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Institutional EYE

Commentary on Corporate Governance Issues

Nurturing corporate culture

How often does the board discuss company culture? The Wells Fargo and the Volkswagen incidents highlight the importance of – or rather, the lack of – a corporate culture that put ethical behavior ahead of performance targets.

It took a seemingly long time for the board of Wells Fargo, a US Bank, to act on the cross-selling scandal. When they did, they first fell short of what was expected. The board initially meted out a strong rebuke to its chairman and CEO John Stumpf, but did not sack him. The Bank announced Mr. Stumpf had agreed to forgo all unvested equity awarded to him, worth some $41 million (- an action first proposed by Mr Stumpf himself) and not take his 2016 bonus. He was not to get paid a salary during an independent board investigation into the cross-selling scandal and he was to recuse himself from all deliberations related to this issue. The criticism continued to mount and five weeks after the cross-selling scandal erupted, John Stumpf stepped down.

Cross selling has been integral to Wells Fargo’s success. In fact, retail banks globally – including in India, benchmark their performance on cross selling to Wells Fargo. But slowly the practices became aggressive, spread across branches, leading to Wells Fargo’s opening some two million potentially fake bank and credit-card accounts. It now appears that this was first spotted as early as 2011 and widely reported within the bank since 2013, but was allowed to simmer – resulting in over 5300 employees being sacked. Clearly the problem was systemic.

Wells Fargo is just one of the handful of companies that has clawed back compensation. Claw-back refers to taking back compensation linked to profit that is derived from illegal activity. Admittedly claw-back from an existing employee is easier than from someone who has left the company, which needs the courts to get involved. The management’s initial reaction, rather than face-up to its mistakes was, to push the problem down to the rank and file. When heat started to build, the Board felt that the claw-back in compensation will help put the problems behind. But given that the problem had spread across the length and breadth of the bank, meant otherwise. The senior management finally shouldered the blame. As Lucy Kellaway of Financial Times put it “If one employee offends against the banks vision and values it’s theirs. If 5300 do, it’s the bank’s.”

While the Wells Fargo cross-selling abuse is dominating the headlines today, the Volkswagen emission scandal roiled the company this time last year. Volkswagen had programmed its diesel vehicles to ‘cheat’ on the emission tests. About 11 million cars were ‘fitted with the defeat device,’ spewing noxious fumes into the atmosphere.

What followed after the scandal surfaced is similar to the script we have just seen play out in Wells. Martin Winterkorn the CEO initially attributed wrongdoing to a handful of his juniors, and only after the scale became apparent – and the share price lost over 30% of its value - that he resigned as the CEO.

Again like in the case of Wells, this scandal had been fermenting for a while. European researchers had spotted this discrepancy as early as 2011, but were brushed aside as being technical glitches.

While the unanswered question in both these examples is what did the board know and when, these episodes brings to focus corporate culture – something that (Indian) boards should pay attention too. This includes the impact the incentive structure might have on corporate culture.

The financial crisis highlighted the importance of the incentive structure. Before the financial crisis swathes of traders shared immediately in profits, for putting in place structures that would take years to pay-out. This prompted risk taking behavior that finally led to the blow-out. Incentive structures must have a healthy mix which rewards not just the short-term, but also long term thinking. A claw-back need not be off the table, but being difficult to enforce, the Reserve Banks solution of putting in place a staggered pay structure, where a portion of the incentive is paid after a fixed time frame is worth emulating.

In the case of Wells, the pressure to cross-sell was so severe, that the employees resorted to unethical behavior. For Volkswagen the dynamics were different. The company needed to replace ageing factories if they did not find the right engine which put huge pressure on the engineers to design fuel efficient low emission engines. In both companies, the corporate culture allowed – and possibly promoted – such egregious behavior, by letting performance targets reign supreme.

Suffice to say, risks no longer reside on the balance sheet – it can come from the sovereign (eg Brexit), market, social media, supply chain …. just about anywhere, but also employees. In times of uncertainty, it is corporate culture that protects the organization. What are the value systems that the company encourages and equally discourages?

While as a concept corporate culture is amorphous, employee behavior plays an important role enhancing business performance, ensuring regulatory and process compliance and protecting the company’s reputation. Admittedly, the tone and tenor is set at the top. But what happens outside the C-Suite, is just as important as what happens within.

Boards can act early if they learn to read corporate culture. Engagement with all stakeholders – employees, suppliers, distributors, etc. – will give it a sense of this. But first, the board must think about the corporate culture it wants to nurture.

A modified version of this column by Amit Tandon, appeared in Business Standard on 27 October 2016. You can access the column by clicking this link.

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