In 2015 Volkswagen AG’s supervisory board comprised 20 members, with only one independent director. The founding Piëch and Porsche families co-dominated the board in alliance with unions and the government. Volkswagen chairman Ferdinand Karl Piëch, the grandson of Ferdinand Porsche (Porsche founder), leaked the following comment to the press without the board’s knowledge: “I am distancing myself from Winterkorn (Volkswagen CEO).” These six words further inflamed a decades-long battle between the two-shareholding families behind Volkswagen and Porsche. Ferdinand Karl Piëch probably instigated this tension with the intention of extending his influence as a controlling shareholder. But during the shareholder showdown, Winterkorn won the support of the Porsche family, the labor leaders and the state of Lower Saxony. After losing the battle, Ferdinand Karl Piëch resigned as chairman of Volkswagen AG. However, before long Martin Winterkorn found himself having to resign amid the VW emissions scandal in September 2015.
In 2020, BlackRock accused Volkswagen of continuing to suffer from a lack of independent governance five years later. This has cost the carmaker €32 billion. Despite BlackRock’s criticism, 94.33 per cent of VW’s preferential shareholders voted to approve the actions of the management and supervisory boards in the 2019 fiscal year.
The Volkswagen case shows that it is difficult for a board to optimize the interests of shareholders when they have conflicting interests. In practice, when most directors on boards are shareholders or stakeholder representatives, infighting becomes a common issue. Minority shareholders are vulnerable when the controlling owner attempts to squeeze out the other shareholders, for example by buying, selling or leasing assets at non-market prices, as a way to shift corporate resources to the large owner.
Conflicts within one group of stakeholders are not limited to shareholders. Creditors on boards could have an unfair advantage over other creditors in that they could use insider information to shield themselves from potential trouble and hurt other class of debt holders, especially when the firm is in financial distress.
The following is a checklist of tier-III conflicts of interest:
- Why is a key stakeholder group pushing for decisions that may benefit themselves but potentially hurt the interests of the company in the long run?
- How can the pie be divided when there are conflicts of interest between the different classes of stakeholders, such as shareholders vs. creditors, executives vs. employees, or executives vs. shareholders?
- How can conflicts of interest between subgroups of one particular stakeholder group be dealt with?
- How can a director make a wise decision when stakeholders have conflicting incentives and goals?
Tier-IV conflicts: company vs. society
The way a company views its purpose will affect its notion of responsibility, accountability and how it creates value. The ethical behavior of executives has deep roots in Western ethical traditions. Discussions on business ethics have been ongoing since the market economy emerged more than 750 years ago. In general, company and society are not in conflict: Corporations contribute to society by inventing new technologies, fulfilling consumers’ demands for goods and services and creating jobs; society creates the conditions that allow companies to harness their potential for the common good of humanity.
In 1981, Business Roundtable, an association of chief executive officers of leading US companies working to promote sound public policy, stated that “Corporations have a responsibility, first of all, to make available to the public quality goods and services at fair prices, thereby earning a profit that attracts investment to continue and enhance the enterprise, provide jobs, and build the economy” and that, “the long-term viability of the corporation depends upon its responsibility to the society of which it is a part. The well-being of society also depends upon profitable and responsible business enterprises.” Initially executives accepted this definition of the responsibilities of companies but their stance changed dramatically when in 1997 the Business Roundtable redefined the purpose of a corporation in society as being “to generate economic returns to its owners” and that if “the CEO and the directors are not focused on shareholder value, it may be less likely the corporation will realize that value.” It became a duty for board members to admit that the sole purpose of corporations was to maximize shareholder value.
If not managed properly, maximizing returns for shareholders – for example by deceiving customers, defaulting on payments to creditors, squeezing suppliers and employees and evading taxes – can strip value generation from other stakeholders. Indirect harmful effects on society include shaping the rules of the game (e.g. lobbying to change a law, tax rules, accounting rules, subsidies, etc.), pollution, market manipulations through collusion, or limiting the opportunities for future generations to improve their lives. Such behavior may well increase payoffs to shareholders in the short term but it can only lead to the eventual demise of the corporation and total destruction of long-term shareholder value. The only class of stakeholders that benefits from this short-term value maximization exercise is the chief executives enjoying high compensation, severance packages and golden parachutes. According to the Wall Street Journal, the average tenure of CEOs in the S&P 500 is 10.2 years. When a CEO believes they could be dismissed at any time, they may be more inclined to take decisions that maximize their own income in the short term in the name of maximizing shareholder value. If all CEOs behave in this manner and boards of directors allow it, companies will end up doing more harm than good to society.
In a study of stewardship, companies potentially ranking highly in stewardship used a broad vocabulary to describe their relationships with other stakeholders in their 10K reports – words including air, carbon, child, children, climate, collaboration, communities, cooperation, CSR, culture, dialog, dialogue, ecological, economical, environment, families, science, stakeholder, transparency and well-being. This mirrored their long-term approach to building rapport with local communities and the broader society.
By comparison, companies potentially ranking low in terms of stewardship used words like appeal, arbitration, attorney, attorneys, claims, court, criticized, defendant, defendants, delinquencies, delinquency, denied, discharged, enforceability, jurisdiction, lawsuit, lawsuits, legislative, litigation, petition, petitions, plaintiff, punitive, rulings, settlement, settlements, and suit. This indicates that companies rarely benefit from bad actions in the long run, as cost will come back to the company in the form of litigation, sanctions, fines or public humiliation.
The aftermath of the 2008 financial crisis demonstrated that greed does not pay. From 2008 to 2015, 20 of the world’s biggest banks paid more than US$235 billion in fines for having manipulated currency and interest rates and deceived customers. For example the Bank of America alone paid approximately US$80 billion while JP Morgan Chase paid up to US$20 billion. These fines were expected to deter further wrongdoing and to change corporate culture.
Society and various stakeholders place their trust in board directors to run companies and they hold them accountable for doing so. Directors need to understand that a company cannot prosper if it is in conflict with society, and that since they have the power and authority to recruit, monitor and support management, they are on the front line when it comes to changing the company’s culture from having a short-term focus to considering the long term when resolving potential conflicts between the company and society.
Self-assessment questions to ponder with regard to this last dimension include:
- Why does your company exist?
- How does it create value?
- Is your company a contributor or a value-extractor in society?
- Do you have the courage to take an ethical stand when your company is in conflict with society?
How to create a board that works for stakeholders and shareholders
A company is the nexus that links the interests of each stakeholder group within its ecosystem. The board is the decision-making body and its successes and failures are determined by the ability of its board directors to understand and manage the interests of key stakeholder groups. It is not an easy task to balance the interest of different stakeholders when shareholders are the ones who put money and often more visible and demanding. There is no ‘one-size-fits-all’ solution to corporate governance issues, and there are no straightforward answers to manage all the conflicts of interest given the unpredictable nature of business environment contexts, boardroom dynamics and human behaviors. In principle, decisions at the board level should be ethical and reasonably balanced.
Boards need to have a specific policy in place for dealing with tier-I conflicts of interest between individual directors and the company. This policy needs to specify processes for dealing with major actual and potential conflicts, such as misappropriation of assets; insufficient effort, focus and dedication to board work; self-dealing and related transactions; insider trading; and taking advantage of corporate opportunities in an open and transparent way. If possible, the policy should be signed by all directors and updated regularly, and conflicts of interest should be declared at each board meeting. The control mechanisms could be institutionalized.
ICBC’s supervisory board is composed of five to seven stakeholder professionals and some of them are full-time on-site supervisors. By attending board meetings as non-voting delegates, ICBC’s board of supervisors is able to monitor the performance of directors and senior management, auditing processes, and overall activities and decisions that affect the company in the short and long term. Monitoring is based on several criteria, such as work attitude, behavior, capacity to fulfill duties, contribution, and so on. In addition, retiring and leaving directors, presidents and other senior management members have to undergo an auditing process by the board of supervisors. This type of institution is rarely seen in Western countries, so a similar and feasible solution is to allow external auditors to play a role here.
To deal with tier-II conflicts, directors need to disclose their relationship with stakeholders. This gives them an opportunity to declare in advance whom they represent. Even if the law requires all directors to represent the interests of the company, identifying their connections with specific stakeholder groups improves transparency and avoids the risk of conflicts of interest. It is also crucial to specify who nominates new directors; who decides on directors’ compensation; how the pay structure and level are determined, and how pay is linked to performance and function. In performing their duties, all directors need to put ego aside, follow rules in discussions, respect others, and avoid toxic behavior in the boardroom. Coalitions can be beneficial when they are aimed at acting in the best interest of the company, but they can be harmful when they are formed with the aim of dominating the board or benefitting a particular stakeholder group.
Tier-III conflicts of interest can be minimized when directors and boards ‘slice the company pie’ properly in an effort to support cooperation and avoid inducing sabotage, riots, retaliation, fines, in-fights or legal actions. Wise decision making requires understanding deep-rooted conflicts between stakeholders and the company, between different stakeholder groups, and between subgroups of one stakeholder group. No company can survive without the input of each stakeholder group: responsible shareholders, understanding debt holders, innovative employees, satisfied customers, happy suppliers, great products and services, friendly communities as well as effective and efficient government.
Tier-IV conflicts between the company and society are philosophical. Solving them requires directors to act as moral agents and be able to distinguish ‘good’ from ‘bad’. Do companies compensate stakeholders because they are useful, because the law protects them or do they do so because stakeholders contributed to the success of the company? Should companies consider the interests of future generations who have not directly contributed to profitability and who are not represented on the board? Should companies make corporate sustainability investments because they are popular, because they portray the company in a favorable way and increase profitability in the long run, or because they are a way to show true gratitude?
Good governance starts with the integrity and ethics of every director on every board. Board directors have a moral obligation not to take advantage of the company, but to be loyal to the company, make wise decisions, neutralize conflicts among stakeholders, and act in a socially responsible way. An ethical board sets the purpose of the company, which in turn influences all dealings with stakeholders. The four-tier pyramid summarizing the different levels of conflict of interest can help board directors anticipate and identify potential conflicts, deal with conflicts and make sensible decisions to chart a course for the future of the company.