Corporate and Human Failure

Categories: Business Failure Financial Markets Human

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Corporate failure happens due to poor management, incompetence, and bad marketing strategies. The basic symptoms of corporate failure are low profitability, high gearing and low liquidity. To a large extent corporate failure is a baby of human failure as the major cause are directly related to human actions. Issues to do with mismanagement, failure to timeously adjust to technological changes, fraudulent staff complement, poorly organized board and management structure and overexpansion and diversification are caused of corporate failure and are directly related to human error whether intended or unintended.

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Definition Of Terms

Corporate Failure

The term corporate failure entails discontinuation of company's operations leading to inability to reap sufficient profit or revenue to pay the business expenses.

According to Levinthal (1991), failure occurs when the level of organization capital reaches zero. It is no longer able to meet its financial obligations to debt holders, employees, or suppliers and resorts to or is forced into bankruptcy or liquidation

Human Failure

Human error means that something has been done that was "not intended by the actor; not desired by a set of rules or an external observer; or that led the task or system outside its acceptable limits

Corporate Failure in the West

Case Study 1: Barings Bank, PLC

In February 1995, Nick Leeson, a "rogue" trader for Barings Bank, UK, single-handedly caused the financial collapse of a bank that had been in existence for hundreds of years.

Leeson was dealing in risky financial derivatives in the Singapore office of Barings. He was the lone trader there and was betting heavily on options for both the Singapore (SIPEX) and Nikkei exchange indexes.

These are similar to the Dow Jones Industrial Average (DJIA) and the S&P500 indexes in the US.

In the early 90s, Barings decided to get into the expanding futures/options business in Asia. They established a Tokyo office to begin trading on the Tokyo Exchange. Later, they would look to open a Singapore office for trading on the SIMEX. Leeson requested to set-up the accounting and settlement functions there and direct trading floor operations. The London office granted his request and he went to Singapore in April 1992. Initially, he could only execute trades on behalf of clients and the Tokyo office for arbitrage purposes. After a good deal of success in this area, he was allowed to pursue an official trading license on the SIMEX. He was then given some discretion in his executions meaning; he could place orders on his own speculative, or proprietary trading.

Even after given the right to trade, Leeson still supervised accounting and settlements. There was no direct oversight of his book and he even set-up a dummy account in which to funnel losing trades. So, as far as the London office of Barings was concerned, he was always making money because they never saw the losses and rarely questioned his request for funds to cover his margin calls. He took on huge positions as the market seemed to go his way. He also wrote options, taking on huge risk.

He was, in fact, perpetuating a hoax in his record-keeping to hide losses. He would set the prices put into the accounting system and cross-trade between the legitimate, internal, accounts and his fictitious "88888" account. He would also record trades that were never executed on the Exchange.

In January 1995, a huge earthquake hit Japan, sending its financial markets reeling. The Nikkei crashed, which adversely affected Leeson's position. It was only then that he tried to hedge his positions, but it was too late. By late February, he faxed a letter of resignation, and when his position was discovered, he had lost $1.4 billion USD. Barings, bank became insolvent and was sold to a competing bank for $1.00.

Case Study 2 Parmalat

Parmalat's fraud began in 1990 and lasted until 2003. In essence, when the company's financial performance began to slip in 1990, and rather than resolve its problems, management chose to disguise them through fraud and collusion. During this 13-year period, Parmalat executives used a wide range of unethical techniques to extend the fraud. They inflated revenues by creating fake transactions through a double-billing scheme. They used receivables from these fake sales as collateral to borrow more money from banks. They created fake assets thereby inflating reported assets. In some cases, they took on legitimate debt that they hid from investors (New York Times, 27 January 2004). They also eagerly worked with investment bankers to engage in financial engineering which moved debt off balance sheet or disguised it as equity on the balance sheet. They even colluded with third-party auditors and bankers to finance the fraud indefinitely.

Problems at Parmalat began to emerge publicly in mid-2002. Between July and December of that year, Parmalat's credit spreads widened by 250 to 300 basis points. Tightening credit conditions in Latin America and the default of food industry rival Cirio in 2002 drove the rising spreads.

Despite having reported 4 billion in cash and short-term assets on its balance sheet, Parmalat defaulted on a 150 million eurobond payment.

Also in March 2003, Parmalat produced a (forged) verification letter on Bank of America letterhead validating the account and submitted this letter to the requesting auditor. On one front, the company was attacking Wall Street firms for allegedly suggesting it had accounting irregularities, while on the other front, it was forging documents to verify a false account statement for a phantom 4 billion in cash. That is world-class brass. Parmalat even went so far as to forge the signature of an actual Bank of America employee. How the auditor sought and allowed this document to be produced by Parmalat itself remains a mystery. A basic function of auditors is to independently verify accounts, and the auditors very clearly shirked this responsibility. We may never know whether this particular shortcoming was intentional. Nevertheless, the forged letter ultimately became the center of controversy when Bank of America revealed on 19 December 2003 that the Bonlat account did not exist. At this time, a former auditor with Deloitte quipped, What is the one line item in an audited balance sheet that no one questions? Answer: the cash and other short-term assets. And that is precisely where this fraud was directed."

Then, in December 2003, the twisted scam began to unravel. On 8 December 2003, despite having reported 4 billion in cash and short-term assets on its balance sheet, Parmalat defaulted on a 150 million eurobond payment. Parmalat claimed a customer had not paid its bills (it was later revealed that the customer was owned by Parmalat). On 9 December 2003, Parmalat's bond rating was downgraded to junk by S&P, and the stock price fell an additional 40% in subsequent days (see Figure 1). That same day, Tanzi stepped down as CEO and the Parmalat board hired turnaround expert Enrico Bondi to resolve the crisis. On 16 December, Bondi engaged PWC to review Parmalat's finances. That same day, Bank of America's New York branch notified existing auditor Grant Thornton that the company's Bonlat account did not exist. On 19 December, Parmalat publicly announced that 3.95 billion in cash was missing, sending the Parmalat stock price near zero (see Figure 1). Parmalat executives subsequently went on a binge, destroying computers and shredding documents related to these off-balance-sheet transactions. On 27 December 2003, Parmalat was officially declared insolvent, and CEO Calisto Tanzi was indicted for fraud and arrested.

After completing its review of the company's books, PWC determined that Parmalat's financial statements had been misstated since at least 1990. Parmalat reported positive and growing earnings every year from 1990 through 2002. After properly restating its financials, however, PWC revealed that Parmalat had actually lost money in 12 of those 13 years. PWC concluded that Parmalat's fraud began in 1990 as an attempt to cover losses at a South American subsidiary.

The corruption was so widespread and long lasting that multiple red flags should have appeared for multiple people both inside and outside of Parmalat.

In one example, Tonna devised a double-billing scheme to inflate Parmalat's revenue and assets. For accounts sold on credit to a supermarket or retailer, Parmalat accountants would selectively duplicate invoices (typically in the name of the shipping company that delivered the milk), generating fake sales. These duplicate invoices would increase reported revenues and accounts receivable. Parmalat would then take the fake receivables to banks and use them as collateral to obtain loans. The loans, in turn, increased the company's liabilities and, of course, cash.

Such a tactic, however, only escalates the original problems over time. If a company reports revenues of $100 but in reality has revenues of $90, it might still have costs of $92. So, although it may report an $8 profit margin, it has actually generated a $2 loss. If the company then takes on $10 in debt to fill the gap, it can feign profitability so long as it can continue to pay off the debt. In the case of a chronically unprofitable company such as Parmalat, the problems introduced by taking on too much debt must ultimately meet their day of reckoning. Then, the accounting ruse eventually reflects the company's underlying economics. This scenario illustrates why Parmalat's case first manifested itself as a debt crisis and was only later revealed as a fraud.

Ultimately, it was discovered that Tanzi and 16 other executives had collectively misappropriated over 1 billion for personal gain. The post-bankruptcy Parmalat CEO Bondi filed suit against 45 banks with which the company had done business, alleging that these banks helped Parmalat hide losses from investors. In June 2008, Parmalat reached a settlement with UBS and Swiss Bank for a total of 357 million. Neither bank acknowledged any wrongdoing. The rest of the suits were dismissed in Italian courts.

The corruption was so widespread and long lasting that multiple red flags should have appeared for multiple people both inside and outside of Parmalat. Nevertheless, as an outside investor, there is no magic bullet to avoid this sort of scam in the future. Effective due diligence always has a limit. Only vigilance by all interested parties will bring about swifter discovery than in Parmalat's case. Of course, awareness of how other companies perpetrated their scams can provide a good starting point.