Volkswagen AG (VW), with annual revenues of $244 billion in 2014 and some 600,000 employees worldwide, now stands accused of systematically circumventing and violating environmental safety rules and regulations the world over, possibly for years. News first broke in September 2015 that the German automaker improperly installed engine control software in millions of cars beginning in 2008, to disguise the actual pollution caused by many of its diesel engines–pollution that in some cases reached more than 40 times what is allowed by law. VW CEO Martin Winterkorn resigned five days later after the company’s stock saw a one-day decline of 20 percent and another 17 percent the following day. How could something like this have happened at Germany’s largest—and otherwise reputable—corporation?
As an American born and raised in Germany whose professional career has focused on corporate governance principles and ethics in business, my peers have frequently posed this question to me. I point to the following three factors to help explain how this crisis emerged:
- A supervisory board comprised of non-independent directors who were either unwilling or unable to effectively challenge management.
- VW’s corporate culture has been described as one that discourages dissent and is characterized by an outsized respect for company hierarchy.
- Management made the business decision to “bet the company” on diesel engines, going against the prevailing trend toward hybrid electric vehicles, and putting tremendous pressure on engineers to meet stricter-than-expected emission standards.
Germany has a two-tier corporate governance system comprised of a management board, which oversees the company’s day-to-day operations, and a supervisory board, which oversees the management board, similar to how a board functions in the United States. This system of co-determination has been in place since the end of World War II and has become an anchor of German industrial law. An important rule of this style of governance, among many others, requires worker representation on the supervisory board, which has led to fairly large boards. German corporate law does not require that a certain percentage of directors be truly independent from management. Volkswagen’s supervisory board comprises 20 directors, but only one—Annika Falkengren, group CEO of Skandinaviska Enskilda Banken AB—can be objectively deemed independent from management or the company’s controlling shareholders.
For a corporation that markets and sells its products all over the world, the lack of geographical diversity on the supervisory board is shocking: 17 members are of either German or Austrian descent. (Two are Qatari, Falkengren is Swedish.) The company’s largest shareholders are also well represented: the German state of Lower Saxony, a 20 percent shareholder, has two seats; the Porsche and Piëch families hold five seats; and two are held by a Qatari fund. I would respectfully submit that any board with such a composition may be unwilling or unable to effectively challenge management when necessary.
In his 2008 book Outliers: The Story of Success, author Malcolm Gladwell examined how cultural issues at Korean Air snowballed into a string of crises. For a period of time in the 1990s, Korean Air had more plane crashes than any other airline in the world. Rather than blaming poor maintenance or other technical factors, Gladwell observed that the airline’s struggles were driven by Korea’s hierarchical culture where, in his words, “You are obliged to be deferential toward your elders and superiors in a way that would be unimaginable in the U.S.” For example, cockpit voice and flight data recorders revealed that, in several cases, when the captain incorrectly manipulated the controls, the first officer neither said nor did anything to rectify the error.
A similar culture may have been at work at VW. Junior members of management often are not empowered, too timid, or downright frightened to speak freely. A lesson learned early in a career at VW was to obey and fall in line, according to published reports quoting junior staff. After the diesel emissions scandal broke, even a member of the supervisory board, Bernd Osterloh, urged the company to foster a new company culture where problems are “not concealed but are communicated openly to superiors.”
Diesel cars are very popular with consumers in Europe, accounting for roughly half the passenger vehicles on the road today, much of this being a result of selectively high gasoline tax policies in Europe. (By comparison, just 3 percent of cars on the road in the United States run on diesel.) Although the diesel engine is 30 percent more energy efficient than its gasoline counterpart, it produces more emissions, namely the nitrogen oxides that not only create that signature diesel smell, but have been linked to causing cancer in humans.
In 1997, Toyota introduced the Prius, the first mass-produced hybrid car. A number of carmakers around the world took note and started or accelerated their own development of engines and powertrains using hybrid technology. Not VW. The company instead decided early on to invest heavily in its so-called “clean diesel” technology, hoping to win over consumers in the United States and around the world. VW, however, either underestimated the engineering costs associated with reducing nitrogen oxide emissions or the zeal of California and other U.S. environmental regulators. When the company looked to introduce the 2008 Jetta model with a new diesel engine, VW found itself in a serious bind. According to company tests, the engine simply would not meet U.S. emission standards. Unfortunately, much of the company’s strategy for the U.S. market was built around this new engine—and VW was not prepared to pull back from the U.S. market.
There were warning signs that an especially astute shareholder or a director willing to challenge management might have been able to heed. The earliest perhaps came in 1993 when then VW CEO Ferdinand Piëch unscrupulously recruited GM purchasing executive José Ignacio Lopez. When 70 cartons of confidential documents subsequently made their way from Detroit to Wolfsburg, criminal charges were filed in Germany and the U.S. alleging that Lopez and VW committed corporate espionage, document theft, and patent infringement. Other crises at VW that suggested a corporate culture of cutting corners include a bribery and prostitution scandal in 2006. And shareholder alarm bells should probably have gone off when, in 2012, VW appointed Ursula Piëch, the wife of Ferdinand Piëch, to its supervisory board. (Both have since resigned).
In summary, when the strategic “bet the company” decision on diesel engine technology began to look like a big mistake, VW’s corporate culture encouraged (or at least did not sufficiently discourage) cutting corners. And the supervisory board, which under German law has the duty to exercise oversight over management decision making, failed to do so. Proven corporate governance best practices simply were not followed at VW.
The company’s response since the eruption of what has been widely described in the press as a crisis of potentially existential proportions, has not been encouraging. A new chair of the board was appointed within weeks. Was this person a well-respected outsider with extensive board governance credentials, gravitas, and a record of successfully challenging entrenched senior management teams? No. The new chair of the beleaguered company’s board is a man who might be seen as having a serious conflict of interest: Hans-Dieter Pötsch, the long-time CFO of—drum roll please—VW. He has pledged to get to the bottom of what happened.
When another German giant dealt with an enormous bribery scandal, it followed a different path. Siemens, in 2006, appointed an outside (read: independent) chair (Gerhard Cromme from ThyssenKrupp) and an outside CEO (Peter Löscher, formerly with Merck and General Electric) for the first time in the company’s 160-year history. Working side by side, the two managed to transform the culture at Siemens. The chair even initiated legal action against a former Siemens executive for not doing enough to stop the illegal bribery practices.
VW is a company with a rich history, but senior management has violated the trust of all of its important stakeholders. It has put the company at great financial and legal risk, threatening its very survival in its current form. For the sake of VW shareholders, employees, and customers worldwide, it is incumbent upon VW’s supervisory board—backed by its majority shareholders—to reverse course, adopt sound corporate governance practices, and follow the rules.
This article was first published in the March/April 2016 issue of Directorship, a publication of the National Association of Corporate Directors (NACD).
Michael Marquardt serves as a global business advisor to corporations in Asia, Europe, and the United States. He works closely with the CEO and members of the senior leadership team on issues strategic to the enterprise, and advises audit committees and boards on effective risk management measures, corporate governance, and emerging technology issues. He is an NACD Board Leadership Fellow.
Follow Michael on Twitter @MarquardtGlobal.