Accounts Due

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MARCH 29, 2004

Accounts Due

It was February 2002, and Frits Bolkestein, the European
Commission's (EC) chief financial regulator, was feeling more than
a touch of schadenfreude. At the height of the Enron scandal,
financial misdeeds were becoming public at WorldCom, Tyco,
Adelphia, and a host of other U.S. companies--proof to Bolkestein
that U.S. capitalism was hopelessly corrupt. In an interview with
Financial Times, Bolkestein gloated, "If you look at the various
scandals in the financial field, it seems they have occurred more
in the U.S. than in Europe, or am I being rude saying that?" One
could almost see the sneer creeping across his face.Two years later, a series of European corporate scandals has surely
wiped away that smile. If 2002 was the year of U.S. corporate
malfeasance, 2003 was Europe's turn: Accounting fraud and other
criminal activities were uncovered at Switzerland's Adecco, the
Netherlands' Ahold, and, of course, Parmalat, the Italian dairy
concern whose owners may have defrauded investors of billions,
including more than $1.5 billion from American investors. Whereas
two years ago Europeans claimed that Enron proved the superiority
of European corporate culture, now many admit that, in fact, fraud
can happen anywhere.

What they won't admit is why. The Parmalat scandal is more evidence
that European business culture is becoming more global and, almost
by definition, more American. But, while the structure of European
business is changing-- moving not only toward regional integration
but toward distinctly American practices like capital market
financing as well--many Europeans are nevertheless slow to push for
commensurate changes in how it is regulated. As a result, despite
heated rhetoric post-Parmalat, there has been little effort to move
toward the stronger enforcement mechanisms required by a more open,
American-style system. So, for all Europe's mockery of American
cowboy capitalism, the next Enrons will probably occur not on our
side of the Atlantic, but on theirs.

It's easy to see Bolkestein as the bad guy, the continent's version
of disgraced Securities and Exchange Commission (SEC) Chair Harvey
Pitt--a corporate shill who pays lip service to reform but, in the
end, blocks it. Last month, in the wake of Parmalat, Bolkestein
told the European parliament that "the financial-services industry
had better get its act together and do so fast. We need some real
industry leadership to stand up and take charge--to clear out the
crooks, expose their unscrupulous practices, and curb excessive
greed." Fortunately, he said, the Commission was already working on
a series of governance reforms inspired by the Enron scandal, and
it was set to adopt the new universal accounting standards being
devised by the International Accounting Standards Board (iasb).
Problem solved, right?

Wrong. The problem with Bolkestein's announcement is that, at the
same time he is promising to implement iasb rules, he is trying to
block some of the most important--and controversial--planks in the
board's new rulebook, the bulk of which have already been approved.
Called Directives 32 and 39, they would require adherents to
account for fluctuations in the value of derivatives (financial
instruments, such as futures, that derive value from the value of
something else) held by their firm. Because derivatives provide an
easy way to hide losses (this was one of the many tricks pulled by
Enron), making companies account for them would go a long way
toward curtailing fraud. But the continent's banks, along with the
French government, oppose the measures, saying that derivatives'
inherent volatility could expose them to excessive balance-sheet
volatility, and they pressured Bolkestein to block it. He complied
readily, accusing the iasb of crafting rules without discussing
them with the EC and even threatening that "future [International
Accounting Standards] endorsement will become more difficult unless
ways and means are found to ensure that the standards-setting
procedures become more open." Soon after, he added that, if the
iasb continued to press the directives, he would allow individual
member states to ignore them, negating the very purpose of
universal standards.

Thanks to intransigence on the part of European officials like
Bolkestein, there is little chance that any substantively new
regulations will emerge from the Parmalat scandal beyond those that
had already been planned following Enron (which, though definitely
a step forward, are inadequate to the long-term task at hand). In
February, Bolkestein announced that "the Commission will not rush
headlong into announcing new legislative initiatives--beyond those
already announced. ... What is required now is a pause for
reflection." And, if this is the Commission's attitude toward
reform just months after its largest corporate scandal in years,
imagine how resistant it will be once the Parmalat fires die down.

But, while it's convenient to blame Bolkestein for the Commission's
foot- dragging, he is more a consequence of Europe's insular
business culture than its cause. Though Europe may offer bountiful
consumer and labor protections, it also maintains a powerful
tradition of cronyism in which capital is controlled by a tight
matrix of government institutions, state-run banks, and large
corporations. "The EU is driven more by business interests than by
political interests," says Paul Frentrop, a professor of corporate
governance at the University of Tilburg in the Netherlands. "Voters
in EU countries do not care much about the EU, as evidenced by the
low turnout at elections for the EU parliament. It's the big
multinational companies that want one market. ... A pro-big
business attitude is an integrated part of European institutions."
As a result, the Commission--which implements and oversees the
rules governing the EU--is loath to enact policies that, while good
for business ethics, are viewed as bad for big businesses

But even that isn't the whole story. Traditionally, European and
U.S. business cultures have been defined in part by how much
influence outsiders wield over a company's operations. In the
United States, there is a strong shareholder ethic, in which
anyone, at least in theory, can gain influence over a company by
purchasing shares in it. Moreover, because pension funds invest a
large share of their money in stock and bond markets, even average
Americans who do not own stocks directly have a vested interest in
the country's corporate health. And, because companies usually
raise capital through public measures, such as bond or stock
issues, there is in turn a sense of responsibility to the investing
public. As a result, going back well before Calvin Coolidge issued
his famous dictum that "the business of America is business," there
has been a strong connection between the interests of U.S. business
and the nation as a whole; and our regulatory philosophy, though
not always effective in practice, has developed along those lines.

The opposite has been true in Europe. European companies have
traditionally raised capital through the continent's heavily
insulated (and historically government-run) banking system or
through retained earnings rather than from the public. Pensions are
mostly guaranteed by the state, which protects the average citizen
from the rise and fall of the stock and bond markets but also
removes most incentives for him to care about what goes on in the
corporate world. And, thanks to the legacy of socialism running
through European mass culture, there has long been public distrust
of the corporate world and distaste for individual investing. Not
surprisingly, European corporate and accounting regulations reflect
this system's needs and facilitate its operation. They provide
fewer shareholder protections and less corporate information to the
public, but they also make it easier for banks and large companies
to work together. Fundamentally, Europeans rely on a strong
government hand in the economy, rather than a strongly regulated
private sector, to keep fraud under control.

This would be all well and good if European business weren't moving
quickly away from the continent's traditional model. Like most
regions of the world, the European economy took off during the late
'90s, a trend BusinessWeek attributed to Europe's "U.S.-style New
Economy," in which the euro and rapidly expanding capital markets
suddenly made fast growth a possibility. And the continued pace of
privatization--especially in the banking sector--rendered obsolete
the crony capitalism that had kept government and corporate
interests in line for so long. No longer, therefore, could
government serve as a brake on the private sector. Once this trend
reached critical mass, it was unstoppable-- even when the European
economy slowed significantly a few years ago, the reaction from
most EU governments wasn't to say the experiment had failed but
rather that it hadn't gone far enough. Privatization, promoted by
even the Socialist government of former French Prime Minister
Lionel Jospin, continues apace, and, with ongoing EU economic
integration and the opening of European capital markets to outside
investors, the continent is suddenly a much different economic

As a result, there is a dangerous disconnect between the new reality
of the European business world and the outdated rules that still
govern it. "What we see in Europe is a push toward more capital
market financing, and that requires changes in oversight," says
Christian Leuz, a professor at the University of Pennsylvania's
Wharton School. Among other things, Europe needs stronger
securities oversight, shareholder protections, and, above all,
uniform enforcement--if not an actual policing body akin to the
SEC. (Even tough regulations that could have outed Parmalat earlier
would have done little good in Italy, where current enforcement
mechanisms are weak.) "The U.S. got securities regulation,
including the SEC, after the 1929 crash. No European country did,"
says Frentrop. "What Europe needs most urgently are security laws
that protect investors"--not to mention enforceable corporate
governance and accounting rules.

This is not to suggest that U.S. reforms have insulated the United
States from malfeasance. But the extent of recent U.S. regulatory
changes--and the scope of further changes being considered--goes
far beyond anything being contemplated in Europe. That's partly
because of the complexities of developing Union-wide rules. But
Europe's apparent unwillingness to push the envelope when new
regulatory thinking is so obviously needed is striking. After
Enron, Congress quickly passed the Sarbanes-Oxley Act, which
greatly improved the country's corporate governance and accounting
rules, most significantly by creating the Public Company Accounting
and Oversight Board to monitor and enforce compliance. And the SEC
has continued to press for reform, such as its soon-to-be-proposed
requirement to allow shareholders to more easily vote out company
directors. These changes are relatively uncontroversial in the
United States, but they remain a regulator's dream in Europe.
There, the gap between regulatory philosophy and economic reality
dwarfs anything in the United States, and it's only a matter of
time before greedy corporate types start exploiting it.

Indeed, it seems they have already begun. Last year's scandal at the
Dutch grocery concern Ahold erupted after evidence emerged that
company managers, having been given loads of stock options,
inflated the earnings of its American subsidiary, U.S. Foodservice.
In the old world of European business, this probably would not have
happened, not only because stock options were rarely used but
because the slow pace of the continent's capital markets meant
there was little to be gained--at least in terms of stock
prices--by manipulating earnings. And, in the wake of the mid-'90s
privatization of Italy's banking sector, Parmalat's directors used
U.S.-based banks to convince investors that they held billions in
assets, which in turn allowed them to raise real capital through
bond issues.

These scandals also highlight the risks that an insufficiently
regulated continental economy poses for the United States. As
Europe begins to raise capital from markets and outside
investors--including those across the Atlantic- -those markets and
investors are put at risk. American investors lost more than $1.5
billion in the Parmalat scandal, and, with the growing number of
European firms registered with U.S. stock exchanges, the harm
future scandals could do to the American investment community can
only grow. This is one reason the SEC recently announced that by
2005 all European companies that register with U.S. stock markets
will have to abide by all iasb standards, regardless of what the EC
or the companies' home countries require.

Things will likely get worse as European capital markets open even
more and become more central to private financing. "History teaches
us that scandals erupt after a strong inflow of new money--i.e.,
new participants from the public--into the capital markets," says
Frentrop. So Parmalat, Ahold, and other scandals are not outlier
examples of good European businesses gone wrong; they're examples
of what happens when a system outgrows the rules that had guided
it. What Europe needs now is U.S.-style regulation to go with its
U.S.- style capitalism. Let's hope someone tells Frits Bolkestein.

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