Features
2 Dec 2015 10:24am

VW scandal: ethics versus profit

Professor Carol Adams examines the Volkswagen scandal, “green” revenue manipulation and what it means for corporate governance

For anyone interested in the subject of business ethics, these have been tantalising times. The Volkswagen (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. This is perhaps an unprecedented mass business ethics failure in terms of scale and reputational loss. But questions remain as to whether this incident will fundamentally change how companies are run. In the case of VW, the motivation to mislead environmental regulators was significant and the supervisory board’s reportedly blissful unawareness that this was occurring was in the company’s interests. Further, a number of statements made prominently in VW’s most recent annual report, with hindsight, are dubious and increase the trust and reputation crisis that VW now faces.

The VW emissions scandal must shake up corporate governance and risk management

What’s so magnetic about the case of VW is that it concerns an über global brand seen as dependable by 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 worldwide”. Not so responsible. While an environmental scandal was brewing, up front in the report Martin Winterkorn, former CEO of the VW Group, claimed “our responsible approach will help to make us the world’s leading automaker by 2018 – both economically and ecologically”. Instead, a reputation built up over decades was in tatters overnight.

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 it. 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”.

The VW crisis is the result of a three-pronged governance and culture failure in marketing, risk management and internal controls, and the failure came from the inability 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. With environmental issues there is always a danger that the promises of marketers are 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. These risks very often come from social and environmental issues and ethical concerns. They often don’t appear on the radar because they are hard to quantify and manage. They are often difficult 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 risk management people should be looking at the operational and financial risks that could occur from any potential wrongdoing

The third aspect of this crisis and the lessons to learn stems from internal control and audit. This monitoring is part of the governance function. Firms need to 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, 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 profitability, and with it the remuneration of the board of management and supervisory board. 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 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, focusing “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.

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, the risk manager should be alert to it and internal audit should be monitoring for compliance breaches and other unethical behaviour.

The risk management people should be looking at the operational and financial risks that could occur from any potential wrongdoing, particularly where the incentives are there. Having a risk management team that speaks across departments and functions will enable an organisation to understand and document what’s happening in different parts of the business, lessening the chances of such matters going awry. In this respect, the tone is set by the board. Corporations, particularly large multinational ones, need to prioritise that connectivity and integrated approach.

The other point to make about this VW scandal is it exposes some topsy-turvy thinking on 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, among 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 sustainable longer-term. The very first performance indicator in VW’s annual report for 2014 is volume of vehicles sold, an increase of 5% over 2013. It is clear what mattered and why.

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, among others, owners and employees who have links back to employee organisations and unions. 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 increasing 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.

VW highlights the vital role of independent directors on company boards. Contrary to some opinions, 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 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 know-how in addition to other skills. An understanding of how CSR and sustainability practices add value, and present risks and opportunities, is a vital component of strategic oversight today. Culture and strategic direction flows from the top of the organisation and the board has a role to play.

There is a very big gap in terms of their understanding of CSR 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.

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. 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.


Carol Adams is a professor in accounting at Durham University Business School, an adviser and non-executive director. She writes on her website at drcaroladams.net


 

Read here about the highest standards of professional conduct chartered accountants are expected to demonstrate through their Code of Ethics.

 

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