Italian PM Matteo Renzi in Rome, Italy at the Quirinal Palace. indiPHOTOpress/Demotix. All rights reserved.Last May, Italy’s parliament passed a law that was intended to tighten the criminal sanctions for accounting fraud. A few weeks later the Court of Cassation, Italy’s highest court, ruled that the new law had in fact achieved the opposite effect. This perplexing story merits a comment, for it offers an excellent illustration of some of Italy’s main politico-economic problems.
A company can falsify its financial statements in order to show either a higher or a lower value than its fair value. A company that wishes, for example, to support the market price of its shares, obtain better financing terms, reassure banks and long-term suppliers, or avoid a recapitalisation shall inflate its value, whereas a company that wishes to evade taxes or create slush funds (from which bribes are typically drawn) shall artificially reduce its accounting value.
Whatever its purpose, accounting fraud can take one of two forms, depending on whether the falsification concerns the existence of a company’s assets or liabilities, or their valuation. If a company wishes to inflate its value, for instance, it can either include in its financial statements an asset that the company does not own, or it can include in its financial statements a knowingly inflated valuation of an asset it owns.
A company’s financial statements are composed almost entirely of valuations, of both assets and liabilities: only items such as cash and cash-equivalent securities need not be evaluated, as they have a well-established value. Moreover, unlike the actual existence of an asset or liability, which generally is a black-or-white question, valuations are a more complex matter, governed by elaborate rules (the ‘accounting principles’), and it can be hard to prove that a valuation is both (a) incorrect (i.e., not done according to the accounting principles), and (b) knowingly incorrect (for accounting fraud is a crime only if it is deliberate). For both reasons accounting fraud frequently takes the form of valuation fraud: companies tend to lie on how much their assets are worth rather than on how many assets they own.
The judgment issued in June by Italy’s highest court states that the new law no longer punishes valuation fraud. So if a company says that it owns a car it knows it does not own it commits a crime, whereas if the same company values a ten-year old car at little less than the purchase price there is no crime: because the question concerns the valuation of the asset, not its existence.
Only civil remedies remain for valuation fraud: damages, if any, and the rectification of the company’s accounts. These remedies are largely toothless, however, because they are in the hands of agents – creditors and shareholders – that typically lack the necessary information to use them, and do not have the prosecutors’ means to obtain the necessary evidence (controlling shareholders in non-listed companies do generally have the necessary information, of course, but they often lack the incentive to use it: as they typically either directly manage the company or closely supervise the managers, accounting fraud can hardly happen without their consent).
This is precisely why most advanced economies employ also criminal sanctions to deter and repress accounting fraud. And what such sanctions are intended to protect is not just the interests of creditors and shareholders but also an important public interest, for accounting fraud can distort both the product markets and the market for capital.
Yet, according to the judgement of the Court of Cassation any Italian company that chooses to falsify its accounts – whether to defraud the stock market or its creditors, or to lower the tax bill or accumulate slush funds out of which to pay bribes – now has a safe and very versatile instrument at its disposal: valuation fraud. Only those companies that are so unsophisticated, or desperate, as to engage in the crudest forms of accounting fraud will be caught by the new law. By decriminalising valuation fraud, in other words, the new law has opened a loophole that is so large, and so easy to use, that the criminal sanctions for accounting fraud are now largely illusory.
Some lawyers and government officials have cast doubts on the court’s interpretation. Yet the judgement is profusely motivated, and it seems reasonable to assume that Italy’s highest court – which, by statute, has the final word in interpreting laws – has not seriously misread the new law. Indeed, as part of its suggestions to fight corruption, in order to raise productivity, a few weeks after the new law was passed the IMF advised the Italian authorities also to ‘criminaliz[e] the false accounting offense’ (p. 13 of this report).
The report was completed on the very day the judgement was issued, and is therefore unlikely to have taken it into account. But as the IMF wrote its advice once the new law was already in the books, it must follow that the Fund interpreted it in the same way as the court, and was not persuaded by the Italian authorities’ response that the new law already ‘includes… the criminalization of false accounting’ (pp. 13–14 of the same report). So we shall proceed on the assumption that the new law has decriminalised valuation fraud, as the court concluded, and has, by consequence, deprived the criminal system of any real capacity to deter accounting fraud.
The context and history of this loophole make it even more perplexing. It is often reported that a significant weakness of the Italian economy is the small average size of its businesses, which seem ill prepared to compete effectively in increasingly globalised markets. Indeed, as Table 1 shows, around 95 per cent of Italian businesses are micro enterprises (1–9 employees), employing almost 46 per cent of the occupied labour force and producing about 30 per cent of value added.
Table 1: Size of Italian enterprises
Source: SBA Europe factsheet, 2014
The problem, however, lies less in the static picture – too many small companies – than in the dynamics: too few small companies grow to medium size, and too few medium-sized businesses mature into large ones. As Table 2 illustrates, in fact, over the past decade ‘downsizers’ were relatively more common in Italy than either firms that remained in the same class size, or firms that were able to upsize.
Table 2: Growth dynamics of Italian enterprises in the period 2001–08
Source: Navaretti et al., 2012, with data from Amadeus and Efige
According to the European Commission’s periodic review, shown in Figure 1 below, Italy’s ‘SME context’ remains below the EU average, with weaknesses reported in areas such as access to finance, red tape, SME access to public procurement, and the insolvency framework.
Figure 1: Italy’s SME context
Source: SBA Europe fact sheet, 2014
One important – and equally well-established (see, for instance indicators 1.17–1.21 in this report by the World Economic Forum) – reason for these dynamics is that Italy’s corporate governance standards seem less conducive to growth than those of comparable economies. And one part of the problem is precisely the relative unreliability of corporate financial statements. This is itself partly an effect of other corporate governance inefficiencies, such as the weakness of minority shareholders’ protections (the World Economic Forum report ranks Italy in position 127 out of 144, between Nepal and Iran) and of the strength of auditing and reporting standards (Italy’s rank is 99, between Lebanon and Moldova).
The causal link seems rather clear, and would appear to proceed primarily through the market for capital, as Table 3 and Figures 2-6 below suggest. It is also because they trust their accounts less, that outside investors – i.e. investors not connected to the controlling shareholders – are less inclined to provide long-term capital to Italy’s SMEs, and demand a higher premium than in comparable economies. So, Italian SMEs grow less, on average, than their French or English peers also because they face comparatively higher costs for acquiring both equity capital and long-term debt financing, which are crucial for growth.
Table 3: Percentage share of SME loans in total business loans (2007–13)
Source: OECD, 2015
Figure 2: Trends in SME loan interest rate and spread with large business loans
Source: OECD, 2015
Figure 3: Trends in SME non-performing loans
Source: OECD, 2015
Figure 4: Venture capital in selected EU economies (million euros)
Source: OECD, 2015
Figure 5: Early-stage venture capital (left) and expansion investment to Italian SMEs (right) by number of employees (in thousand EUR)
Source: OECD, 2015.
Figure 6: Number of short-term and long-term loans to Italian SMEs
Source: OECD, 2015
This is the background against which the political history of the loophole should be viewed. Before turning to it, however, it might be useful to recall that between the 1994 and the 2013 general elections Italy has been run by a roughly bi-polar political system, in which two broad coalitions of the centre-right and centre-left generally alternated with each other in government.
One of the many peculiarities of this political system is that during these two decades, criminal investigations and the criminal laws were often very prominent in public debate: not just because the rule of law is weak in Italy, and corruption and organised crime widespread, but also because ever since his first accession to power, in 1994, the leader of the centre-right coalition – Silvio Berlusconi – was targeted by numerous investigations for corruption and other crimes, including accounting fraud (in 2013 he was convicted for tax fraud). As such the events described below unfolded under closer scrutiny from the media and public opinion than one would expect in other nations.
In 2002, the centre-right effectively decriminalised accounting fraud, except for listed companies. It drastically shortened the jail term and statute of limitations for this crime, and made it punishable only upon the denunciation of either the shareholders or the creditors – who typically either cannot or won’t denounce it, as we noted above – and only if the amount of the falsification exceeded either 5 per cent of the company’s net income or 1 per cent of its net assets. This last limitation applied to listed companies too, however, opening a rather wide space for accounting fraud also in the higher echelons of the Italian economy.
The 2002 law was widely criticised, most vociferously by the opposition. And the main charge was that the centre-right coalition had passed it in order to favour their leader, who was in fact acquitted in his false accounting trials precisely because of the limitations brought by the new law. In the 2006 elections, the centre-right was narrowly defeated by a very heterogeneous centre-left alliance. Despite electoral promises, however, the centre-left did not repeal those limitations. That alliance collapsed in the spring of 2008, leading to early elections that the centre-right won decisively.
In late 2011, when Italy seemed close to a debt crisis, the centre-right ceded power to a technocratic cabinet, supported also by the centre-left, which governed Italy until early 2013. This government did pass an anti-corruption law – not a very effective one, as we have argued – but it acknowledged that restoring effective criminal sanctions for accounting fraud was beyond its capabilities. The elections held in early 2013 produced a grand coalition government, which lasted until the spring of 2014. This government too failed to reform the 2002 law.
That government resigned shortly after Italy’s main progressive party – the Democratic Party, which in 2013 obtained 55 per cent of the seats in the lower chamber, but remained a few seats short of a majority in the senate – elected a new leader, Matteo Renzi, who became prime minister in February 2014 and still governs Italy, in coalition with a small segment of the former centre-right coalition.
It is under this cabinet that the new law was adopted in June. It formed part of the government’s wide and ambitious reform programme, and was hailed by several politicians and commentators (e.g. here). This law does indeed repeal each of the limitations brought in 2002. The jail term for accounting fraud is now the longest in Europe (eight years); the statute of limitations has been correspondingly lengthened; the crime is again punishable ex officio; and there are no thresholds. Yet this law has removed four words – ‘ancorché oggetto di valutazione’ – from the clause describing the crime: those that refer to valuation fraud. This is what has opened the loophole discussed above, which makes – under the assumption we made above – the rest of the law largely illusory.
The amendment deleting those four words was brought rather late in the legislative process, in March, and was a government-sponsored amendment. The press noted this choice and explained its probable effect. But the government and its parliamentary majority neither responded to this criticism nor explained the amendment, which was rapidly approved by the parliament. It is also interesting to note that three months earlier, in January, the government took the position that the thresholds adopted in 2002 should be maintained. This position was widely criticised, however, and the government withdrew it.
For the reasons we discussed above the deletion of those four words might harm long-term business-induced growth. Yet the rationale that underpins this choice remains unclear (not least because the media showed very little interest in this matter). A hint emerged during the debate on the thresholds in January, when the justice minister explained that it was the business sector – he named the confederation of Italian industry, Confindustria, and similar organisations of the agricultural and craftsmanship businesses – that had advised the government to retain them.
Indeed, Confindustria never criticised the 2002 law; and the head of Italy’s anti-corruption agency, a respected former magistrate, has recently argued that it was passed in response also to a ‘request from Confindustria’. (In fairness, on 28 May, addressing the organisations’ national assembly, its president said that the new law is ‘absurd’ and ‘specifically studied against business’: but as he spoke before the recent judgment it is unclear whether he referred to the repeal of the 2002 limitations, to the opening of the new loophole, or to the combination of the two).
This suggests that an influential segment of the business sector might assign greater value to the benefits that accounting fraud can offer than to the prospect of acquiring better access to long-term capital. Rather than the virtuous route to growth and profits they seem to prefer other routes, which carry Italy’s companies to less distant destinations, no doubt, but are easier to walk.
Finally, it is interesting to note that neither the print nor the electronic media – owned mostly by either the state or by industrial companies – have taken much interest in this story. Only two newspapers followed it, in fact: the Corriere della Sera, generally viewed as Italy’s newspaper of reference, and the Fatto Quotidiano, a much smaller outfit, very critical of the government. The Corriere informed the public also of the amendment deleting those four words, and explained its likely effects: but even this newspaper never discussed the matter in its op-ed pages, and left it to a few (excellent) articles of its judicial affairs editor (Luigi Ferrarella).
One lesson that could be drawn from this story is fairly obvious, if often forgotten in the discourse about structural reforms: details matter. The 2002 law was a structural reform, and an important one, but it went in the opposite direction of what the country needed. The 2015 law was a structural reform too, because it undid that previous one: except that it didn’t.
But this story also corroborates the conclusions of our earlier post for Open Democracy, on corruption: that Italy’s political system seems still unable, alone, to reform the country’s economic (and political) institutions. In short, the problem seems to be that without greater pressure from the electorate, reforms shall neither be deep enough, nor seriously implemented; and yet such pressure is not forthcoming because citizens face severe collective action problems, display growing dissatisfaction with the political system, and seem increasingly inclined to respond to its inefficiency by opting for ‘exit’ rather than for ‘voice’. Electoral turnout is in decline, and according to a reputable report trust in the ‘political authorities’ taken as a whole – from the EU down to municipalities, and including both executive and legislative authorities – has dropped from 41 to 21 per cent over the past decade.
Tenacious and skilful though they are, even the current government’s efforts to inject confidence in the nation do not appear to have reversed that trend yet. Indeed, according to the same report – which is based on observations taken during 2014, and was published at the end of the year – as few as 7 and 3 per cent of citizens now trust the parliament and political parties: down from 13 and 8 per cent in 2010, respectively.
Thus a vicious circle might have set in, in which political parties will rely ever more on their loyal constituencies – including sometimes patronage networks – for electoral support, and will become ever more distant from the electorate. And as no events or political forces that could break this cycle and lead citizens to a more active stance seem visible on the horizon, one wonders for how long that inefficiency/exit equilibrium can hold.
An different version of this article – written before the motivations of the judgement had been published – has appeared on the EUROPP blog of the London School of Economics (here).