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Why Boards Must Step Up To Deter Corporate Scandals

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Why Boards Must Step Up To Deter Corporate Scandals

CEOs often suffer cultural myopia and outside directors frequently fail to provide adequate oversight

Monday, March 13, 2017
By Len Sherman, Contributor

This month brought more fallout from the Wells Fargo consumer banking fraud, as the company fired three regional managers in its continuing efforts to deal with lawsuits from former workers, customers and investors, and ongoing investigations from the Department of Justice and other regulatory agencies.

Wells Fargo also recently stripped CEO Tim Sloan and seven of his top lieutenants of their 2016 bonuses, fired four other executives, and discontinued the stringent sales quotas that unwittingly incentivized bank employees to set up 2 million unauthorized consumer bank accounts. All of this comes as Wells Fargo braces for the release of findings from an independent board investigation, which is expected prior to what could be a contentious annual meeting with shareholders on April 25.

A disturbing backdrop to this story is that Wells Fargo’s fall from grace is not an isolated aberration, but only the latest in a series of corporate scandals that have betrayed consumer trust and destroyed shareholder value in many large enterprises, including Enron, HealthSouth, Tyco, Arthur Andersen, Siemens, Barclays, BP, General Motors, Takata and, most recently, Volkswagen.  Why is unethical corporate behavior so prevalent and what can be done to prevent future falls from grace?  The short answer is that CEOs often suffer cultural myopia and outside directors frequently fail to provide adequate oversight.

Corporate cultural breakdowns tend to emerge as gradual backsliding from a company’s noble founding vision, rather than as a sudden, reckless unethical act.  In Wells Fargo’s case, as the bank ratcheted up pressure on employees to meet ever more challenging sales quotas, the incidence of fraudulent activity crept up over time.  But much like a frog in a pot brought to a slow boil, senior executives remained unalarmed, dealing with each employee transgression as an isolated incident, while continuing to boast of the bank’s customer-friendly values and superior financial performance.

Volkswagen’s rigged emissions test scandal provides another case in point.  Prior to his resignation in September 2015, CEO Martin Winterkorn had set extremely ambitious growth targets in an obsessive drive to overtake Toyota and GM as the world’s top-selling automaker. He was also well known for his mercurial aversion to hearing bad news from subordinates. It is not hard to imagine how such a CEO mindset promoted a toxic culture in which the  ends justified the means, and guided corporate decisions on who got praised, rewarded, promoted or fired.

The trouble with incentives is that they work, and in both the Wells Fargo and VW cases, employees reacted accordingly.

Executives and employees deeply immersed in the day-to-day activities of an eroding corporate culture are often unable to see emerging danger signs that would be glaringly obvious to an outsider granted access to observe company operations.  As a career management consultant, I observed numerous instances where employees accepted dysfunctional or unethical behaviors as “just the way things are done” in their organization.  For example, GM’s frog-in-the-pot slide into tolerating a fatally flawed ignition switch design was in part caused by “the GM nod” — a cultural norm where managers in a meeting would nod in agreement at the need for corrective actions, but leave the room doing nothing, other than blaming coworkers for known business problems.  This pervasive cultural norm tragically led to over 100 deaths from a flawed component design that was well known within the corporation for years.  Yet the final reckoning of GM’s critical need to rethink its corporate culture surfaced only after a comprehensive independent review by a former U.S. attorney.

The essential need for an external perspective to detect and respond to potential corporate ethical lapses and dysfunctional cultural norms is precisely why outside directors have the need and responsibility to provide ongoing vigilant oversight. For example, the Wells Fargo board Corporate Responsibility Committee has the explicit charter to monitor the company’s reputation, including with customers.  Its members are all outside directors with distinguished careers who currently also serve on other corporate and nonprofit boards. This experience should have given board members the broad perspective and objectivity to ensure compliance with the firm’s vision “to value what’s right for our customers in everything we do.” Why did they fail?

In my experience advising corporate boards, while outside directors want to do the right thing, they too often remain overly reliant on information fed to them by corporate executives.  Since transcripts of board meetings are not public, and Congress chose not to question board members in its recent hearings, we really don’t know precisely what steps Wells Fargo’s board did or did not take.  But it is not too hard to imagine that the Wells Fargo Corporate Responsibility Committee was given and accepted assurances from management that the bank was taking appropriate steps to control growing incidents of fraudulent banking practices.  But the evidence is now clear that such was not the case.

Multiple reports of illegal employee behaviors began flowing in to Wells Fargo’s internal ethics hotline as early as 2005. “Everyone knew there was fraud going on,” said a former branch manager who was fired after contacting both HR and the bank’s ethics hotline about illegal accounts he had seen being opened. In 2013, the Los Angeles Times published a story about 30 Wells Fargo employees that were fired for opening unauthorized consumer bank accounts. Despite numerous subsequent internal and external reviews of its retail banking practices, Wells Fargo's incremental corrective actions were insufficient to stem ongoing fraudulent activity.

In May 2015, the Los Angeles City Attorney’s office filed a sweeping lawsuit against the bank, culminating a year and a half later in a $185 million settlement. In the wake of this damaging public disclosure, the Senate and House Banking Committees held emotionally charged televised hearings in Septmeber 2016, highlighted by a rare display of bipartisan condemnation of Wells Fargo’s illegal and unethical corporate behavior.

In retrospect, despite repeated and readily observable alarm signals over a prolonged period, the Wells Fargo’s Corporate Responsibility Committee convened only the minimally mandated three times annually during the past three years, apparently doing little to focus more attention on or to force a sufficient response to the growing corporate scandal.

The warning signals in the VW fraud case were a bit more faint, but shared with Wells Fargo the reality that a large number of employees were concertedly engaged in fraudulent activity over many years. Germany’s Bild newspaper and Spiegel Online reported that former VW CEO Ferdinand Piech alerted Martin Winterkorn and four VW board members about the diesel emissions scandal six months before the company finally acknowledged (but continued to deny) charges against the automaker.

Beyond this alleged claim, board members should have been aware that VW had staked its strategy for global industry leadership largely on the success of its “clean diesel” technology. As such there were other danger signals that should have concerned a vigilant board. Several other automakers, including Honda, Mazda and Nissan, had similarly announced aggressive plans for new diesel cars and light-duty trucks in the U.S., but then abruptly canceled them, citing technical challenges with meeting government emissions standards. VW itself delayed launching its new generation diesel engines for two model years prior to 2009, and when it did, there were widespread reports of consumers beating their “sticker” fuel economy values by upwards of 10 miles per gallon – a suspiciously anomalous result.

Given the events that unfolded, it would be instructive for other boards to understand whether Wells Fargo’s and VW’s directors had sought complete and timely information (including from independent sources) on the progress, regulatory compliance and integrity of their company’s core strategies, whether they responded with sufficient rigor, and if not, why not?

This is particularly germane to broader questions on the adequacy of independent board oversight, given recent research published by McKinsey. Of 772 directors surveyed in 2013, a mere 34% agreed that the boards on which they served fully comprehended their companies’ strategies. Only 22% said their boards were completely aware of the ways their firms created value, and just 16 percent claimed that their boards had a strong understanding of the dynamics of their firms’ industries.

What we do know from the Wells Fargo and Volkswagen cases is that absent their boards' ability to deter pervasive corporate fraud, the damages to shareholder value have been severe. Over the past six months, Wells Fargo has paid over $2 billion in fines and reserves for pending legal claims. Moreover, as shown below, since the scandal broke, the company's shareholder value has tumbled relative to direct competitors. Had Wells Fargo performed as well as Bank of America and JP Morgan over the past six months, its market value would be $50 billion to $100 billion higher today.

VW’s fall from grace has been even more severe. Six corporate executives have been indicted, and criminal investigations of the company’s ex-CEO and other senior executives are still ongoing. The company has already agreed to pay fines in North America in excess of $20 billion related to the defeat devices installed on 500,000 vehicles. Across the EU, investigations are still underway to assess penalties for the 8.5 million diesel vehicles produced with deliberately doctored emissions components. As shown below, VW has lost almost half its pre-scandal market value relative to the performance of the S&P 500.

The severe and possibly irreparable damage done to Wells Fargo’s and VW’s corporate images and market values should be a wakeup call for all outside directors to reexamine how they exercise their oversight function.  Unless and until all boards ensure compliance with reasonable standards of ethical corporate behaviors by vigilantly and independently seeking information from a variety of sources, we are likely to witness more corporate falls from grace.
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