedures and would be better

able to spot the next Enron. They claimed that they had hired accountants and

would look much more closely at the published accounts of companies in the future.

355

....

FINM_C12.qxd 1/18/07 1:28 PM Page 356

Chapter 12 • Financial market failure and nancial crises

They claimed also to have intensied their focus on governance and management

at the companies they rate, spending time with board members. However, smaller

companies in the industry doubt that much has changed. Large nancial scandals are,

they say, always followed by confessions of guilt by the big credit-rating agencies

and by claims that things would be better next time. The credit-rating market is also

dominated by a small number of large companies and there have been complaints

of a possible conict of interest because the large agencies are paid by the issuers of

debt, not by investors.

One needs to add to this last comment that nancial analysts acting on behalf

of investors have not had a particularly good record in spotting nancial scandals.

We mention above the popularity of Enron with nancial analysts during the period

when the fraud was being practised. In the Parmalat case, in August 2003 (just

over three months before the fraud unravelled), nine out of fourteen international

nancial analysts advised investors to buy the company’s securities and another three

recommended holding existing investments. In November, seven out of fourteen

analysts still recommended purchase and two continued to favour holding existing

investments, and studies by two international banks were released giving positive

judgements on the group’s prospects and the relative value of its shares. In the early

days of December 2003, the rating still reected a positive opinion of the company’s

ability to redeem its bonds (Fazio, 2004).

We deal with the issue of nancial regulation in Chapter 13. Financial regulators

also face difculty in coping with the complexity of the nancial arrangements of

rms. Equally importantly, nancial irregularities are practised by non-nancial rms

that are not covered by the remit of nancial regulation – Enron, WorldCom and

Parmalat were not nancial rms. In any case, in any form of regulation, a balance

has to be struck between the need to prevent frauds and other types of nancial

malfeasance and keeping the costs of regulation as low as possible in order not to

stie the activity of the market. In Chapter 13, we look specically at that issue in

relation to the FSA in the UK.