The VW Scandal
Lessons to Be Learned
By Ian Quigley, MBA, CFA, CBV | Original publication October 2015
Stalin wanted it first, but failed, largely because of the language barrier. Hitler tried in 1934 and was successful. Designed by Ferdinand Porsche, Germany got its car for the masses: the VW Beetle. Russia got the Lada (and nobody cares who designed it).
The Porsche clan has maintained a long integrated history with VW, with Ferdinand’s son-in-law Anton Piëch managing the original VW plant in 1941. Anton’s son, Ferdinand Piëch, was the chairman of VW from 1993 until his resignation in 2015. Despite being a public company, investors were never fully informed about why he resigned. Rumors centered on trouble between him and the CEO at the time. To some, Piëch was a saint and the savior of VW from prior financial hardships. To others, he was simply the highest paid, most entitled auto executive in Europe.
To the Porsche family, VW has always been their own. In their eyes, it did not belong to the people of Germany, who privatized the company in the 1960s, or to the pension funds who invested in it, or to the general public who bought its shares on the German stock exchange. VW’s legacy is the Porsche legacy. Since privatization, they patiently and stealthily accumulated additional shares. Then in 2008, with the help of the Qatar Sovereign Wealth Fund and some complicated and sneaky legal maneuvers, they took the controlling interest.
Outside of the Porsche clan, Qatar, German institutional investors, and the State of Saxony (in Germany) hold the remaining dominant stakes. Less than 10% of the company is available for outside investors.
Today VW is a $45 billion dollar company with over $200 billion in annual revenue and is the second-largest automaker in the world next to Toyota. This has been a problem for the Porsche family. If they could simply increase an already small market share in the USA, they could then claim first place and become the largest automaker in the world. Global domination—for the Porsche family, a righteous destiny.
Scandal 2015
A previous VW scandal in 2008 included secret brothels, bracers and bribes—and as juicy as that sounds, the 2015 scandal is even better. VW employees created secret software that ran on millions of its diesel-engine cars that would change the emissions profile while American regulators were busy measuring them. Under normal operating conditions, the cars are actually mini-environmental disasters, emitting up to 40 times the NOx limits measured by regulators.
Who would believe such an allegation, made on September 18th from America’s Environmental Protection Agency (EPA), that VW’s onboard software would monitor and switch on special NOx-controlling software only when the regulators were driving? The EPA was confident enough to immediately order a recall on 500,000 cars and subsequently, on September 22nd, VW admitted over 11,000,000 cars were using the regulator-tricking software.
Almost overnight, the company’s shares collapsed by a third (see chart), losing nearly $15,000,000,000 of value to its shareholders (that’s 15 billion). On the basis of 482,000 cars sold and a maximum fine of $37,500 per vehicle under the Clean Air Act, the Department of Justice could fine VW $18 billion—which is unlikely based on other similar cases. On top of this, VW faces billions in fines elsewhere and other financial penalties related to civil lawsuits. Add in VW’s ruined reputation, which, according to Kevin Plank (CEO of Under Armour), is gained in drops but lost in buckets. Reputational damage will take years to rebuild.
Yes, the big boss Martin Winterkorn has resigned, a traditional solution to a systemic problem. A systemic issue, because it would take many, many people inside VW to enact a tactic like this. Sadly, the problem here runs deeper—down to the owners who elect the board of directors that monitor, govern, and prevent “management-gone-wild” scenarios. One can argue that the buck stops with ownership; owners direct how they want the corporation to be run.
The good news is that few investors actually own VW. There are less than 9% of VW shares on the open market and Qube does not have a position in VW in any of its models. The bad news is that companies like VW are far too common. VW is controlled today by what many consider its founding family (the Porsche / Piëch dynasty). This family has been ranked the 8th wealthiest in the world and are not motivated by the same things that we are. They are not interested in benign middle-class dreams like maximization of shareholder value. They will aim for global domination and have no qualms about risking our shared value in their quest.
Governance is the Engine
Governance at VW has checks and balances uncommon to American companies. For example, German law requires an 80% vote for all major decisions and operates under a special system of co-determination (worker rights). This is why, in 2008, a scandal broke. The Guardian newspaper broke the story on sleazy activities at VW involving bribes, free Viagra, and sex workers. CEO Ferdinand Piëch was unresponsive to external investors, uncommunicative about product development and strategy, and unapologetic when examined in court about methods used to recover ailing employee relations.
Piëch (grandson of Porsche’s founder) was the second-largest shareholder in Porsche, and also sat on the boards of both companies while at the helm of VW. In theory, these companies were competing for market share. Instead, analysts found billion-dollar emergency loans between the companies during tight times. How would you feel if the company you invested in was making risky billion-dollar loans to a competitor without your consent?
Businessweek has called the rule under Piëch a “virtual autocracy.” In 2002, he reached mandatory CEO retirement at the age of 65, but remained as Chairman and retained his “dictatorial power.” In 2012, Piëch appointed his spouse (a former kindergarten teacher) to the board—a board appointment not designed to protect shareholder value, but to strengthen and demonstrate family control.
Is There a Lesson Here?
A survey of CFA Institute Financial NewsBrief members asked if the share decline at VW could have been anticipated through analysis of the company’s governance and internal controls. The answer: 81% of 826 respondents said no.
Why? The majority of analysts ascertain that decisions are based on public information. As VW used deception, the scandal was therefore not something that could be predicted.
Qube Passionately Disagrees
Governance failures at VW have been within the public domain for years, including a major exposé in 2009 revealed in articles from the Financial Times. While spotting the exact manifestation is impossible, considering the risk in human capital management is entirely possible. The VW history of ignoring outside views and disregarding classic external controls, while affording the temptation for boundless self-gratification was toxic and present for all to see.
If you invest in VW, you are not investing in a global blue-chip automaker; you are investing in the Porsche/Piëch family, Porsche/Piëch ambitions and Porsche/Piëch values. You cannot rely on spreadsheets, mathematics and classic business analysis, but must consider the unrestrained and unaccountable human capital leading the organization. Qube has always shied away from such situations, but sadly admit a negative screen on shares, unduly influenced by founding families, would be too restrictive on any investment model.
According to research by the consulting firm McKinsey & Co., family-controlled firms made up 19% of the Fortune Global 500 in 2014. They define family firms as companies whose founding families have the biggest stake, at least 18%, plus the power to appoint the chief executive. By 2025 McKinsey forecasts there will be more than 15,000 companies worldwide, with at least $1 billion in annual revenues, of which 37% will be emerging-market family firms.
Approximately 85% of $1 billion-plus businesses in South-East Asia are family-run, along with around 75% in Latin America, 67% in India and almost 65% in the Middle East.
While shy of such firms, Qube has taken positions over time in Nike, Loblaw, IGM Financial, Nordstrom, Microsoft, Talisman and Yahoo, all considered to be subject to founder influences. These investment positions required extra attention to ensure the cost/benefits of the founder influence were understood and included in the decision.
What Lessons Are Learned?
Governance research is not a waste of time and effort. VW shares have plunged by a third in value from this scandal, an event that demonstrates a misguided corporate culture where deception of a regulator was institutionalized throughout the entire company. We can reduce this type of risk by continuing to include governance in our investment decisions. At Qube, Brenda Wilber and Stacey Quigley perform regular analysis on each company in our portfolio, calculating an associated ESG (Environmental, Social and Governance) Score which impacts our interest in holding the shares.
Further, Qube has participated in four United Nations PRI (Principles of Responsible Investment) engagement committees: Steering Committee, Director Nomination, Responsible Fracking and Labour Standards in the Supply Chain. By collaborating with other portfolio managers, we have promoted higher levels of corporate responsibility that will benefit all investors.
Finally, Qube plans to be active again in 2016 with submissions of proposals to the boards of companies we have positions in during the season of annual shareholder meetings. Our focus, as in 2013/14, is on governance.
We continue to believe that it is our duty to promote better governance, and in fact an important risk management technique to avoid holding investments where scandals can wipe away massive share values overnight.