Charles Elson, pictured during a recent corporate governance symposium, discussed problems at Volkswagen in a presentation to the University of Delaware Association of Retired Faculty.

UDARF meeting

Corporate governance expert Elson debugs emissions scandal at VW


11:34 a.m., March 18, 2016--When it was recently revealed that Volkswagen had been involved in a massive emissions regulation evasion scheme from 2007-15, many wondered how such widespread deception went unnoticed by its board of directors, which was responsible for monitoring and oversight functions. 

Charles Elson, Edgar S. Woolard, Jr. Chair in Corporate Governance and director of the John L. Weinberg Center for Corporate Governance in the Alfred Lerner College of Business and Economics, discussed the scandal at Volkswagen during a luncheon meeting of the University of Delaware Association of Retired Faculty (UDARF) held March 8 in Clayton Hall. 

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Elson spoke about many of the issues addressed in “The Bug at Volkswagen: Lessons In Co-Determination, Ownership and Board Structure,” an article he wrote in the Nov. 25, 2015, issue of the Journal of Applied Corporate Finance

Co-authors were Craig K. Ferrere, a UD alumnus and a member of the Harvard Law School Class of 2017, and Nicholas J. Goossen, a junior mathematics and economics major at UD.

“For many years, Volkswagen was dominated by Ferdinand Piech, grandson of Porsche company founder Ferdinand Porsche, and the Piech and Porsche families,” Elson said. “Piech, along with the government of Lower Saxony, Germany, controlled over 50 percent of the stock. Basically, Piech ran the show.”

Piech’s goal, Elson noted, was for Volkswagen to become the world’s largest automobile company. 

To help realize this goal, Volkswagen engineers had developed a new diesel engine that delivered great mileage and fuel economy, but didn’t meet U.S. Environmental Protection Agency (EPA) standards. Emissions from the engine contained as much as 40 times the allowable amount of nitrogen oxide, among other pollutants. 

Rather than change the engine to comply with EPA standards, which would mean reduced mileage and power, Volkswagen came up with a defeat device that would give a good reading when the car was plugged in at an inspection site and, when unplugged, would revert to the actual reading. The device was installed on at least 11 million vehicles. 

The Volkswagen board claimed to have been unaware of this scheme, and Martin Winterkorn, the company’s CEO, expressed surprise at the news of the wrongdoing. 

“It was brilliant, but it got discovered,” Elson said. “The bottom line is that it did happen, and the question is, how could a scandal so massive occur in a major corporation?” 

In the article, the authors noted that, “From a corporate governance standpoint, three major problems existed, including board composition and function, the identity of certain large shareholders, and the unique corporate regulatory structure common to many German corporations.”

Among these problems, Elson noted, is the conflicting nature of the dual-class stock held by the Piech and Porsche families, who own 31.5 percent of Volkswagen’s equity.

“Usually, when you buy shares in a company, it’s one share, one vote,” Elson said. “In Piech and Porsche’s dual class stock they got many votes for each share, and this magnified their control of the company.” 

The danger of dual class stock, Elson noted, is that it has the potential to cause misfeasance and malfeasance on the part of management.

The second problem with the Volkswagen board had to do with the nature of the ownership of the company, Elson said. 

“In addition to the Piech family, you have the government of Lower Saxony, which owns 20 percent of the company,” Elson said. “The government got it when the state-owned company evolved into a private company, but they still maintained the right to chose two directors on the board.” 

The government of Lower Saxony had very different goals than those of the other shareholders, Elson said.

“Profitability is not the first goal of the government as an investor,” Elson said. “Their goal is political, with the bottom line being to get themselves re-elected. When you create employment in your area, you are more likely to get re-elected. Volkswagen employs 400,000 workers in the area and the government’s goal is full employment.” 

The third problem, Elson said, is co-determination, mandated by German corporate law, which states that half of the board of directors of a private company have to be representatives of the owners or shareholders, with the remaining half consisting of employees. 

The Volkswagen supervisory board has 20 members, with 10 elected by the shareholders and the remaining 10 selected by the workforce. This board is mainly responsible for selecting and monitoring a separate management board that in turn runs the company. 

The idea of a union, Elson added, is to guarantee better working conditions, wages and more jobs for its members.

“The goal labor members on the board is not necessarily being profitable for the company, but getting better wages, hours and employment for their members,” Elson said. “On the other half of the board you have Mr. Piech, whose interest was building a bigger and better automobile company, and his co-directors from Lower Saxony, whose goal was jobs for their citizens.”

The result, Elson noted, was the creation of a corporate culture where the main objectives became full employment, growth in revenue and growth in size and market share. Profitability and compliance with the law may have been relegated to second place, he said. 

Elson noted that the second half of the problems at Volkswagen had to do with compensation, as he introduced Goossen, a co-author whose research appeared in an article from Ethisphere, a compliance magazine for corporations. 

“While board and ownership structure played a key role in creating the kind of atmosphere that sustained the compliance failure at VW, we believe there was another salient element present that may have exacerbated the problems created by do-determination and further contributed to the compliance breakdown,” Goossen said. “Under a significant change in German law (VorstAG), enacted in the aftermath of the financial crisis, mimicking to some extent the U.S. 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.” 

Under this regime, Goossen noted, it would appear that Volkswagen’s primary executive focus was job creation and preservation to sustain the 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,” Goossen said. “This statutory compensation regime only acts to reinforce the bias toward employment created by co-determination and further places shareholder interests along with the concomitant compliance regime lower on the priority list.”

Elson finished by noting that when the company culture says that unethical conduct is acceptable, the possibility for a major scandal is certainly possible. Corporate structures that embrace transparency and integrity thrive, while those that are lacking do not.

“It’s rare to hear the term integrity today, but it is a critical thing to have,” Elson said. “Integrity is the ingredient that keeps things going, and you can’t justify not having it. When you don’t, it’s a very slippery slope.”  

Article by Jerry Rhodes

Photo by Kathy F. Atkinson

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