The VW scandal, “green” revenue manipulation and corporate governance

by Carol A Adams

Board of DirectorsFor anyone interested in the subject of business ethics, these have been tantalising times. The VW emissions scandal has brought business ethics to the forefront of the global news agenda and into public consciousness. In this case up to 11 million global consumers are potentially affected by questionable practices. This is perhaps an unprecedented mass business ethics failure in terms of scale and reputational loss. But while all eyes are on this topic, questions remain as to whether this case will fundamentally change how companies are run. In the case of VW, I will argue that the motivation to mislead  environmental regulators was significant and the Supervisory Board’s reportedly blissful unawareness that this was occurring was in their interests. Further, a number of statements made prominently in VW’s most recent annual report, with hindsight, are questionable and increase the trust and reputation crisis that VW now faces.

What’s so magnetic about the case of VW is that it concerns an “über” global brand. VW,   or “Das Auto”, has become known as dependable to ordinary families and business executives. VW has become synonymous with robustness – it’s a good product.  But more than that, the latest annual report states up front, “the brand delivers innovative, responsible mobility to people world-wide”.  Not so responsible.  Whilst an environmental scandal was brewing, up front in the report, Martin Winterkorn claimed “…our responsible approach will help to makes us the world’s leading automaker by 2018 – both economically and ecologically.” Instead, a reputation built up over decades was in tatters overnight.

In no uncertain terms, the VW emissions scandal must shake up Corporate Governance and Risk Management – and accountants and non-executive directors should consider how they work in the light of this scandal. In today’s broader interconnected world, consumers and regulators will not put up with questionable business practices – especially where they have been self-proclaimed as ‘responsible’, ‘ecological’ and ‘leading’.

Three-pronged failure

The VW crisis is the result of a three-pronged governance and culture failure. The three spokes were: marketing, risk management and internal controls and the failure of these three parts to connect.

Reputation loss follows in part from the approach to marketing. Marketing is about driving sales (excuse the pun) and crisp environmental messages are a marketer’s dream. In the process of marketing products there can be a tendency to brag in order to increase sales. And with environmental issues there is always a danger that the promises of marketers are simply PR fluff. Ultimately, a lot of consumers bought cars because they were led to believe they were environmentally friendly. When such marketing approaches and promises are found to be incorrect, consumer mistrust and reputation loss follow.  Rebuilding trust, if indeed possible, is a long and hard process.

Secondly there is the risk management process in the organisation. It is vital in this interconnected digital world, where brands are under growing public scrutiny for businesses to look beyond financial and operational risks. All businesses particularly large, multinational conglomerates, which have huge global footprints, must start to think more broadly about potential risks that might impact on reputation.

Furthermore these risks very often come from social and environmental issues and ethical concerns. These are the sort of risks that often don’t appear on the radar because they are hard to quantify and manage. They are often hard to even identify because they often fall outside traditional areas of expertise.

The big lesson for risk management is that organisations need to make sure major reputational threats are incorporated into the Risk Register and the Board should be asking managers to look at all potential risks that could affect the company’s balance sheet.  Branding yourself as an ecological leader when you are not coming clean with the environmental regulator is begging for a reputation risk crisis.

The third aspect of VW and the lessons to learn stem around internal control and audit. In my mind this monitoring is all part of the governance function. Firms, again, need to look beyond the bonnet and get a grip on what’s going on by cataloguing potential issues and then developing governance systems and controls, including for non-traditional issues that could have a big financial impact. In essence, businesses need to prioritise looking at non-financial issues that could bite back at them and develop appropriate controls over these issues, particularly where there is an incentive for manipulation.

In the VW case there was an incentive to manipulate the software, the outcome of which increased sales, revenue and profitably, and with it the remuneration of the Board of Management and Supervisory Board (the components of which are explained in the annual report). Such incentives to overstate revenue and profit should lead to internal controls and internal audit of the possible means of manipulation – whether the sources are financial or non-financial.  Large companies are getting better at monitoring environmental compliance and other possible sources of reputation risk in their supply chains, but do they have appropriate internal controls over such matters in their own operations? Are they judging their own operations by the same standards? It’s a simple analogy, but there’s a lesson there.

Over recent weeks there has been a lot of debate around who has been responsible for VW’s problems with various finger pointing from the Board to management. But at the end of the day, the buck stops with the Board.  Indeed, in the ‘Report of the Supervisory Board’ in the 2014 Annual Report, Board members attest that they received from the Board of Management all documents relevant to their decisions on “compliance-related topics and other topical issues”.  The Audit Committee, which was also responsible for risk, held just four meetings in 2014 focussing “primarily on the consolidated financial statements, risk management (including the internal control systems), and the work performed by the Company’s compliance organisation.”  Clearly the work was not enough to support the claims in their report.

Connected business

In my experience as an adviser to organisations on sustainable business and reporting on long-term value creation, avoiding reputational problems is not just about the functional areas identified above – marketing, risk management, internal control and audit – functioning properly, but also about synchronicity between them. This is a holistic issue and solution.

To illustrate this: the marketing person working on their own trying to sell a car as a green car is not such an issue, but when you link that to the potential for manipulation in order to increase sales elsewhere in the organisation as was the case at VW, the risk manager should be alert to it and internal audit should be monitoring for compliance breaches and other unethical behaviour.

Within these spokes of the corporate wheel, the risk management people are the gel, because they should be looking at the operational and financial risks which could occur from any potential wrongdoing, particularly where the incentives are there. Having a risk management team that speaks across departments and function will enable an organisation to understand and document what’s happening in different parts of the business, thereby lessoning the chances of such matters being awry. In this respect, the tone is set by the Board. Corporations, particularly large multinational ones, need to prioritise that connectivity and integrated approach.

Executive pay

The other point to make about VW is it exposes some topsy turvy thinking of how corporations are rewarding and incentivising executives and Board members.

Senior executives in charge at VW and Supervisory Board members responsible for governance have benefited from a false premise being sold by the company.  According to the most recent annual report a proportion of the remuneration of Supervisory Board members “depends on the amount of the dividend paid”. Consumers bought the cars because, amongst other things, they thought they were environmentally friendly, increasing executive and Board remuneration. To get a pay out when the remuneration has already been inflated is ridiculous and companies must heed this lesson to make sure their reputations are maintained and their businesses are sustainable in the longer-term. The very first performance indicator in VW’s annual report for 2014 is volume of vehicles sold, an increase of 5.0% over 2013.  It is clear what mattered and why.

Creating challenging cultures

Culture is directly related to governance. Culture and the ethical tone are led from the top of the organisation, by senior executives and Board members. VW’s Supervisory Board includes, amongst others, owners, employees who have links back to employee organisations and unions. To some extent some members of the Board thus have a conflict of interest. The owners are looking to maximise dividend and share price and employee groups have an interest in maintaining or increase pay and employment, therefore having an incentive to increase profitability.  Given that Supervisory Board pay is linked to dividend payouts, there is a conflict of interest to question anything that might have a negative impact on short to medium term revenue, profitability and dividend payouts. The irony is that the reputation crisis will have a long term impact.

Electing independent directors

VW highlights the vital role of independent directors on company boards. Contrary to some opinion, an outsider can understand a corporation’s culture and have a broader perspective with which to question it. Having someone from outside looking in is sound business practice. Negative cultures can embed within organisations which become blinkered to them. At times boards need to be challenged and questioned.

My work with boards and board directors indicates that there is a gap in board competencies around Corporate Social Responsibility (CSR), particularly in understanding the risks and benefits. CSR isn’t on the skills matrix. There is a view that you have to have skills in a mainstream business area and CSR on top of that might be a ‘nice to have’.  But boards should also be explicitly looking for someone with CSR knowhow in addition to other skills.  An understanding of how CSR and sustainability practices add value, present risks and opportunities is a vital component of strategic oversight in today’s world. Culture and strategic direction flows from the top of the organisation and the Board itself has a role to play.

There is a very big gap in terms of their understanding of corporate social responsibility and the impact on reputation and trust. And how to integrate that into mainstream business practices. CSR is relevant to risk management, financial performance and how you market products. There is an essential role for it on the corporate board.

The future

So will business learn the lessons from the latest corporate ethics failure? Corporate problems such as the emissions scandal tend to happen to businesses that are blinkered, who think they are beyond these sorts of things happening to them, who are not challenged by differing perspectives.  It falls upon all directors and independent directors to speak up when they have concerns about business operations. Boards operate on consensus and it takes courage to go against the majority or an influential individual. Having a positive boardroom culture where different views are respected and allowed to be discussed can play a big role. It could be that someone on the VW Supervisory Board did have some concerns, for example about communication with the Management Board, but went unheard. It would be interesting to know.

This is the version of the article submitted to Economia for publication in the December 2015 issue where it was first published. This article is not to be republished.

Share this article

Comments

  1. Dear Carol, the VW events lead me to ask a series of questions. These include how many VW and other makes cars did the UK and EU public sector testers actually test before the cheat was uncovered to ensure that the VW and all the other manufacturers emissions figures were right? Who set the tests and standards that the manufacturers “got round”, was it the manufacturers or the public sector, if it was the latter can the public sector staff who have so comprehensively failed society with such an important task be properly dealt with and replaced; can we be told that this has happened? Re vehicle excise duty, road fund licences, and the tax paid on company car benefits, very large amounts of tax appear to have been deliberately underpaid, there appears to have been what in reality is mass and deliberate tax fraud – are the tax authorities going to prosecute, if so when, and if not, why not; and who is going to pay the exchequer all the sums of tax that have been deliberately underpaid? The victims who have bought the fiddled cars – will they have to pay that unpaid tax – or the manufacturers? When one starts to think this scandal through, as well as all the other aspects of this case, what one also might possibly appear to have is a very serious and large case of tax evasion and tax fraud. And tax fraud – depending on the circumstances – means exactly what? Well, me learned friends tell me what it actually means is a trip, with ones tooth brush, for several years down the road……..one wonders what will happen?

  2. Thoroughly enjoyed this article – rather than singling out the company as a solitary case, you have pointed out that this could happen in any company with the same conditions. Time for change. Time for Responsibility.

  3. Carol,
    Thank you for the article and the in-depth analysis. Very pertinent. A new study should examine the question as to the size of the rebate that will entice owners to buy VW again.
    The simple question you raise is a universal one. How do we know that we comply?
    Consider the black and white response and forget the risk assessment for the moment.
    If one asks the question (to the Company Secretary Legal Director) in the right setting, be prepared.
    Comply to what? The law – which jurisdiction? Do you have a list?
    Comply to company policy? Internal policies or policies made public?
    Do we consider compliance issues related to the supply chain?
    etc, etc.

Speak Your Mind

*