Sunday 23 October 2016

Shareholders can learn about company risk from Volkswagen scandal

Elaine Laing

Published 17/01/2016 | 02:30

Dr Elaine Laing, Assistant Professor in Finance, Trinity Business School, Trinity College Dublin
Dr Elaine Laing, Assistant Professor in Finance, Trinity Business School, Trinity College Dublin

Poor corporate governance is always dangerous. Foreign observers blamed this for the financial crisis that engulfed Ireland. Poor governance is not unique to Ireland; just look at the disaster that has befallen Volkswagen (VW). The actions of a few employees have damaged the carmaker's reputation and knocked €30bn off the company's value.

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We should hardly be surprised by the VW emissions scandal, as the company was flagged in 2009 as having the worst governance practices of any German blue-chip company. But what can VW and similar scandal-struck organisations do to rebuild reputation, trust and drive long-term success? As an academic in Trinity Business School, specialising in corporate-governance research, I advocate the link between strong corporate governance and enhanced company value and outline factors that strengthen governance culture.

Board structure and independence

Boards consisting of a majority of independent directors increase shareholder value. Independent directors are board members who are not otherwise affiliated with the company and provide monitoring, advice and prevent management from pursing their own self-interests. Volkswagen's 20-person supervisory board had only one independent director, highlighting the serious lack of oversight and accountability. VW urgently needs to address the issue of supervisory board independence and should also appoint an independent chief executive and chairman to lead the group out of crisis and rebuild trust in the brand.

Directors who serve on multiple boards should be carefully examined to ensure independence is not compromised by 'interlocking' relationships. Multiple directorships can certify a director's ability to perform but 'over-boarded' directors can diminish the quality and independence of board decisions, resulting in lower firm performance.

Board size is also an important issue. Large boards can decrease the ability of directors to control management as co-ordination and communications on the board gain complexity. Chief executive officers (CEOs) can gain greater power and influence over large boards, particularly if they also hold the position of chairman. To avoid group-think and entrenchment issues, board size should optimally consist of 12 members and directors should be rotated periodically.

Board diversity

Boards embracing age, ethnic, gender and skills diversity have been shown to enhance company performance. Volkswagen lacks any meaningful board diversity and should consider appointing diverse experienced executives who foster independent thinking and board dissension.

Ownership structure

Ownership structure can negatively impact company value if internal control is high. In the case of Volkswagen, the three largest shareholders hold 88pc of shares - leaving external investors with limited control, holding only 12pc of voting shares. Studies highlight the valuable role of external institutional investors in improving corporate governance, transparency and mitigating fraudulent activities. Activist investors pressurise boards to make necessary changes, generating higher capital returns for shareholders.

Such activism was seen in Rolls-Royce Holdings PLC when shares jumped 5.4pc in April after activists had demanded a shake-up of the entrenched board structure, resulting in the appointment of a new CEO.

Executive remuneration

Executive remuneration packages comprising of both equity- and non-equity based compensation mitigate agency costs and incentivise directors to increase long-term performance. Effective executive remuneration packages need to be determined by a fully independent compensation committee.

Failures in remuneration procedures are evident in Volkswagen as the supervisory board lacked independence when approving executive compensation. In 2014, the ex-chief executive officer (CEO) of VW Martin Winterkorn was paid a salary of €16m and could receive a further €60m in severance and pension payments.

Closer to home, revelations of the staggering €535,000 remuneration package of now ex-Irish Farmers' Association (IFA) general secretary Pat Smith will once again bring into sharp focus the lack of remuneration committee independence in representative bodies. When comparing the salary-to-turnover ratios, the IFA's general secretary salary payment is three times higher than Mr Winterkorn - one the highest-paid executives in Europe!

In recent months, the 'shareholders spring' reported rising numbers of investors refusing to approve executive pay plans. Are we going to witness a new spring as contagion spreads from these high-profile governance controversies, including the scandal-hit world footballing body FIFA?

Ethical leadership

Ethical leadership lies at the root of most corporate scandals. Mr Winterkorn fostered a culture of achieving aggressive sales targets, which led VW to deliberately deceive the public. CEOs, as architects of company culture, are obliged to provide ethical leadership that moulds employees to operate honestly.

Companies should adopt better governance practices to increase transparency and accountability, which ensure that stakeholders' best interests are maintained. Regulators also need to urgently review governance codes and implement comprehensive compliance mechanisms.

What key governance questions can be asked to ensure companies that don't crash like Volkswagen?

1. Are the positions of CEO and chairman held by the same person?

2. Is there a majority of independent directors appointed to the board?

3. Is the board diverse and are directors rotated periodically?

4. How is ownership structured and is there institutional investment in the company?

5. Does an independent remuneration committee approve executive compensation?

Dr Elaine Laing is Assistant Professor in Finance, Trinity Business School, Trinity College Dublin.

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