This was to be a momentous year for Volkswagen. Over 22 years after auto analyst Maryann Keller predicted the company would become market leader, the Wolfsburg-based manufacturer finally beat Toyota to the top spot. Having sold five million vehicles in the opening six months of the year, the automaker was riding high on the back of an aggressive push for scale and a less-than-stellar period for its closest rivals. More than that, the news meant an early end to a longstanding ambition and, whether intentionally or not, underlined VW’s credentials as the carmaker to which all others should aspire.

Skip forward a few months, and the company’s downfall has been Hollywood-like in its scale. September investigations showed that engineers at VW had installed software in diesel cars to ensure they read clean when in testing conditions, whereas on the road they spilled out 10 to 40 times the legal emissions limit. 11 million vehicles were fitted with these so-called ‘defeat devices’, and 500,000 cars were programmed to game tough emissions standards. This all amounted to one of the biggest scandals in the industry’s long history.

There is certainly too much politics involved; Volkswagen even has its own law – the ‘Volkswagen Act’

Looking at the situation in the US, the group is facing the likely prospect of $18bn in fines, or $37,500 per car, under the Clean Air Act. Should the company suffer the same or a similar fate in Europe, where closer to eight million cars were affected, the liabilities could grow to unmanageable extremes ($40bn by some estimates) and threaten VW’s very existence. “The challenge for VW relates not just to the substantial fines and penalties it faces; that may be small in the context of the impact of the damage done to its brand and the trust that has been destroyed”, claimed George Dallas, policy director of the International Corporate Governance Network.

“Deeply troubling”, was how VW’s US CEO Michael Horn described the situation, as he and other senior company figures apologised for their part in the multi billion-dollar scandal and acknowledged that the failure was theirs. However, the situation wasn’t helped when Horn later went on to claim the issue was down to “a couple of software engineers”, and insisted he and others had no knowledge of the deception. Confounded – and understandably so – by the assertion, Congressman Chris Collins, himself a former engineer, said of the claims: “Either your entire organisation is incompetent when it comes to intellectual property, and I don’t buy that, or they are complicit at the highest levels in a massive cover-up that continues today.”

Who exactly was at fault for the scandal is as yet unclear, and likely will remain so for some time. What’s not so much a mystery is the role of governance in allowing the incident to pass unseen – or at least unreported – by senior figures at the group.

“I think what the VW scandal really highlights is that corporate governance matters”, noted Howard Sherman, Executive Director of ESG Research at MSCI. “And I mean governance in the broadest sense possible – not just the obvious questions about who is on the board and how management is incentivised, but the governance of environmental and social risks and, importantly, what is the tone at the top? Does it foster a culture of winning at all costs? Based on what’s been disclosed so far, that seems to be the most problematic aspect of this scandal – how was it possible that senior management and the board weren’t aware of a software application that affected 11 million cars? That’s why I see this as a failure to govern properly – the heart of corporate governance is board oversight of the management team.”

Governance failure
It is now many years ago that VW was first singled out for its unsavoury organisational structure, and in 2009 the automaker was hailed as the worst performer of any among Germany’s blue-chip companies, according to IVOX. “The issues are manifold and we highlighted them already in 2010”, observed the organisation’s general manager, Alexander Juschus. “First, VW’s supervisory board lacks independence. Only one out of 10 shareholder representatives can be considered independent. Furthermore, qualification and experience are questionable. There is certainly too much politics involved; Volkswagen even has its own law – the ‘Volkswagen Act’. And last, but certainly not least, due to the shareholder and share structure, there is no control by investors possible.”

Even before the emissions scandal hit, investors were issued repeated warnings about the company’s less-than-impressive performance, although the vast majority were at a loss about to how best to proceed. Vigeo, a company which specialises in gauging ESG performance, awarded VW 48 out of a possible 100 in the week prior to the crisis, only for the company’s sub-par standing to slip further when news of the crisis arrived.

“Our concerns with regard to VW’s corporate governance predate the emissions scandal. They include a dual-class ownership structure that reinforced the Porsche and Piëch families’ control, and a non-independent supervisory board”, noted Sherman. Based on these and other factors, VW’s corporate governance score ranked in the 28th percentile prior to the scandal; a rating otherwise expressed as lower than 72 percent of the companies MSCI covers worldwide.

To take one example of the company’s shortcomings, at the time of the scandal 17 of its 20-member council of directors were of German or Austrian nationality, and only one of the 20, SEB’s CEO Annika Falkenfren, was a truly independent voice. Of the remaining 19, many were without the requisite experience to warrant a seat, and this same culture can be seen throughout much of the automaker’s dealings.

Earlier in the year, VW made public some fractured relationships on high, when its chairman Ferdinand Piëch resigned in quite spectacular fashion. Having previously forced out high-ranking officials, including one of his own choosing, VW’s then-CEO Martin Winterkorn was backed against Piëch by a five-member steering committee, which, according to a statement, “came to a consensus that, in the light of the past weeks, the mutual trust necessary for successful cooperation was no longer there”. Viewed by some as an opportunity to bring the curtains down on an era beset with in-fighting and deception, any hopes of a culture change dissipated when VW’s reigning CFO Dieter Pötsch was confirmed as Piëch’s successor.

The two examples here are indicative of VW’s failings when it comes to corporate governance, and the company’s latest executive appointment shows a disconcerting level of consistency in a period where change is most needed and public scrutiny is at its sharpest.

Enter Matthias
Speaking in the aftermath of the emissions scandal, VW’s then-CEO Martin Winterkorn insisted he would remain in his role, despite company shares having shed a third of their value in the space of only two days. Unsurprisingly, Winterkorn’s confidence proved to be misplaced, and the news came in late September that Matthias Müller, formerly of Porsche, would fill his boots.

Speaking in front of a 20,000-strong crowd of employees at VW’s Wolfsburg plant, the newly appointed CEO promised a “swift and relentless clarification” of the emissions scandal. “Apart from the enormous financial damage, which it is still not possible to quantify as of today, this crisis is first and foremost a crisis of confidence. That is because it is about the very core of our company and our identity: it is about our vehicles. Our most important task will, therefore, be to win back the trust we have lost – with our customers, partners, investors, and the general public.”

Müller today faces something of a challenge, particularly when compared to the relatively easy job he had at Porsche, where he near enough doubled the number of cars sold per year and grew profit margins to an easy 18 percent without much of a challenge. Compare this to VW, where he is tasked with leading the resurrection of the group’s image and the regaining of consumer trust – easily lost but not so easily clawed back – and the difference couldn’t be starker.

Those in favour of Müller argue that his experience of leading a VW brand, and the co-ordinating of another two at Audi and Lamborghini, stand him in good stead to take the helm. However, critics insist an outside appointment was nothing short of a necessity in the present climate, especially as the situation facing him and the group is unfamiliar. With an internal appointment, the situation (as far as governance is concerned) remains unchanged. Qualified as he is, Müller’s appointment fails to address the issue of independence, and will likely stoke fears that VW is unwilling to make the necessary changes.

“An insider may have the advantage of knowing the company and taking charge quickly in a period of crisis”, said Dallas. “But to the extent that culture is a fundamental problem, there may be limits on the extent to which an insider can lead a change in culture, values and tone.”

Speaking about the central issues of independence, experience and shareholder participation, Juschus observed: “I do not see that this appointment addresses these issues at all. But, to be fair, governance should be the job of the supervisory board and not the management.” Herein lies the biggest challenge for VW, and clearly the problem is not Müller’s longstanding ties to the company, but an unwillingness from the supervisory board to right the company’s ways. “Governance is a question of system before an issue of person”, said Fouad Benseddik, director of methodology and institutional relationships at Vigeo, speaking on the sometimes-misplaced emphasis on Müller in the affair.

“There are problematic aspects of VW’s ownership structure – including large block stakes held by a family and a block held by the German state of Lower Saxony”, said Dallas. “From the perspective of minority shareholders these ownership influences may reflect ambitions and agendas that are not always consistent with the interests of long-term institutional shareholder interests. But, apart from these structural concerns, the key problem that is emerging appears to be one of culture and poor values – and inadequate governance and oversight by both the management and supervisory boards.”

All German companies are required by law to have two boards, one comprising management and the other made up of supervisory members, to which the CEO must report. VW’s structure is no different from rival automakers in this regard, although the fact that two seats go to representatives of Lower Saxony warrants serious cause for concern. “They certainly need to restructure the supervisory board and aim at more independence and qualification. They need to win back the confidence of institutional investors – primarily through transfer of influence”, claimed Juschus. “Politics needs to give way to pragmatism.”

No matter the root cause of the scandal, be it rogue engineers or patchy governance, there is a question of whether VW’s influence, both in the political spectrum and automotive industry, will remain, not least in Europe, where it is most acute.

Influence wanes
Of the reported 11 million vehicles affected, approximately eight million were in VW’s home continent, and 2.8 million in its native Germany. Only time will tell if the German government, which relies on the auto industry for most of its manufacturing revenue and has a stake in the carmaker itself, will penalise VW to the same degree as those across the Atlantic. However, early signs indicate they might be wise not to.

With an employee base of 600,000, VW is not only Germany’s largest private employer, but Europe’s leading automaker by some margin. Any loss for VW is a loss for the continent, and, while affected individuals are right to seek the claims they so deserve, the implications for Europe’s slow-to-recover marketplace could be severe. Having already pulled 8.5 million vehicles from across Europe, VW will likely face colossal fines, where half of the company’s sales are for diesel cars. However, the carmaker’s primary concern should rest with governance reform, not financial costs – a sentiment that has been echoed by many an analyst in the area.

“As for VW’s biggest challenges, they start with getting to the bottom of the scandal – how and why was this allowed to happen – and, more importantly, understanding how to remedy its governance and internal controls so there’s no possibility of something like this ever happening again on such a scale”, said Sherman.

The group’s high standing has long handed VW an advantage, particularly in Europe, and without this distinction the company will likely struggle to convince consumers of its superiority over rival manufacturers. What’s important now, however, is that the group, under Müller’s leadership, is seen to be righting the wrongs done in the lead-up – and arguably the aftermath – to the recent emissions scandal. “VW needs to finds its way back to a sense of ethics which do not consist of the substitution of immediate gains for long-term interests and vision”, said Benseddik. “This requires that an end be put to the methods and governance structures of the past.”

VW’s stated commitment to environmental preservation has suffered a major setback, and its credibility is close to zero. It was with this in mind, perhaps, that the group unveiled plans in October to accelerate its efficiency programme and to up its investment in electric engines, which, for the present time at least, is little more than a distraction from the real issues at hand. Although these commitments are of great importance, they’re secondary to the central issues of governance and reputation.

“The key challenge is to rebuild trust unambiguously, which is not an overnight fix and which is not likely to begin until there is clarity on the extent to which existing senior managers were aware of or involved with the deception relating to the emissions scandal”, said Dallas. This much is true, and before Volkswagen signs up to any more path-breaking new initiatives or makes any more bold energy efficiency promises, it must first focus on the core issue of governance. This was a crisis that was due to company culture as opposed to broken promises, and once this issue has been righted, the barriers to change will significantly lessen.