The importance of appropriate board composition, theory and structure in assuring a corporate culture that promotes integrity and success.
The current conflagration enveloping Volkswagen (VW), involving a massive emissions regulation evasion scheme, has many causes and provides important lessons on compliance for US directors and compliance professionals. At the heart of the scandal is, of course, bad management. That such a pervasive and highly developed scheme to evade emissions standards could occur over such an extended period of time and through so many levels of the organization attests to a management culture gone awry.
Generally, corporate cultures that embrace transparency and integrity thrive. Those that are lacking do not. Why, then, did such a problematic culture exist at Volkswagen? The culprit may be twofold.
First, we have concerns with the board itself and its unique governance structure, known as “co-determination,” that defines many German companies. The proper function of the board of directors is to actively monitor management and thereby ensure maximum corporate performance. If management knows that the board is scrutinizing its actions critically, it will tend to behave better. But this does not appear to have been the case at VW.
Second, the compensation structure for the company’s executives, mandated by German law, creates a perverse incentive to maintain employment at all costs to the ignorance of, and detriment to, a proper compliance culture.
To begin with, the ownership structure and consequent board structure of the company was problematic from a governance standpoint.
Members of the Piëch and Porsche families own and control over half of the company’s voting shares through the controversial dual-class structure. Combined with the government of Lower Saxony, which owns another 20 percent, these two groups effectively controlled the entire operation.
Controlling shareholders always complicate the governance paradigm. The issue is a misalignment with the goals of the other non-controlling shareholders. Two problems are presented here: First, controlling shareholders cannot monitor themselves so as to prevent self-dealing or poor management, and minority shareholders have too little say. In this case, the company was dominated by Ferdinand Piëch, the grandson of Ferdinand Porsche, who chaired the company’s board for years. That he managed to have his fourth wife, who had no prior corporate experience, named to the board is a strong indicator of his control of the board and a perplexing action for the minority holders.
Second, where a dominant shareholder happens to be a government, the goals of that shareholder are unlikely to match those of the public shareholders.
To the shareholders, the concept of long-term return on capital is paramount, but to a government, it is not—especially a local government.
Typically, governments are motivated by political considerations, particularly the notion of the full employment of its citizens. A governmental shareholder is thus not aligned in interest with the other shareholders and the two representatives of that government who served on the VW board of directors were clearly conflicted as to their loyalty and responsibilities.
The larger problem with the VW Board, however, is not its composition, but the animating theory behind it. In Germany, under a policy known as co-determination, corporate boards are equally divided between company employees and shareholder representatives; at VW, this means that 10 of its 20 directors are labor representatives.
The goal of unions is clearly higher employment, higher wages and benefits.
The point of the board, however, is management monitoring for greater entity value, with compliance with law a preeminent objective. It is almost impossible to reconcile these conflicting goals at the board level. Consequently, the union board member is philosophically and motivationally at odds with the traditional corporate profitability purpose. This is the whole problem with co-determination and its inherent conflict between employment and shareholder return.
In the case of VW, the shareholder representatives on the board either came mostly from management, their allies or the local government, while the rest were union representatives. Consequently, the board’s interest lay in protecting jobs—either those of management or the employees.
This creates the kind of environment in which the board is no longer a monitor or accountability mechanism for management, yet becomes effectively an echo chamber that facilitates managerial largesse delivered to employees.
Each group acts in its own interest, to the detriment of accountability and consequent corporate probity.
This may, at the end of the day, explain why so massive a problematic activity occurred at VW for so long without notice or remedy.
While board and ownership structure played a key role in creating the kind of atmosphere that sustained the emissions compliance failure at VW, we believe there was another salient element present that may have exacerbated the problems created by co-determination and further contributed to the compliance breakdown. Under a significant change in German law (“VorstAG”) enacted in the aftermath of the financial crisis, mimicking, to some extent, the US Dodd-Frank legislation, corporate boards were strongly encouraged to reduce executive compensation in the event that, among other things, they had to lay off workers or reduce general wages.
While, on the surface, this approach has some visceral appeal, it may have created a management climate that, like co-determination, put compliance in a secondary role on the management agenda.
Under this regime, it would seem that a primary focus of the executives was job creation and preservation, so as to sustain their income stream. The incentive, as in co-determination, was to maintain employment with ultimate profitability, enhanced by an appropriate compliance regime, a seemingly unimportant goal. This compensation regime, established by statute, only acts to reinforce the bias towards employment created by co-determination and only further places shareholder interests along with the concomitant compliance regime on a lower rung on the corporate ladder.
The solution to the problems created in Germany by co-determination, an employment-connected compensation scheme and governmental shareholdings would involve a broad and complex legal and societal reset. But each of these approaches creates great risks for the enterprise and needs to be reconsidered.
For the near term, though, the lesson of VW is pretty clear. For shareholders: Invest in such ventures at your own risk. Ultimately, it may prove quite hazardous to your financial health.
But what lessons may US directors and compliance officers take from the Volkswagen debacle? There are essentially four points worth considering. First, the problematic board function concerns that co-determination provoked in VW are not limited to German companies. In the United States, stakeholder theory, from which co-determination emanates, can lead to the very issues that VW faces today. Even though the stakeholder approach, which involves shifting board fiduciary obligations from shareholders to other corporate constituents, including employees, remains popular in some contemporary US financial circles, it leads to the same misalignment of incentives that created the issues plaguing Volkswagen.
Second, governmental shareholders are always troublesome. The complications US directors faced in numerous corporations with governmental equity investments as a result of the financial crisis clouded their responsibilities and created conflicting obligations similar to the issues confronting the VW board.
Third, the problems created by the dual-class controlling shareholders that defined Volkswagen are also present in many US corporations. Where economic investment is separated from voting interests, numerous issues arise involving potential malfeasance and misfeasance by the controlling holder. Hence, the presence of this structure at VW has implications for US directors: What are the appropriate standards of care for directors serving on such boards? Should one serve at all or, perhaps, should this problematic structure be eliminated completely?
Fourth, while Dodd-Frank does not mandate the same compensation straightjacket as its German counterpart, the actions of the German government and subsequent VW controversy is a warning of the dangers of an employment-based compensation scheme. The scandal gives investors, compliance professionals and directors alike much to reflect upon. But ultimately, it is a testament to the importance of appropriate board composition, theory and structure in assuring a corporate culture that promotes integrity and ultimate company success.
Author Biographies
Charles M. Elson is Edgar S. Woolard, Jr., Chair in Corporate Governance and Director, the John L. Weinberg Center for Corporate Governance, University of Delaware.
Craig K. Ferrere, Harvard Law School, is Former Edgar S. Woolard, Jr., Fellow in Corporate Governance, John L. Weinberg Center for Corporate Governance, University of Delaware.
Nicholas Goossen is an Undergraduate and Research Assistant at John L. Weinberg Center for Corporate Governance, University of Delaware.
