What started as a straightforward notification to stock market overseers has developed into the most significant revelation of corporate fraud in the modern history of the Chilean business community. On June 9, publicly traded retailer La Polar — the fourth-largest retailer in Chile — informed the market that its financial reports had vastly under-provisioned its consumer credit card portfolio.

As the scandal unraveled, La Polar's share price has dropped more than 70%. The firm's management has been sacked. Criminal and civil charges have been filed. And the accounting discrepancies have turned out to be much greater than initially thought. Investment funds, brokers, ratings agencies and regulators have all been caught by surprise.

In the bigger picture, the scandal has put a spotlight on business practices that have been part and parcel of publicly listed Chilean companies in a sector that's by far the most developed and competitive in South America. Many retailers depend heavily on massive, unregulated consumer lending operations to jazz up profits, and the La Polar debacle has raised concerns about whether those actions are dangerously risky. The scandal has also raised calls among politicians and pundits for better regulation of the industry.

So far, the worst fears of the market have yet to be realized. While La Polar remains down for the count, no similar scandals have emerged at other major retailers — namely, Falabella, Cencosud and Ripley. Analysts and academics say that while other companies face challenges due mostly to a saturated domestic market, the Chilean retail model is still, for all intents and purposes, a sound one. "The business of Ripley, Cencosud and Falabella is tenable if you do the business in the right way," notes Gustavo Fingeret, a retail analyst at local investment bank Celfin Capital.

Although no one has been convicted yet, or even arrested, reports in the media and statements from authorities suggest that the La Polar scandal is shaping up into a prosaic case of accounting fraud. A chain of 43 department stores that went public in 2003, La Polar has grown by targeting the lower end of the Chilean retail market, offering electronics, clothing and other goods that its customers can purchase with La Polar credit cards. Last year, the firm reported earnings of 29.8 billion Chilean pesos (US$64 million) on revenue of 536 billion pesos (US$1.5 billion). Through the first quarter of 2011, La Polar had 586,000 active customer credit cards, with a total credit portfolio of 881 billion pesos, 28.5% of the non-bank retail credit portfolio.

La Polar was once a popular stock. Chile's private-sector pension fund managers — known as AFPs — collectively owned about a quarter of the company. Most of the prominent local brokerages recommended the stock to investors. "La Polar was an example of all kinds of best practice, not only as far as its business model and professional success were concerned, but also because it didn't have a controlling shareholder and had representatives of the leading investment funds, pensions and insurance companies" as investors, according to Fernando Lefort, dean of Universidad Diego Portales's school of economics and business in Santiago.

But something was not right. During the recent economic downturn, La Polar's competitors suffered as revenues dropped and credit portfolio delinquency increased. La Polar, on the other hand, remained buoyant, with a growing credit portfolio and a decent bottom line. All the while, complaints against the company were piling up with Chile's consumer ombudsman's office, Sernac. Customers accused the company of unilaterally refinancing their debts, rolling millions of pesos of fees and arrears interest into their principals and assigning impossible monthly payments.

Gradually, the picture became clear. In late May, a group of minority shareholders filed a complaint with securities regulator SVS and called for a hearing to examine La Polar's credit portfolio. Shortly afterward, Sernac demanded the same. On June 9, a La Polar statement informed the market that "practices for managing its credit portfolio have come to light that have not been authorized by the board and that are contrary to the company's parameters and standards." The statement also said the company estimated that between 150 billion pesos and 200 billion pesos of additional provisions would be required to fix the situation.

It turns out that the practice of unilateral debt refinancing had both kept reported delinquency rates down and artificially swelled the size of the company's loan portfolio with all of the added fees and interest. Investors were horrified. In one day, La Polar's share price dropped 42%, its largest-ever single day drop. Trading of the stock was suspended for a week. But things just got worse. The firm's final estimate of extra provisions needed to cover the delinquencies came in at 420 billion pesos, more than double the original figure. When trading of La Polar opened again on June 20, the stock plunged more than 60%.

The scandal has reverberated throughout the business community for a number of reasons. For one thing, Lefort of Diego Portals says, it is basically without precedent in recent Chilean history. "In previous cases, there was always the image of an evil controlling shareholder," he notes. "That was the caricature."

But unlike other retailers — and, indeed, most of Chile's other public companies — La Polar has no controlling shareholder. This was not a case of misbehavior of the owner, but of the managers. "It's a problem much more like the scandals seen in the United States," Lefort says.

In addition, the large minority stake owned by the country's AFPs (not to mention the nearly US$600 million in La Polar debt they hold) means that the scandal has a direct impact on the pension savings of many Chileans. The hoodwinking of securities and banking regulators was total, with the exception of Sernac. Both Fitch Ratings and local ratings agency Feller Rate were also duped, while La Polar's auditor, PricewaterhouseCoopers, appears to have been asleep at the switch, observers note. 

More viscerally for a country experiencing a massive wave of popular protests not seen in decades following the introduction of new policies by Sebastian Piñera's new right-leaning presidential administration, La Polar had been padding its bottom line by pounding lower-class customers with exorbitant fees and interest rates. Since the scandal broke, Sernac has received an additional 5,000 complaints from La Polar customers, and more are coming in. This accounting scandal has a populist flavor.

Just the Beginning?

The immediate concern of many is about the implications the La Polar case might have for the rest of Chile's retail sector. The focus is on the large amounts of credit provided by Chilean retailers to customers through the chains' unregulated credit card businesses. According to national bank regulator SBIF, unregulated retail credit cards account for 75% of all credit cards in Chile. Through the end of the first quarter of 2011, the total value of these unregulated credit cards was 3 trillion pesos, or 22.5% of all consumer lending.

Falabella is Chile's leading retailer by market share and its leading card issuer, with 1.8 million active cards and a credit portfolio of 890 billion pesos. Cencosud is in second place. The chain has a credit portfolio worth 426 billion pesos and has 1.2 million cards on the market. Ripley, in third place, has a 376 billion-peso portfolio and 965,000 active cards. The average debt for the active cards of the three issuers ranges between US$750 and US$1,000, figures that have been rising in line with the country's inflation and GDP growth.

But all credit is not equal. Analysts draw a distinction between single- and multi-business retailers in Chile, since the latter depend less on the financing arm for their earnings. Despite being the lead card issuer, gross consumer financing revenue at Falabella — a holding company that operates department stores, grocery stores, home improvement centers and a real estate business — is less than 60%. Likewise, the financial income of Cencosud, which is also multi-business company with a strong grocery store arm, comes to only about 10% of earnings before interest, taxes, depreciation and amortization (EBITDA).

In contrast, Ripley operates solely as a department store chain, as does La Polar. For both companies, financial earnings are very significant to their business, worth more than 100% of EBITDA. According to Peter McMenamin, a retail analyst with Banchile, Chile's extremely competitive department store business is rough on margins. "Those companies [have been] in large part priced out of the competition in terms of new retail business, so they could sell on credit," he says.

Celfin's Fingeret agrees. "All the [department store] retailers do customer financing because the margins in the retail business are really, really thin," he notes. "Depending on the company, it is between negative and 5%…. [The department stores'] business is mostly related to the use of credit cards."

The consensus seems to be that while La Polar likely cooked its books during the financial crisis to hide delinquency, Ripley took its lumps. Ripley had three consecutive quarters in the red during the crisis and its share price was hammered as it aggressively moved to provision almost 20% of the portfolio. "It looks as if [Ripley] went through the process that La Polar should have gone through at that point, and now it looks like it's got a much cleaner portfolio," McMenamin says.

McMenamin and Fingeret also point out that the growing trend of expanding abroad is helping to blunt the significance of unregulated financing to the Chilean retail market. Cencosud leads in the home improvement store segment and is also the second-largest grocer in Argentina, and the top grocer in Peru, both markets in which consumer financing plays only a minor role.

Likewise, Falabella is investing US$3.5 billion over the next five years as it expands into Brazil, Peru and Colombia. Ripley is also expanding its presence in Peru, where the chain already has 15 stores. Analysts say retail margins are better in these larger, less competitive markets. Also, in countries like Peru, retailers must seek banking licenses to issue credit, so that business is both less lucrative and better regulated.

Assets and Liabilities

Still, the heavy dependence on financing in Chile remains a concern. Juan José Soro, Santiago-based director of Universidad Adolfo Ibañez's retail program, says one way to address the concern would be for retailers to improve how they define and separate their financing businesses from core retail operations. "A retail business has to be successful by itself, not because it offers loans," he notes. "In the future, the challenge is going to be separating those business segments" in public disclosures.

But would new regulations force retailers to adjust their business models? The impact of the La Polar scandal has already been so great that some kind of new regulation seems to be a foregone conclusion, observers say. According to Banchile's McMenamin, regulators may move to put a cap on the interest rates that unregulated card issuers can charge. New provisioning reporting requirements are probably also in the cards. However, the retailers are likely to push back against any move requiring more transparency with regard to customer credit history, including shopper data they collect extensively and guard jealously. "Retailers … consider this information as an asset," McMenamin notes. At a minimum, the data gives the firms an advantage over potential credit card rivals, including banks, which lack that information to help them know who is creditworthy.

In the end, however, there is little regulators can do about straightforward malpractice by management, Lefort of Diego Portales points out. The best that can be hoped for in the La Polar case is that the system works this time, and that laws already on the books are applied appropriately, providing a deterrent to possible future wrongdoers. "They can't have the kind of supervision that a bank has. It's different," he says. "But the question is, is it enough to tell PricewaterhouseCoopers, 'You have to supervise this?' In this case, it wasn't enough."