VOLUME 27 | NUMBER 4 | FALL 2015

Journal of APPLIED CORPORATE FINANCE

In This Issue: German Capital Markets and Corporate Governance

Law and Corporate Governance: within Europe 8 Klaus J. Hopt, Max Planck Institute for Comparative and International Private Law, Hamburg, Germany

Corporate Governance in Germany: Recent Developments and Challenges 16 Marc Steffen Rapp, Philipps Universität Marburg, and Christian Strenger, HHL Leipzig Graduate School of Management

The Survival of the Weakest: Flourishing Family Firms in Germany 35 Julian Franks, London Business School, Colin Mayer, Saïd Business School, University of Oxford, Hannes F. Wagner, Bocconi University

The Bug At : Lessons in Co-Determination, Ownership, and 27 Charles M. Elson, University of Delaware, Craig K. Ferrere, Board Structure Harvard Law School, and Nicholas J. Goossen, University of Delaware

Corporate Finance in Germany: Structural Adjustments and Current Developments 44 Wolfgang Bessler, Justus-Liebig University Giessen and Wolfgang Drobetz, Hamburg University

The Cross-Listing and Cross-Trading of German Companies 58 Wolfgang Bessler, Justus-Liebig University Giessen, in the U.S. and of Foreign Companies in Germany Fred R. Kaen, University of New Hampshire, and Colin Schneck, Justus-Liebig University Giessen

Stock Liquidity and the Cost of Equity Capital in Global Markets 68 Yakov Amihud, New York University, Allaudeen Hameed, National University of Singapore, Wenjin Kang, Renmin University of China, and Huiping Zhang, JCU Singapore

Cash Equity Markets in Germany 75 Peter Gomber, Goethe University

Bund for Glory, or It’s a Long Way to Tip a Market 81 Craig Pirrong, University of Houston

Derivatives and Repurchase Markets in Germany 88 Thomas Book, CEO, Eurex Clearing

Transaction Costs for German Institutional Investors: 96 Lutz Johanning, WHU—Otto Beisheim School of Management, Empirical Evidence from Stock Markets and Marc Becker and Arndt Völkle, XTP GmbH

International Evidence on Value Creation in Private Equity Transactions 105 Benjamin Puche, Reiner Braun, and Ann-Kristin Achleitner, Technische Universität München, Center for Entrepreneurial and Financial Studies The Bug At Volkswagen: Lessons in Co-Determination, Ownership, and Board Structure by Charles M. Elson, University of Delaware, Craig K. Ferrere, Harvard Law School, and Nicholas J. Goossen, University of Delaware

orporate governance scholarship has long consid- The board claims to have been unaware of this scheme. ered the problems that arise in public companies But at this point, it may be important to note that German C with dispersed ownership. In the absence of companies have an unusual “two-tier” board structure in large, concentrated shareholdings, no party is which a “management board” is accountable to a “supervisory positioned to effectively monitor management. When strong board.” A member of the “supervisory” board representing the oversight is lacking, managerial misfeasance and even malfea- State of asserted that the board was informed sance are more likely to result. about the regulatory violations only shortly before they were The automaker Volkswagen does not suffer from a disclosed to the public.5 Even , the compa- dispersed ownership structure. In fact, it has several strong ny’s CEO, expressed surprise at news of the wrongdoing. He and highly active owners. The and Piëch families have insisted that the violations were the result of “the grave errors been involved with the company for many years and own of a very few” employees.6 The evasion of emissions regula- 31.5% of Volkswagen’s equity.1 The German state where the tions through a highly developed and widespread managerial company is headquartered, Lower Saxony, holds 12.4%, and effort suggests a serious failure in the board’s monitoring and an outside investor, Qatar Holding, owns 15.4%.2 Following oversight function. the conventional corporate governance paradigm, we would But, again, given the company’s concentrated ownership not expect the company to now be embroiled in a major structure, the problem cannot be attributed to the separation scandal. With such powerful economic incentives in not one of ownership from control. In the discussion of the Volkswa- but three actors, management should be subject to the kind gen emissions scandal that follows, we explore the causes of exacting oversight that could readily ferret out misconduct. of the scandal, highlighting issues that arise outside of the Yet problems arising from the separation of ownership conventional dispersed ownership paradigm. We believe that and control are not the only issues that can lead to corporate the failure of oversight at VW can be explained in large part wrongdoing—and Volkswagen is a striking case-in-point. by problems arising from the composition and functioning It has recently been revealed that, despite the influence and of the company’s two-tier board (including the principle of financial stakes of its three largest investors, the company has “co-determination”), and the identity and seriously conflicted long been involved in a massive emissions regulation evasion incentives of its largest shareholders. scheme. From 2007 to 2015, the Environmental Protection Agency has disclosed that the company cheated on federal The Emissions Scandal and Its Causes emissions tests through the installation of a so-called “defeat The current conflagration enveloping Volkswagen has many device” on at least eleven million of its vehicles.3 causes and provides many important lessons for corpo- The defeat device operated by rendering inoperative the rate directors. At the heart of the scandal is, of course, bad emissions control system in certain Volkswagen car models. management—and, more pointedly, unethical behavior on a This software would track federal testing procedures and corporate-wide scale. That such a pervasive and highly devel- activate when the car was being inspected, suppressing oped scheme to evade emissions standards could occur over emissions at that time so that they would appear to meet the such an extended period of time and throughout so many EPA requirements. With the device in place, the company levels of the organization attests to a management culture fooled regulators and hid emissions of as much as 40 times gone awry. As a general rule, corporate cultures that embrace the allowable amount of nitrogen oxide.4 transparency and integrity thrive—and those that do not end

1. Volkswagen AG Annual Report 2014, at 92. Fortune, Sept. 30, 2015 available at http://fortune.com/2015/09/30/volkswagen-golf- 2. Id. emissions-criminal/. 3. Environmental Protection Agency, Notice of Violation, November 2, 2015 available at 6. Jack Ewing, “Volkswagen Says 11 Million Cars Worldwide Are Affected in Diesel http://www2.epa.gov/sites/production/files/2015-11/documents/vw-nov-2015-11-02. Deception,” New York Times, Sept. 22, 2015 available at http://www.nytimes. pdf. com/2015/09/23/business/international/volkswagen-diesel-car-scandal.html?_r=0. 4. Id. 5. Michal Addady, “This Volkswagen Board Member Says Staff ‘Acted Criminally,’”

36 Journal of Applied Corporate Finance • Volume 27 Number 4 Fall 2015 up failing sooner or later. Why then did such a problematic are typically “widely dispersed.” For example, one widely cited culture exist at Volkswagen? We suggest that the culprit may study of global corporate stock ownership reported that, in the be the composition of the board itself in combination with year 2000, only 7.6% of NYSE-listed companies had at least the unique governance structure, known as “co-determina- a 25% control block, and only 1.7% of such companies had a tion,” that defines many German companies, including VW. 50% control block.7 In the rest of the world, by contrast, most The proper function of the board of directors is to actively public companies are much more likely to be controlled by monitor management and thereby ensure corporate efficiency families, groups, or individual blockholders. For example, the and competitiveness. If management knows that the board is same study cited above reported that, in the year 2000, 82.5% scrutinizing its actions critically, it tends to behave better. But of German-listed companies had a greater than 25% control this does not appear to have been the case at VW. block and almost two-thirds (64.2%) had a 50% control block.8 There are three major problems from a corporate gover- And even though the percentage of listed German companies nance standpoint with the Volkswagen Board. First is the without a 25% blockholder has more than doubled in the past well-known distortion of incentives stemming from the dual- 15 years, over two-thirds of such companies continue to follow class stock held by the dominant shareholding Porsche and this alternative model of public company ownership structure.9 Piëch families. Second is the presence of a government as a In such controlled companies, the dominant shareholder’s major shareholder. And third is the organization of its super- voting control is frequently established or enhanced through visory board around the principle of co-determination, which a number of mechanisms. First, control often results from the mandates significant labor representation. We will argue that use of dual or multi-class shares that confer voting rights that each of these features of the VW ownership and governance are disproportionate to the dominant shareholder’s percent- structure contributed in varying degrees to the board failure age economic stake in the firm. Second, control is sometimes of oversight that made possible the management decision to obtained through the use of pyramidal ownership structures. evade emissions regulations. Because of the combination and In 2000, as reported in the same study cited earlier, 17.6% of interaction of these three features, VW had what amounts to an listed German companies had dual-class stock and some 15% “insider’s” board. Members of the board had interests that were of companies with a family control block of 20% made use inconsistent with their duty to outside shareholders and that of a pyramidal ownership structure.10 The agency problem in can be seen as leading ultimately to the company’s current crisis. controlled companies is only worsened by mechanisms like shares with enhanced voting rights and pyramid company The Issues Arising from the Controlling Shareholders ownership structures, which both further insulate controllers The first potential problem in the Volkswagen Board structure from the economic consequences of company transactions. is the presence of a significant controlling shareholder, which Volkswagen has a controlling shareholder that uses both complicates the governance paradigm. In theory at least, the pyramidal and dual-class structures to enhance control. presence of a controlling shareholder can work to preserve value Through Porsche Automobil Holding SE, an investment by limiting the agency conflict between management and share- holding company, members of the Porsche and Piëch families holders in public companies with dispersed ownership. own shares that, as noted earlier, represent 31.5% of the equity But in practice, the interests of the controlling shareholder interest in Volkswagen. This interest is leveraged through are also likely to conflict with those of the remaining public (or a dual class structure11 that gives the Porsche and Piëch “minority”) shareholders in ways that often end up reducing families control of 50.7% the voting rights.12 This control the value of their shares. Such minority shareholders gener- is further leveraged through the use of a pyramid structure. ally have little say in the voting process and management of Half of the shares of Porsche Automobil Holding are ordinary the corporation. When the board is dominated by a particular voting shares, and the other half are non-voting shares.13 The investor, there is really no one to monitor them so as to prevent Porsche and Piëch families own the ordinary shares, but not self-dealing or inefficient management. And this absence of the non-voting shares.14 Through these structural devices, the oversight can lead to deficient legal compliance and scandal, families control five board (half of the investor represen- even of the kind that we have just seen at Volkswagen. tatives on the supervisory board), while limiting their own In the United States, shareholdings in public companies economic exposures.

7. Ronald J. Gilson, “Controlling Shareholders and Corporate Governance: Complicat- before common shareholders receive dividends. For this privilege, preferred shareholders ing the Comparative Taxonomy,” 119 Harvard Law Review 1641, 1646 n. 13 (2006) usually give up their voting rights. However, the voting right comes alive if no dividend is [hereinafter Gilson, “Controlling Shareholders”] (citing Marco Becht, “Reciprocity in paid for two years. Moreover if a dividend is not paid for one or two years, the preferred Takeovers” 19). dividend has to be fully paid for the past years before the common shareholders receive 8. Id. a dividend. 9. See Julian Franks and co-authors, in this issue. 12. See footnote 1 above. 10. See Gilson at 1646-47. 13. Porsche Automobil Holding SE, Annual Report Fiscal Year 2014 at 40 available at 11. Under German company law (Aktiengesetz) common and preferred shareholders http://www.porsche-se.com/pho/en/investorrelations/mandatorypublications/annualre- have similar rights except for the following differences: Preferred shareholders receive a port-14/. higher dividend than common shareholders. The preferred dividend has to be paid in full 14. Id.

Journal of Applied Corporate Finance • Volume 27 Number 4 Fall 2015 37 The nature of the agency problem that affects controlled stem from the diversion of value through self-dealing trans- companies differs from the agency problem that tends to actions designed to enrich the controlling shareholders. The reduce the value of, and is the main corporate governance real issue that led to the scandal appears to have originated challenge facing widely held companies in the United States. in the ways that nonpecuniary private benefits influenced the For the outside investors in U.S. public companies, the blunt- management and strategy of the company. One member of ness of the market for control as a disciplinary mechanism the controlling families, Ferdinand Piëch, was able to take and the difficulties inherent in disaggregated shareholders’ leadership of the company and direct it in pursuit of his own use of formal power through proxy voting create an inabil- ambitions for industrial domination. It was in the course of ity to effectively monitor the officers and directors of such that pursuit that the emissions scandal occurred. companies. In this sense, the directors and officers of U.S. Agency problems of this non-pecuniary type can be companies have de facto control, and the agency concern in especially pernicious. To be sure, the top managers of widely such cases is thus about management opportunism.15 held public companies may have a similar predilection for In controlled companies, by contrast, the controlling activities such as empire building, but there is at least some shareholder has an economic incentive to monitor manage- constraint on inefficient behavior from markets and the ment because it stands to capture a significant proportion of shareholder franchise. In the case of controllers, though, that any increase in share value that results from such monitor- constraint is entirely lacking. Controllers are immune from ing. For this reason, a controlling shareholder has at least the proxy contests and can “just say no” to any takeover offer. potential to be a more effective monitor of corporate manage- They are, in large part, free to set the company’s strategy ment than is possible with the mechanisms available in the largely as they wish, subject only to a different, much less widely held model. demanding set of constraints, that we discuss later. Finally, So, in a controlled company, then, management oppor- the courts, as the final backstop, are almost completely tunism is, again, at least in theory, much less likely to be ineffective as a restraint on this type of behavior because the a significant problem. But there is another kind of agency concept of self-dealing is not elastic enough to encompass problem that can arise in such companies—namely, oppor- actions such as deciding to expand into new markets, and the tunism by the controlling shareholder at the expense of the deferential business judgment rule would shield this form of minority shareholders.16 The incentive for such opportu- conduct from judicial scrutiny. nistic behavior arises from the fact that not all of the costs Ferdinand Piëch, the grandson of Ferdinand Porsche, borne by the company are “internalized” by the controller the founder of the Porsche company, owns 10% of Porsche because the controller does not own 100% of the equity. Automobil Holding, the family investment fund.20 From This creates the potential for non-proportional diversions 1993 until 2002, he was the CEO of Volkswagen.21 After he of pecuniary benefits from the company to the controller retired from that position, he became chairman of the super- through self-dealing transactions.17 In addition to such visory board. He was chairman when the emissions scandal pecuniary “private” benefits that come at the expense of occurred, stepping down only earlier this year after a failed other minority shareholders, there may also be non-pecuni- attempt to oust the then-CEO.22 ary—or what might be referred to as “psychic”—private At some point, Piëch’s interest in VW appears to have benefits associated with the position of control over a become largely non-pecuniary, his goal no longer (if it ever business enterprise.18 As one example, the prestige and status was) to create more wealth for this family (or his sharehold- associated with being at the helm of a large enterprise may ers). A number of commentators have claimed that, for him, weigh more heavily with some controlling shareholders than “what is important is power, not money”23—and that his the increase in their wealth resulting from a higher share real underlying objective was to create the world’s largest value. To the extent this is so, some controllers are likely to automobile manufacturer.24 He was very nearly successful pursue goals other than the maximization of profitability in that respect. For instance, in 1993, the year he took over and firm value.19 as CEO, the company sold just 62,061 cars in the United The problems at Volkswagen, however, do not appear to States. At the end of his tenure, in 2002, United States

15. Lucian A Bebchuk, “The Elusive Quest for Global Governance Standards,” 157 21. Id. University of Pennsylvania Law Review, 1263,1281 (2009). 22. William Boston & Todd Buell, Volkswagen Chairman Ferdinand Piëch Resigns, 16. Id. at 1281-82. Wall Street Journal, April 26, 2015 available at http://www.wsj.com/articles/volkswa- 17. See Gilson, “Controlling Shareholders,” at 1663. gen-chairman-ferdinand-piech-resigns-1429978992. 18. Id. at 1663-64. 23. Richard Milne, “Ferdinand Piëch’s Influence Seen Everywhere at Volkswagen,” 19. Id. at 1665 (“the existence of private benefits of control means that for the con- Financial Times, October 19, 2015 available at http://www.ft.com/intl/cms/s/0/ trolling shareholder the separation theorem does not apply; that is, the controlling share- fe07b240-7645-11e5-933d-efcdc3c11c89.html#axzz3sKFOloxs. holders’s utility is affected by company decisions in ways other than through the deci- 24. Harald Hamprecht, “Volkswagen’s No. 1 Ambition: How it Plans to Rule the sions’ impact on the company’s stock price”). World,” Autoweek, March 28, 2011 available at http://autoweek.com/article/car-news/ 20. David Kiley, “How Ferdinand Piëch Lost Control of Volkswagen,” Automobile, -no-1-ambition-how-it-plans-rule-world. April 28, 2015 available at http://www.automobilemag.com/features/columns/1504- how-ferdinand-piech-lost-control-of-volkswagen/.

38 Journal of Applied Corporate Finance • Volume 27 Number 4 Fall 2015 sales had reached 355,648 cars.25 In this quest to expand divestment, retained ultimate control over the enterprise. his company’s size and market share, Piëch assembled a 12 Governments as shareholders almost invariably prove to brand automotive empire—one that included the likes of be problematic. The interest of Lower Saxony in VW, while and as well as VW—that aimed to displace theoretically economic and so consistent with the interests of Toyota as the world’s largest.26 other shareholders, was actually political in nature. The principal A number of observers have also suggested that such interest of political leadership is the retention of power through drive and ambition may well have been tinged with a degree reelection, and governments tend to be reelected when there is of “megalomania.”27 As Piëch built his empire, seemingly popular content created by high employment. A higher rate of without much regard for profitability and shareholder value, employment for the citizenry acts to solidify a leadership’s politi- the means by which the company achieved its growth may cal base, rendering the ultimate corporate profitability of the have been irrelevant (see the box inset on the attempt by enterprise to shareholders a secondary objective. Therefore, the Porsche to take over VW in 2009). As the controlling share- main motive of the governmental shareholder is to maximize holder, with the cooperation of the labor unions and the employment, if necessary at the expense of shareholders. And government—which both sought greater employment— so in cases where the board is composed in part of political Piëch had for years the effective power to direct all corporate representatives, even very limited government ownership creates activities toward this goal. The emissions actions at VW, a skewed board decision-making process. Furthermore, the unfortunately, are consistent with this paradigm of growth incentives of governmental directors to expand the employee at all costs, including as it turns out, outright misfeasance. base at the expense of the proper corporate objective—that And in the face of such pressure for growth, the culture of is, long-run profitability and value maximization—also has VW’s board failed to provide the appropriate counter-weight the potential to divert the focus of other directors from value to the dominance of its chairman. maximization out of the fear that the government will campaign for their replacement should they fail to comply with its goals. The Issues Arising from With government representatives on the board, the other board Having the Government as Shareholder members are likely to feel pressure to accommodate them by The second major structural problem with the VW board— making decisions under the constraint of the government’s one that might be viewed as leading to the controversy—was incentives, particularly the preservation of jobs. In such a case, the identity and influence of one major shareholder. When the government effectively acts as a controlling shareholder and, a dominant shareholder happens to be a government, the when combined with the family-controlled votes, the potential goals of that shareholder are unlikely to match those of the for conflicts with outside investors is compounded. Either of remaining public equity investors. To the shareholders, the these blockholders can veto any major decisions. With dual-class concept of long-term returns on capital is paramount, but stock, the Porsche and Piëch representatives can act in their self- governments are typically motivated by political consider- interest as long as the government’s interests are also reflected in ations, particularly the employment of their citizens. The their actions. This extraordinary mix of incentives seems quite government of Lower Saxony has had significant influence capable of giving rise to and then tolerating a culture in which over the affairs of VW and its board since the company’s there was an incentive to cut corners and falsify emission rates, creation. Volkswagen was originally a state-owned enterprise in order to satisfy both the government’s expectations for jobs until, in 1960, the “Volkswagen Law” was enacted by the and Piëch’s goal of market dominance. German government that enabled the company to be priva- Perhaps not surprisingly, in the face of the emissions tized28 while allowing Lower Saxony to retain a 20% voting scandal, Lower Saxony has shown no sign of abandoning its interest in the company (despite the fact that their actual 20% holding.31 In a recent press release, Stephen Weil, one equity position was only 12.4%) in order to maintain govern- of the government’s representatives on the board, announced ment influence.29 The VW Law also required the vote of 80% the State’s continuing support of the company.32 In an odd of the shareholders to approve any corporate action by the coincidence, Weil was elected to office with the support of the company and mandated the appointment of two governmen- German Green Party, which certainly did not promote exces- tal board members.30 In this way, Lower Saxony, despite the sive automotive emissions.33 Although there is no evidence

25. “Ferdinand Piech’s Career with ,” Car and Driver, February 29. Id. at 803 2011 available at http://www.caranddriver.com/features/ferdinand-piechs-career-with- 30. Id. volkswagen-group-feature. 31. Donahue, Patrick, “Lower Saxony Premier Warns Consequences May Follow from 26. Kate Connolly, “VW Boss Martin Winterkorn Defeats Chairman Ferdinand Piëch,” VW Probe,” Bloomberg Business, September 21,2015, Retrieved from http://www. The Guardian, April 17, 2015 available at http://www.theguardian.com/business/2015/ bloomberg.com/news/articles/2015-09-21/lower-saxony-premier-warns-consequences- apr/17/vw-boss-martin-winterkorn-defeats-chairman-ferdinand-piech. may-follow-from-vw-probe. 27. Id. 32. Id. 28. Florian Mosleim, “Compliance with ECJ judgments vs. compatibility with EU law 33. “Last-Minute Win for Germany’s SPD and Greens,” Spiegel, Jan 21, 2013, avail- – Free movement of capital issues unresolved after the second ruling on the Volkswagen able at http://www.spiegel.de/international/germany/last-minute-win-for-germany-s-spd- law: Commission v. Germany,” 52 Common Market Law Review 801, 802 (2015) and-greens-a-878690.html.

Journal of Applied Corporate Finance • Volume 27 Number 4 Fall 2015 39 that German politicians had any involvement in the emissions the effect of providing oversight designed to ferret out illegal scandal at this time, critics claimed that “Berlin fought hard acts. By so doing, effective oversight reduces the likelihood of to shield its carmakers from closer scrutiny and, in a high both misfeasance and malfeasance. But the conflict of inter- profile clash with its European partners two years ago, ests and incentives inherent in the German model may have from emissions targets.”34 Even in the wake of the emissions undermined the oversight function, and reduced attention to scandal, German Prime Minister Merkel defended the stance appropriate legal compliance. as necessary to protect employment in the sector—a clear The bigger issue is how board practice in Germany has indication of the government’s employment-based goal in its evolved to limit the negative effects of labor representation on investment in VW, the region’s single largest employer.35 investor interests. There is an obvious board-level divergence Of course, the government’s desire to employ its citizens is of interest between the shareholder representatives and the by no means an illegitimate goal. However, when the govern- labor representatives. Shareholders gain when wages are not ment is a major shareholder with its representatives on the allowed to exceed competitive levels, while working condi- board, it creates a misalignment of incentives that may not tions conducive to efficient production are maintained. Of prove to be beneficial to either the overall profitability of the course, the shareholder directors and the labor directors are corporation or the consuming public. Indeed, in this case, at cross-purposes because of the potential for much of the it can be argued that the government, in its single-minded shareholder gains from holding the line on wages to come pursuit of higher employment, did not make compliance at the expense of employees. As a result, the board process oversight a primary goal and left the company vulnerable to in German companies like Volkswagen has often deterio- the lapse whose consequences it now confronts. rated into factionalism.41 In such cases, the most reliable way of serving the interests of the shareholder faction may Issues Arising from The Law of “Codetermination” often prove to be by weakening the board42 and shifting Under the German Codetermination Act (Mitbestimmunge- the deliberative process into informal channels.43 But one setz), all companies with 2000 or more employees must have obvious problem with this response is that it further erodes both shareholder and employee representatives on its super- the ability of the supervisory board to effectively monitor visory board.36 The Volkswagen supervisory board has long legal compliance. met this requirement. Its board has 20 members, with ten In sum, the dual nature of board decision-making under elected by the shareholders and the remaining ten selected co-determination is highly problematic to shareholder inter- directly by the workforce.37 This board is mainly responsi- ests. By giving employees access to more company information ble for selecting and monitoring the separate “management and voting rights within the board decision-making process, board” that in turn runs the company.38 labor is better motivated and positioned to demand a greater The inclusion of labor representatives on the board share of profits through higher compensation and other presents serious difficulties for the employee-monitoring concessions.44 But at the same time, shareholder directors function of management. The board and management may be understandably reluctant to bring new and potentially are responsible for supervising employees. Ordinarily, it is profitable projects to the full board since, by revealing them management’s duty to set compensation levels, prevent and to the labor directors, the values of the projects themselves are penalize shirking and misfeasance, and efficiently coordinate likely to be reduced by being subjected to demands to share labor. But with labor representatives on the board, the party the potential gains.45 Most changes in company policy will that is susceptible to shirking is also the party responsible for affect the wages, livelihood, and working conditions of labor the preventive monitoring.39 As a result, oversight is likely participants; and, as a result of the dual nature of decision- to be less efficient.40 Although the primary aim of monitor- making authority in co-determined firms, all such strategic ing is meant to identify and constrain shirking, it also has decisions are subject to the threat of labor hold-up strategies.

34. Barkin, Noah, “VW Scandal exposes cozy ties between industry and Berlin,” 41. Id., at 1064 (“it is standard practice for employee and shareholder representa- Reuters, September 26, 2015, Retrieved from http://www.reuters.com/arti- tives to have separate pre-meeting caucuses”) (citing Klaus J. Hopt, “Labor Representa- cle/2015/09/26/us-volkswagen-emission-germany. tives on Corporate Boards: Impacts and Problems for Corporate Governance and Eco- 35. Id. nomic Integration in Europe,” 14 International Review of Law and Economics, 203, 204 36. Mitbestimmungsgesetz, 1976 BGB1 I S. (1994). 37. Volkswagen, Supervisory Board, available at http://www.volkswagenag.com/con- 42. Id. at 1064 (“many German firms have used various corporate governance de- tent/vwcorp/content/en/investor_relations/corporate_governance/supervisory_board. vices to limit the power and function of the supervisory board on which labor representa- html. tives sit”); Mark J. Roe, “German Codetermination and German Securities Markets,” 38. Id. Columbia Business Law Review 167, 168 [hereinafter Roe, “German Codetermination”] 39. Stephen M. Bainbridge, “Privately Ordered Participatory Management: An Orga- (“In reaction to German codetermination, players inside the firm, namely managers and nizational Failures Analysis,” 23 Delaware Journal of Corporate Law 979, 1065 (1998) shareholders, seem to have reacted by weakening the large firm‘s supervisory board or, [hereinafter Bainbridge, “Participatory Management”] (“Does it not seem odd, then, that more properly, keeping it weak, despite global business changes that led to its strength- those who are to be monitored should be allowed to choose the monitors?”). ening elsewhere.”) 40. Id. at 1066 (“If employees are entitled to voting representation on the board of 43. Id. at 174 (describing informal channels of information flow to shareholders). directors, monitoring by the board and its subordinate managers will be less effective, 44. See id. at 173 (“[i]nternal rent-seeking between capital and labor could be in which will cause agency costs to rise.”). play”).

40 Journal of Applied Corporate Finance • Volume 27 Number 4 Fall 2015 Despite their equal representation on supervisory boards, and continue to be able to choose the chairperson of the shareholder directors in co-determined firms hold some supervisory board. As we already noted, Ferdinand Piëch, the advantage over labor directors through their ability to select grandson of Volkswagen’s founder, was the long-time leader the chairperson of the supervisory board. If a two-thirds of the company. Under his leadership, the company appears majority of the board, which cannot be obtained without to have followed, without question, his “desire to make VW some shareholder support, does not elect the chairperson, the best and biggest carmaker in the world.”51 then the shareholder representatives alone get to select the Nevertheless, a power struggle earlier this year illus- chair. This is critically important because the chairperson is trated in dramatic fashion that control cannot be exercised given two votes as the deciding tie-breaker on board matters.46 unilaterally at Volkswagen. Piëch, disappointed with the Thanks to this structural advantage, shareholder represen- company’s performance under Winterkorn, the CEO that tatives in German companies have tended to be successful he had hand-selected several years earlier, announced that in seizing control of board function and steering the board he was dissatisfied and attempted to oust him.52 But, it deliberative process through more advantageous channels.47 was immediately apparent that, acting alone, he did not Shareholders representatives in co-determined firms often have the votes to remove Winterkorn. Even within the manage much of the board work informally or directly with controlling families, the members do not vote as a single management in ad hoc committees.48 But as already noted, block nor do they always agree. Some family members, such a practice has the drawback that the board’s access to such as his cousin , did not support the essential information about these projects and its ability change.53 Additionally, Stephen Weil, the premier of Lower to make reasoned decisions about them are often severely Saxony, pledged his support, and the State’s 20% vote, limited. Practices such as giving supervisory directors board for Winterkorn.54 Additionally, the leader of the works materials only slightly before the meeting and sometimes council pledged its support for Winterkorn.55 Therefore, requiring that they be returned just after, reducing the Piëch’s attempt to replace the CEO backfired and Winter- number of meetings of the board and its formal committees, korn survived. And Piëch was forced to resign from the or increasing the board’s size to impractical and unwieldy supervisory board.56 numbers that encourage free-riding and impede efficient The co-determination structure compels this form of meeting management are common in German co-determined power-sharing. Before he was ousted, Piëch’s interest in companies.49 As a result of this response, the supervisory growing Volkswagen into the world’s “biggest carmaker” board is significantly weakened and its ability to function as appeared to be largely if not completely consistent with the a monitoring body is limited. interests of the board representatives of labor and govern- In effect, then, the German co-determined firm appears ment. Most important, the policy favoring growth without to run the risk of becoming something of a headless state, its regard for profitability promised to expand Volkswagen’s supervisory board neutered in an effort to avoid inefficiencies employee base. And thus this failed attempt to unseat Winter- in the manner in which it structures the decision-making korn was at bottom reflective only of a new alignment of the process. What is left is just a balancing of powers, with employees and works council with management. Before the policy largely determined in the confluence of each interest. scandal and after the departure of Piëch, Winterkorn had Of course, the massive regulatory scandal that occurred at the workers’ support: “Together with him we have written an Volkswagen was in no party’s interest. But it occurred under unprecedented success story,” works council chair Osterlich all of their watch because, without a strong supervisory board, said.57 This support was absolutely necessary for a CEO nobody was looking after the common enterprise. like Winterkorn to keep his job. The demonstration of the At Volkswagen, the co-determination structure interacted power of the works council and Lower Saxony, through their with the controlling and government shareholdings. The ability to influence the Volkswagen leadership, has made clear Porsche and Piëch families were able to maintain significant the reality that Winterkorn and the supervisory board are influence over the company through their control of 50.7% dependent on the continued appeasement of both groups to of the shareholder vote.50 Thanks to this control, they were implement their objectives.

45. See id. 52. Id. 46. See Viet D. Dinh, “Codetermination and Corporate Governance in a Multinational 53. Id. Business Enterprise,” 24 Journal of Corporate Law 975, 981 (1999). 54. Id. 47. Id. 55. Id. 48. See footnote 39 above. 56. Id. 49. See Roe, “German Codetermination.” 57. David Jolly & Jack Ewing, “Murmurs of a Shake-Up at Volkswagen’s Top,” New 50. See footnote 1 above. York Times, April 13, 2015 available at http://www.nytimes.com/2015/04/14/business/ 51. William Boston, “At Volkswagen, a Game of Thrones as Chairman Ferdinand international/murmurs-of-a- shake-up-at-volkswagens-top.html?_r=0. Piech Quits,” Wall Street Journal, April, 26, 2015 available at http://www.wsj.com/ar- ticles/challenges-persist-for- volkswagen-as-chairman-piech-exits-1430081445.

Journal of Applied Corporate Finance • Volume 27 Number 4 Fall 2015 41 Piëch, who led the company during the period that Conclusion it was misleading regulators, was long an ideal company The problems at Volkswagen resulted from the conflict of leader from labor’s perspective. His primary focus was not objectives that is inherent in the structure of the VW board. on making money. Rather, he set out to create an empire Policy was determined by the individual interests of each through aggressive brand acquisitions. Piëch believed that party that was represented on the board. Thus large-scale “It is not possible to bring a company to the summit while consideration of the company’s ethical posture seems to have maintaining harmony,” so he had to make a choice between been secondary. This resulting blindness to the potential for labor and shareholders. He chose labor.58 corporate malfeasance on what turned out to be a global The unlikely alliance between an industrial tycoon scale is viewed in these pages as the result of the confluence and labor was possible only within the unique structure of three problems that can be traced to the composition of of Volkswagen and the German law of co-determination. VW’s board. The presence of a dual-class controlling share- The ability of shareholders to control the direction of the holder, the government as a major equity-holder and putative company—for example, through the market for corporate board member, and, finally, the German corporate model of control—was severely curtailed by the voting structures on co-determination all contributed to this massive board fail- the board. Piëch’s own economic incentives were sharply ure in oversight. diminished by the separation of control rights from cash- The implications of this failure of corporate governance flow rights. He owned Volkswagen through both a pyramid practice are straightforward. First, the use of dual-class stock structure and dual-class shareholdings. His holdings were (which is now prohibited in Germany) only magnifies the derived first through the family’s holdings in Porsche, which problem inherent in the presence of a controlling shareholder. it controlled through a 10% economic interest. For him, the Second, the presence of the government as a major investor in private benefits of empire-building clearly outweighed the a public corporation complicates and damages the ultimate sacrifice of potential wealth, most of which would have been corporate mission of shareholder return. Third, the German shared with outsiders. This powerlessness of shareholders to corporate organizational governance structure of co-deter- influence the direction of the company, along with Piëch’s mination creates an environment in which a corporation interest in building the world’s largest automaker, coincided must juggle the conflicting interests of the shareholder and with labor’s interests and gave opportunity and reason for the labor representatives, thereby limiting the prospects for the alliance. long-term corporate success. The scandal gives investors and But, as discussed earlier, the true puzzle of the emissions directors much to reflect on. Ultimately, it is a testament to scandal is that highly interested parties permitted a compli- the importance of board composition, theory, and structure ance failure that not only benefited none of them, but ended in helping to build and maintain a corporate culture that up imposing very large costs on all of them, including labor promotes integrity and, in the final analysis, the long-run and local government. Regulatory non-compliance did not success of the company. in the end further the objectives of any party. However, because the co-determination structure forced an alliance Charles Elson holds the Edgar S. Woolard, Jr. Chair in Corporate between the shareholder-controller, management, and Governance, and is Professor of Finance and Director of the John L. labor—one that was reinforced by the participation of local Weinberg Center for Corporate Governance at the University of Delaware. government—there was no one to monitor any of those Craig K. Ferrere is a student at the Harvard Law School and a parties. Compliance systems require a relationship that former Edgar S. Woolard Jr. Fellow, John L. Weinberg Center for Corpo- includes healthy distrust and skepticism between the board rate Governance at the University of Delaware. and management, and management and labor—a relation- Nicholas J. Goossen is an undergraduate student at the Univer- ship that is less likely to develop when the parties’ primary sity of Delaware. objectives are all so closely aligned.

58. Richard Milne, “Ferdinand Piëch’s Influence Seen Everywhere at Volkswagen,” Financial Times, Oct. 19, 2015 available at http://www.ft.com/intl/cms/s/0/fe07b240- 7645-11e5-933d- efcdc3c11c89.html#axzz3sKFOloxs.

42 Journal of Applied Corporate Finance • Volume 27 Number 4 Fall 2015 Background to Porsche Family Shareholding in Volkswagen

The combined Porsche-Piech family accumulated its large block Porsche began acquiring shares in Volkswagen in 2005 under of Volkswagen voting shares through an extraordinary series of the direction of Wiedeking. On September 25, 2005, Porsche events during 2005-2009. announced that it had a 20% stake but was doing so only to ensure Connections between the extended family and Volkswagen the continued independence of VW.1 In August of 2006, Porsche went as far back as the , when Ferdinand Porsche designed announced its position had increased to 25% but, again, continued the iconic Volkswagen “Beetle.” Several family members were to deny it wanted to acquire VW. actively involved in the Porsche firm, particularly Ferdinand Piech, By March of 2007, its share ownership had increased to 31%.2 a grandson of Ferdinand Porsche. Piech was head of engineering Wiedeking argued that the shares were a good value and that VW at Porsche but stepped down in 1972 after disputes with other could improve operationally. family members. VW’s share price in 2007 (see chart) was twice that of 2005 He then joined Volkswagen, becoming head the Audi subsid- but Porsche continued buying shares and call options at ever higher iary and then, from 1994 to 2002, CEO of the entire Volkswagen prices with much borrowed money. Porsche paid even higher prices Group. He subsequently joined the supervisory board (Aufsichtsrat) in 2008 despite the beginning of a worldwide banking crisis. of Porsche and was one of the family members who still controlled In October 27 of 2008, Porsche announced it owned 42.6% a majority of voting shares. He stepped down as supervisory board of VW shares and held call options on another 31.5%.3 The chairman in April 2015 after a failed attempt to oust CEO Martin combined holdings of Porsche and the state of Lower Saxony Winterkorn. amounted to 94% of VW shares. Between 1993 and 2008, was CEO of Because several investors and hedge funds had shorted VW Porsche (head of the Vorstand, or operating management board) shares, a “short squeeze” developed. VW shares closed at Euro and led a dramatic increase in Porsche’s sales and profits through 514 on October 29, more than ten times the price of early 2005. extensive manufacturing process improvements and some new On that day, Volkswagen was the most highly valued company product lines, particularly the Cayenne SUV. in the world. By contrast, VW’s financial performance was quite mediocre. But Porsche’s position had been acquired with largely short- Although it sold 50 times as many cars as Porsche, it was much term borrowings. $13 billion would be due on March 24, 2009, less efficient and profitable, and its shares sold at a much lower but rolling over more than a bit of that would not be feasible under multiple of revenue. Its market capitalization was only $17 billion the circumstances.4 VW shares began dropping after the end of in 2005. November 2008. The 1960 “Volkswagen Law” had always seemed to make a Despite its operational mediocrity, Volkswagen’s financial takeover of VW out of the question but, starting in the early 2000s, situation was far superior to Porsche’s. It was unlevered and held other EU countries argued that the VW Law violated EU corpo- $12 billion in cash.5 As a member of both companies’ advisory rate governance rules. The possibility that the VW Law might be boards, Ferdinand Piech had a clear view of both of their finances. repealed made a takeover of VW thinkable. Because no banking institution or outside investors emerged

VW Share Price in Euros to rescue Porsche financially, the only solution became, ironically, 500 a VW acquisition of Porsche. 450 Piech became the head of the supervisory board for the now 400 combined companies which included the following marques: 350 Porsche, Volkswagen, Audi, SEAT, Skoda, and . 300 250 After the VW-Porsche merger, and an equity investment by 200 the government of Qatar, the Porsche family holding company 150 (now “Porsche SE”) still retained 50.7% of VW’s voting shares 100 even though their economic interest was only 15.75%.6 Porsche 50 SE was, however, also liable for much of the debt accumulated in 0 Jan 3-05 Jan-3-06 Jan-3-07 Jan-3-08 trying to take over VW.

1. http://www.nytimes.com/2005/09/26/business/worldbusiness/porsche-says-it- debt after acquiring VW and believed that the Volkswagen law would be repealed. The plans-to-amass-a-20-stake-in-volkswagen.html German Government opposed repeal, however, and the 80% voting requirement 2. http://www.economist.com/node/8934965 continues to prevent an outside takeover of Volkswagen. 3. Germany does not have a securities law equivalent the US SEC 13D. 6. The Porsche and Piech families owned 50% of Porsche Holdings SE which held 4. http://www.spiegel.de/international/business/the-vw-debt-trap-has-porsche-bitten- 50.7% of VW group’s voting shares, but which represented only a 31.5% economic in- off-more-than-it-can-chew-a-620020.html terest. See Financial Times, October 19, 2015 at https://next.ft.com/content/fe07b240- 5. Presumably, Wiedeking had intended to use VW’s cash hoard to pay off Porsche’s 7645-11e5-933d-efcdc3c11c89#axzz3t17h6rNx

Journal of Applied Corporate Finance • Volume 27 Number 4 Fall 2015 43 ADVISORY BOARD EDITORIAL

Yakov Amihud Carl Ferenbach Martin Leibowitz Laura Starks Editor-in-Chief New York University High Meadows Foundation Morgan Stanley University of Texas at Austin Donald H. Chew, Jr.

Mary Barth Kenneth French Donald Lessard Joel M. Stern Associate Editor Stanford University Dartmouth College Massachusetts Institute of Stern Value Management John L. McCormack Technology Amar Bhidé Martin Fridson G. Bennett Stewart Design and Production Tufts University Lehmann, Livian, Fridson Robert Merton EVA Dimensions Mary McBride Advisors LLC Massachusetts Institute of Michael Bradley Technology René Stulz Assistant Editor Duke University Stuart L. Gillan The Ohio State University Michael E. Chew University of Georgia Stewart Myers Richard Brealey Massachusetts Institute of Sheridan Titman London Business School Richard Greco Technology University of Texas at Austin Filangieri Capital Partners Michael Brennan Robert Parrino Alex Triantis University of California, Trevor Harris University of Texas at Austin University of Maryland Los Angeles Columbia University Richard Ruback Laura D’Andrea Tyson Robert Bruner Glenn Hubbard Harvard Business School University of California, University of Virginia Columbia University Berkeley G. William Schwert Christopher Culp Michael Jensen University of Rochester Ross Watts Johns Hopkins Institute for Harvard University Massachusetts Institute Applied Economics Alan Shapiro of Technology Steven Kaplan University of Southern Howard Davies University of Chicago California Jerold Zimmerman Institut d’Études Politiques University of Rochester de Paris David Larcker Clifford Smith, Jr. Stanford University University of Rochester Robert Eccles Harvard Business School Charles Smithson Rutter Associates

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