), and Tyco International (TYC
), European chief executives smugly insisted no such fraud could ever occur in Europe. They spoke too soon. The accounting calamity at Italian dairy-foods giant Parmalat has prosecutors scrambling to find out what happened to $8.5 billion to $12 billion in vanished assets. That sum makes Parmalat one of the largest financial frauds in history. Some questions and answers about the collapse of what was once considered a jewel of Italian capitalism:What triggered the financial crisis?Parmalat defaulted on a $185 million bond payment in mid-November. That prompted auditors and banks to scrutinize company accounts. Some 38% of Parmalat's assets were supposedly held in a $4.9 billion Bank of America (BAC
) account of a Parmalat subsidiary in the Cayman Islands. But on Dec. 19, Bank of America reported that no such account existed. In the ensuing investigation, Italian prosecutors say they've discovered that managers simply invented assets to offset as much as $16.2 billion in liabilities and falsified accounts over a 15-year period, forcing the $9.2 billion company into bankruptcy on Dec. 27. Trading in Parmalat shares was suspended the same day.Why is the Parmalat scandal important?It reveals an alarming lack of transparency at one of Europe's largest and most global companies. Parmalat has 36,000 employees in 30 countries, and it does $3.3 billion in business in North America, where it not only sells its trademark milk-in-a-box but also owns Black Diamond Cheese, Archway Cookies LLC, and Sunnydale Farms dairy. Parmalat's shares traded in New York and it sold more than $1.5 billion in bonds to U.S. investors. The U.S. Securities & Exchange Commission has sued Parmalat for misleading investors in a "brazen fraud." The scandal is also a fresh blow to the international accounting industry. Parmalat's auditor from 1990-99 was the Italian branch of Grant Thornton International, one of the largest of the so-called second-tier U.S. accounting firms. In 1999, Parmalat was forced to change its auditor under Italian law, and it replaced Grant Thornton with the Italian unit of Deloitte Touche Tohmatsu. However, Grant Thornton continued to audit Parmalat's offshore entities -- a web of financial companies that were closed down in the Dutch Antilles in 1999 and reestablished in the Cayman Islands. Neither firm uncovered what investigators say was years of blatant accounting fraud. Grant Thornton has issued a statement calling itself a "victim" of the deceit. Deloitte points out that it first raised questions about Parmalat's accounts on Oct. 31.How did the company misplace $4.9 billion?Auditors first inquired about the Cayman Islands account in December, 2002, and received a letter on Bank of America stationery in March, 2003, confirming the existence of the account. The letter was apparently a forgery, concocted by someone in Parmalat's Collecchio headquarters. The very size of the alleged account should have raised a red flag, notes the CEO of one of Italy's largest banks: "Even a $1 million bank account is cross-verified by our auditors." Investigators also believe that in 2003 Parmalat did not buy back $3.6 billion in outstanding bonds, although it claimed to have done so.Who is under investigation?Parmalat founder and former Chief Executive Calisto Tanzi; his son Stefano and brother Giovanni; former Chief Financial Officer Fausto Tonna; and some 16 other individuals, including former board members, and even the company's lawyers. Tanzi, whose family controls 51% of Parmalat, was arrested Dec. 27 on suspicion of fraud, embezzlement, false accounting, and misleading investors. Prosecutors say they suspect Tanzi diverted as much as $990 million in company funds to his own use. Tanzi's lawyer insisted to reporters that "no money disappeared," adding that it was just a case of "nonexistent assets." Prosecutors also allege Tanzi ordered the destruction of company documents; his lawyers say any destruction was done without Tanzi's knowledge.What role did derivatives and other financial instruments play?In the past several years, Parmalat used derivatives and other complex financial transactions to shore up its balance sheet. The company did these through investment banks like Citigroup (C
) and Merrill Lynch (MER
). In one 1999 deal with Citi -- done via a subsidiary of the bank called Buconero LLC, which means "black hole" in Italian -- the bank made a 117 million euro ($146 million) "investment" in return for a chunk of the company's net profit. By setting up the transaction as an investment and not a loan -- a perfectly legal maneuver -- Parmalat made its borrowing costs appear smaller than they actually were. A Citigroup spokesman says it regrets using the name Buconero but that the financing was "relatively small and appropriate."Where did the missing billions go, and how did the fraud stay undetected for so long?No one knows for certain whether missing funds were used to plug operating losses, pay creditors, or illegally enrich management. Tanzi admitted to prosecutors on Dec. 30 that he knew the company's accounts were being falsified to hide losses of as much as $10 billion, mainly in Parmalat's Latin American subsidiaries. The fake balance sheet figures allowed Parmalat to continue borrowing. Tanzi also confessed to misappropriating some $620 million (prosecutors believe the sum to be as much as $1 billion), to cover losses in other family-owned companies. A company computer and floppy disks turned over to investigators by a Parmalat employee who disobeyed orders to destroy corporate documents may help prosecutors.Are European investors likely to be slammed by more Parmalat-style frauds?Probably. Like many companies in Europe, Parmalat is family-controlled through a chain of holding companies, making corporate governance and supervision by regulators more difficult. In Italy, the government of billionaire businessman Prime Minister Silvio Berlusconi last year reduced false accounting from a felony to a misdemeanor. Government critics are hoping the Parmalat affair brings officials to their senses. "The best deterrent would be swift and severe punishment," says one Italian banker. "We have to fix the mess and make it clear to the market [that] there will be no mercy."What happens now to Parmalat?With payments on its old debt suspended by a government bankruptcy decree, the company will continue operations as new management determines the true condition of its balance sheet and restructures operations. Accountants and banks will pursue their forensic analysis. Parmalat's new CEO, Enrico Bondi, has 180 days to present a financial and industrial plan to authorities. If Parmalat cannot be restructured, it will be liquidated.
On the judicial front, formal charges will probably be filed in coming weeks against Tanzi and others. Thanks to the size of the scandal, justice officials will probably be allowed to put trials on a fast track, circumventing chronic delays in the Italian courts. Parliament, meanwhile, is expected to propose a new financial-market watchdog modeled on Britain's Financial Services Authority, pooling powers now held by stock market regulator CONSOB and the Bank of Italy. The ultimate effectiveness of such an institution, however, will depend upon its insulation from the kind of chronic political meddling that undercuts many of Italy's regulatory bodies -- the very interference that has resulted in a series of financial scandals in Italy going back many years. By Gail Edmondson in Frankfurt with Laura Cohn in London