Preventing the Next Existential Moment

By Roy C. Smith

VW is facing an existential moment, one like BP’s after the Deepwater Horizon oil spill that cost its shareholders $70 billion in market value. Surely, someone on VW’s Supervisory Board must have asked “what could we have done to prevent this from happening?”

The same question must have been asked by the Boards of Directors of the dozen of so major banks who between them have paid out approximately $200 billion to settle lawsuits brought by the US Department of Justice, the Federal Housing Authority, the SEC, the CFTC, State Banking Regulators, and British and European regulators since 2008. 

These various and numerous regulatory offenses leave the impression that today’s Big Business firms ignore or deliberately flaunt laws and regulations intended to contain their power and influence.  Observers must wonder whether anyone has ever asked the question of any large corporate board members.

There is, alas, little evidence that anyone has.

Boards are the bodies charged under the law with looking after the interests of the shareholders of private corporations.  They are required to appoint CEOs, but otherwise their duties are unclear, having to do with “monitoring” things, making sure takeover offers are handled fairly, looking after social responsibilities, and, of course, avoiding the existential moments.

How to prevent those moments from occurring is of utmost importance to their shareholders, so boards need to consider some different approaches to doing so. Here are four ideas:

Challenge Strategies

Boards not only appoint CEOs, the CEOs establish business strategies that boards must approve and fund. This may include VW’s strategic initiative to use its diesel engine performance to rise to the top of the auto industry.  If people independent of management had challenged this idea rigorously then the plan’s Achilles heel (they can’t do it without violating emissions standards) might have been revealed.  But it wasn’t.

After the merger of Citicorp into Travellers to form Citigroup, there were dozens of other mergers of big banks.  None were seriously challenged by their boards, all of whom seemed to go along with the idea that being bigger was always better, even when it plunged them into a realm of new businesses and risky activities they knew little about.  Almost all of the litigation settled by the major banks is the result of missteps in trading, underwriting, mortgages, or other activities the banks were not in a decade before.  More pushback from the independent board members (supported by their own experts and advisors as needed) might have made a difference. At least they could have focused attention on the difficult implementation of the strategy that proved to be their Achilles heels.

Rethink Middle Management

Goldman Sachs became a public company in 1999 after 130 years as a partnership.  It wanted to preserve some of the uniform cultural and managerial aspects of the partnership, so it devised a different kind of management structure from other banks, one that put a lot of emphasis on middle management to enforce professional standards for the whole firm.  Today, Goldman Sachs has about 34,000 employees, of whom 2,100 or so are Managing Directors, the firm’s principle culture carriers.  Of these, approximately 20% are Partner-Managing Directors, a senior position that is entitled to partner-like compensation based on a share of the whole firm’s annual income. Managing Directors are selected based on their performance as middle and upper mangers responsible for revenues, risks, costs and legal exposures.  The units they supervise are under constant surveillance to maintain high standards, and to detect and prevent any form of misconduct or wrongdoing. Things fall through the cracks sometimes, but with 2,100 of these guys continuously roaming the halls, there are fewer accidents than might occur otherwise.

Learn from Mistakes

Every legal or regulatory settlement that occurs can be a teaching moment. There is something to learn from a thorough discussion of the events that ended in lawsuits, especially by the standards-enforcing middle and upper managers of a firm. The need to know what motivated the troublesome events, why they went undetected and what the outcome of the litigation was, but can only do so if someone prepares the information (from the extensive legal proceedings) on the cases and enables a full discussion of them by the entire middle management cohort group, however large, though the discussions must be held in small groups overseen by someone in touch with top management.

Few firms do this – they don’t want to highlight their own settlements, or take the time necessary to send everyone to school periodically on such matters.  They should. It would improve everyone’s understanding of what happened, what was wrong with it, and to clarify for everyone’s benefit how such things should be handled at their own firm should they crop up.

Pay and Promote Differently

Increasingly, it seems necessary to replace “you-eat-what-you-kill,” pay-for-performance compensation programs with ones that are more holistic and take into account defensive and preventive measures taken by managers. If the word gets out at the mid-manager level that performance is to be judged by several factors, not just profits contributed, including how well one’s unit performs over time and what managers have done to prevent harm, things will change quickly. Boards should be willing to pay well for good managers that do these things well. They are scarcer than good engineers or traders.

Pay, of course, also needs to be increasingly in company shares as managers rise in the firm, and always subject to “clawback” provisions, including in cases in which a subordinate is charged with wrongdoing. The firm should also make it clear that individuals charged by regulators may not be reimbursed for legal expenses, and the firms will cooperate with prosecutors in their prosecution of the individual.

Existential events are not often fatal, but few companies escape the years of lackluster performance that follow the thumping that the events engender. Boards of Big Business companies need to wake up and recognize that they can lower the probability of such events in the future by reshaping the cultures and middle management cadres that have enabled them.

Whatever Happened at VW?

 

by Ingo Walter

With the resignation of CEO Martin Winterkorn and his replacement by Porsche’s CEO, the firing of three key R&D bosses, the herds of prosecutors and tort lawyers hoping for years of litigation, and the ominous clouds overhead from the media, among regulators and customers – and not least investors who have lost up to 42% of the value of their shares - the VW scandal raises lots or questions that go way beyond the world’s largest car manufacturer itself. They concern corporate governance, management decision processes and individual accountability, the regulatory environment, as well as industry competitive structure and performance. A true learning moment.

As the proud owner of a VW Toureg turbodiesel, it also hits close to home. Happily for now, VW V6 diesels like mine have not been named in the fraud allegations. But that may just be because of the expensive urea-based technology to cut nitrogen oxide (NOx) emissions found in large diesels was what VW was trying to avoid using in small ones by relying a “magic” approach that nobody could replicate and that turned out to be fraudulent. Now pundits have proclaimed the “death of diesel,” probably prematurely and unfairly.

What next for VW? Examples from the banking industry suggest that "rogue" behavior in one firm often turns out to be "industry practice." Examples include manipulation of foreign exchange and Libor benchmarks, hedge fund “late trading” in mutual fund shares, mis-selling of “payment protection insurance to ordinary retail customers,” insurance broker kickbacks from underwriters, falsification of international payment transactions, aiding and abetting tax evasion, and the list goes on.

One firm gets tagged and the others run for the hills and take a very low profile until the posse rounds them up. That could be the case here also, with MB, BMW, Renault, Peugeot, etc. Some are saved (for the moment) because they focus on big or expensive cars able to support urea-based approach. Others focus on mass-market, cheaper diesels and may have encountered engineering problems similar to VW’s. They say they have not, that VW is unique. If not they will step up very soon. Last guy in is a reputationally rotten egg. So we’ll soon see whether the VW problem is in fact firm-specific or industry-wide.

Certainly the nitrogen oxide emissions remain an issue with the US and especially California most aggressive in putting on the regulatory pressure. The European approach seems to have been more retarded and haphazard by comparison, with heavy lobbing from the important car manufacturers and their governments. Travelers can tell you that the air pollution problem is pretty bad in parts of Europe. On a dozen or so days a year the speed limit in the Paris region is cut to 90 km/hr because of the health effects of NOx and particulates – in an air-shed where well over half the cars and almost all trucks are diesels. This is not a matter of engineering fraud but rather one of deficient emissions standards, but now that the VW cat’s out of the bag it points to things to come for the automakers.

To the outside observer it seems that what happened here is that the VW engineers got seriously squeezed between the marketing pitch for modern European common-rail diesels (fuel economy, durability, torque and environmental friendliness – much of it true) and the tightening noose of US environmental standards. This eventually made the two simply incompatible.

The engineers no doubt signaled the problem internally (how high up we don't precisely know) and senior management told them to fix it or else. So they were trapped. Pressed to the wall, the engineers came up with a workaround. Whether in the whole process anyone raised the full range of potential consequences including the possibility of individual criminal charges we also don't know. Anyway, decisions got made somewhere. Under German law such matters tend to move quickly into the criminal domain where unlike in the US firms cannot be charged in civil proceedings (and allow a range of punitive options, possibly including criminal pleas by firms themselves) but rather are targeted on the individual.

So the otherwise walk-on-water CEO has walked the plank instead and may be personally charged (famously, this has rarely happened in banking).

Some Europeans have blamed the US regulatory approach and litigiousness for triggering the brouhaha. In Europe it would have been taken care of in a sensible way by corporate specialists talking to regulatory specialists, eventually arriving at a mutually acceptable solution. Maybe so. But they said the same thing in the FIFA mess.

Two Questions Raised by the VW Case

by Roy C. Smith

The VW case will raise two questions for sure: is someone going to jail?, and what should be expected of boards of directors in preventing corporate misconduct?

Last month Volkswagen’s Supervisory Board asked for the resignation of CEO Martin Winterkorn and said it was investigating the company’s engineering staff to pin down responsibility for the installation of the “defeat devices” used for seven years to disable emission controls on 11 million diesel engine cars sold in the US and Europe. The devices were installed to boost performance standards for the cars that VW emphasized in its advertising. Prosecutors in Germany, the US and Sweden and other countries are investigating the situation for possible criminal violations.

Meanwhile, market analysis have estimated VW’s potential all-in costs of fines and legal settlements to be in the $18 to $20 billion range, roughly equal to the loss of about $25 billion, or a third of the company’s market capitalization since the admission was made to the US Environment Protection Agency on September 18th. VW has taken an initial $7.5 billion charge to its legal reserves to cover the exposure.

This is likely to be the biggest self-inflicted corporate disaster since BP’s 2010 Deepwater Horizon oil spill in the Gulf of Mexico that has cost it $28 billion so far. BP’s market capitalization is about $70 billion less (35%) than what it was in 2010.

Going to Jail

Senior corporate executives do go to jail for their actions. The former CEOs (and other executives) of Enron, WorldCom, and several other companies from the 2001-2003 era are either still in prison or have only recently been released. Financial figures like Bernie Madoff and Allen Stanford are too, though the top executives of global banking firms are not, despite a certain amount of public support for locking them up.

The simple truth is that under legal systems in most developed countries, to be convicted of a criminal offense requires proving that an individual intended on breaking the law, and then did so or compelled others to.

Corporations make a lot of mistakes, and sometimes engage in activities that offend the ethical sensitivities of others, or fail to comply fully with the voluminous regulations to which they are subject. Most corporations exist to make profits in competitive businesses that require them to develop what edges they can. Sometimes they overdo it. When they do, they have to face the consequences in civil courts where a payment of money is thought to be the best way to settle claims against them. If their conduct is considered to be especially objectionable, public opinion becomes a factor that can amplify the consequences.

VW’s admission that it knowingly installed 11 million devices to thwart emission regulations appears to be a case of criminal wrongdoing for which there will be a paper trail of responsibility. We shall see where it leads, but somebody had to approve the plan to install the devices, and probably a range of senior officials knew about it.  German prosecutors have shown themselves to be completely indifferent to the status of individuals they regard to be responsible, and the publicity surrounding the VW incident (reminiscent of Enron) only makes its executives more vulnerable to being charged with a criminal violation.

Duty of Boards

The question of whether boards can be expected to prevent corporate misconduct is one with a long history of unsatisfactory answers. There seems always to be a regular flow of corporate scandals in which boards are shown to have failed to monitor executives adequately. Despite a fair amount of post-VW introspective huffing and puffing, this is not likely to change in the future.

The most important thing that boards do is to appoint the company’s chief executive.  That means choosing someone to be responsible for the company’s financial performance and for safeguarding its reputation. Most boards emphasize the former and take the later for granted. Some think it is a zero-sum game, in which aggressive growth policies come at the cost of increasing reputation risk.

In reality, however, most large company boards are unable to monitor CEOs carefully enough to prevent unforeseen events. This is because of the complexity of corporate operations, the sociology of boards and the limited time any one board member has to delve into details, especially if these are being concealed. Nor is there evidence that splitting the Chairman and CEO roles, or emphasizing long-term results in compensation arrangements makes much difference.

Some economists think that markets are more skeptical of corporate results and explanations, and accordingly are better monitors of CEO performance than a group of loyal and supportive board members, but there is not much evidence of this either.

It just may be that boards are not much good at preventing trouble. What they have to be good at, however, is cleaning up after the trouble – replacing CEOs as soon as evidence of trouble arises, conducting thorough, honest investigations to get to the bottom of things quickly, and then doing what they can to rebuild the company after the trouble.

There is some evidence that this is improving. CEO turnover, according to a 2011 Bloomberg study, was at an all-time high for the world’s largest companies. Certainly this is so for the global banking industry that has turned over the CEOs at nine of the top twelve firms since 2008, some more than once. Even so, the larger the enterprise, the longer it seems to take for boards to step in with a cleanup.

VW, however, has been quick off the mark.