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.