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Hit by an Earthquake: How Scandals Have Led to a Crisis in German

Corporate GovernancePublished : March 28, 2007 in Knowledge@Wharton

German corporations have long prided themselves on beingabove-board, but scandals at some of the country's multinationalicons have seriously tarnished that reputation. The scandalsallegedly involve hundreds of millions of dollars in bribes, theprocurement of prostitutes and misbehavior by some of thecountry's most senior executives. One corporate figure alreadyconvicted was a confidant of former Chancellor Gerhard Schrderand worked with him in a much-publicized attempt to reform thecountry's rigid labor system.

The scandals, implicating officials at Siemens, Volkswagen,Deutsche Bank and other firms, have been so grave that they mayprompt German executives to adopt Anglo-American stylecorporate-governance principles, according to governance andbusiness ethics experts at Wharton and in Germany. Theseprinciples would make the firms more transparent, give investorsmore say in how the companies are run, and diminish the role ofbanks, which have long been major players in the operation of German companies by having bankexecutives sit on corporate supervisory boards (the equivalent of boards of directors in the U.S.).

Thomas Donaldson, professor of legal studies and business ethics at Wharton, says the German casesdiffer somewhat in kind from the corporate debacles that plagued the United States a few years ago, butthey have, in their own way, eroded public confidence in corporate executives. "I think they're at a similar

level of magnitude for Germany as the Enron-era scandals were for the U.S. And I predict that this willforce yet more soul-searching in Germany about corporate governance and especially the issue ofcorruption."

According to Christian Schneider, a German native and managing director of the Multinational ResearchAdvisory Group at Wharton's Center for Human Resources, the rash of unlawful activity is callingattention to the need for Germany to revamp its much-heralded system of "codetermination," whichinvolves what some describe as a cozy relationship between management and labor representatives inmaking important corporate decisions.

Bruce Kogut, professor of strategy at INSEAD, near Paris, says the scandals underscore the fact thatGerman companies have not embraced the trend toward making companies more open and accountable."German business doesn't really understand what the new rules of the game are," says Kogut. "It's caught

between a system they did understand -- a close relationship between banks and corporations, laborunions and government -- and something more Anglo-Saxon, more American. Germany is still far awayfrom that culture."

$72 Million in Bonuses

All of the scandals have taken their toll on the image of Corporate Germany.

In one case, DaimlerChrysler is under investigation by U.S. authorities for maintaining secret bankaccounts around the world to bribe officials of foreign governments. The company has acknowledged thatit made "improper payments" in Africa, Asia and Eastern Europe and has dismissed or suspended several

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employees, according to The Wall Street Journal.

In another case, Josef Ackermann, chief executive of Deutsche Bank, agreed in November 2006 to paysome $4.2 million as part of a settlement with prosecutors on charges he improperly enriched themanagers of Mannesmann, an engineering firm that had been acquired by Vodafone, a Britishtelecommunications company. Ackermann was on Vodafone's supervisory board at the time an estimated$72 million in bonuses were paid to the Mannesmann executives. Klaus Esser, Mannesmann's formerchief executive, received most of the bonuses after he agreed to a $183-billion takeover by Vodafone. In asettlement with prosecutors, Esser agreed to pay about $1.9 million. A court in Dsseldorf acquitted

Ackermann and other defendants in 2004 after a long trial, but a federal court ruled in 2005 thatAckermann and the others had to face a new trial. Despite his settlement with prosecutors, Ackermannremains chairman of the bank's management board.

But it has been the Siemens and VW affairs that have garnered the most attention in recent months.

At Siemens, authorities are investigating whether company executives created slush funds that could beused to bribe potential overseas customers. The investigation became public in November 2006 whenabout 200 police officers searched offices and homes of Siemens employees and seized thousands ofdocuments. Prosecutors also have alleged that employees operated a system to embezzle money fromSiemens, a mammoth conglomerate that had sales of $115 billion for the fiscal year ended September 30,2006.

Siemens has said it is cooperating with the investigation. Since the police raids took place, the companyacknowledged it has uncovered $544 million in suspicious transactions over a period of several years,according to theJournal. Siemens has also said that any wrongdoing was the result of "individual acts."According to the newspaper, however, arrest warrants and witness statements that it reviewed "depict acompany where payment of bribes was common and highly organized."

TheJournalalso reported that Siemens' longtime auditor, the German affiliate of accounting firmKPMG, is under investigation for allegedly ignoring these payments on the company's books. KPMG hasdenied any wrongdoing and is cooperating with authorities, the report states.

Among the specific allegations against Siemens' officials: two former managers of the company's powerdivision allegedly paid $78 million in bribes to obtain orders for turbines from Enel, an Italian powercompany.

It also is alleged that Thomas Kutschenreuter, a senior Siemens executive, arranged in 2004 to pay $50million to Beit Al Etisallat, a Saudi Arabian consulting firm that was once a business partner of Siemens,according to theJournal. Kutschenreuter, whom the newspaper said is cooperating with prosecutors, toldauthorities he arranged the payment with the support of Siemens' management board and with theknowledge of Klaus Kleinfeld, now the CEO of Siemens, and Heinrich von Pierer, the CEO at the time ofthe alleged payment.

Kutschenreuter reportedly made the arrangement to pay the money after receiving a telephone call from aSaudi businessmen representing Beit Al Etisallat. The caller demanded $910 million in commissionpayments as part of its former business partnership with Siemens. If Siemens did not pay, the callerthreatened to forward documents to the U.S. Securities and Exchange Commission detailing bribes paidon Siemens' behalf to win telecommunications contracts in Saudi Arabia, the Journalreported. Of the$50 million, $17 million was allegedly for past obligations and the remainder was hush money to make

the problem disappear.

In a separate case, two former managers of Siemens' power division allegedly paid $7.8 million in bribesto obtain orders for turbines from Enel, an Italian power company. The pair, Andreas Kley and HorstVigener, went on trial in mid-March of this year in Darmstadt, Germany. The men testified that they tookpart in paying bribes but did not violate Germany's law against bribing public officials in foreign countriesbecause the power company had been privatized. Prosecutors, however, say the Italian governmentowned a controlling interest in Enel at the time of the bribes.

Siemens received more bad news on March 27 in yet another investigation into the company. JohannesFeldmayer, a member of the firm's management board, was arrested by prosecutors in Nuremburg on


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charges related to payments made to Wilhelm Schelsky, an official of a labor union, known by its Germaninitials as AUB, that was friendly toward Siemens. Prosecutors believe money was paid to AUB throughSchelsky to offset the influence of IG Metall, the most powerful industrial union in Germany, according toThe Wall Street Journal. Feldmayer denied any wrongdoing. Schelsky was arrested in February oncharges of tax evasion.

The alleged wrongdoing at Volkswagen involves both company executives and labor-union officials.Dubbed the "perks-and-prostitutes" scandal by the press, VW managers allegedly used company funds tobuy the support of labor representatives, known as works councilors, with sex parties, holiday visits with

prostitutes and cash bonuses.

The VW case has shed light on the sometimes close relationship that exists between management andlabor under Germany's consensus-style codetermination management system, which gives organized labora voice in key corporate decisions. The most recent development in the case occurred on March 5, 2007,when Klaus Volkert, former head of the company's powerful employee works council, was charged with48 counts of incitement to embezzlement.

In January, Peter Hartz, VW's former head of personnel, was found guilty of endorsing theperks-and-prostitutes arrangement. He was given a two-year suspended sentence and fined about$736,000. He confessed that he tried to influence employee decisions by buying the support of Volkertfor a plan to restructure and cut costs at the giant automaker. German law requires that works councilleaders be consulted on major decisions taken by large corporations. Volkert allegedly demanded and

received about $2.5 million in bonuses between 1995 and 2004, along with $786,000 for luxury holidays,clothing, jewelry and phony consulting fees for himself and his girlfriend.

Hartz, 65, who resigned from VW in 2005, was a respected national figure. He helped Schrder puttogether a series of labor reforms in 2002 -- through his chairmanship of the so-called Hartz Commission-- designed to reduce unemployment and stimulate the economy.

Comparison with U.S. Scandals

Wharton's Donaldson notes that the German scandals differ in some respects from the corporate andaccounting-firm wrongdoings that brought shame to Enron, WorldCom, Tyco and other companies, andbrought about Sarbanes-Oxley reform legislation, named for two members of the U.S. Congress.

"One notable difference is that Enron and some of the other companies essentially fell almost to ground

zero," says Donaldson. "While WorldCom has recovered, what happened there was disastrous. In the caseof Siemens and VW, we don't have that level of overall destruction to the companies involved."

Another difference is that the pattern of alleged corruption in Germany is not as large as it was inAmerica. "The Enron-era scandals involved about 13 companies," Donaldson says. "Following themclosely were the investment-banking scandal, the mutual-fund-company scandal and the New York StockExchange scandal. We've had a pattern over the last five years of various serious financial and accountingscandals. It remains to be seen whether Germany is going to continue that way."

Yet another difference is in the type of scandals in the two countries. In the United States, the Enron-erascandals often involved elaborate ploys to increase a company's stock value, Donaldson notes. Executivesbenefited from stock options that involved accounting shenanigans. In Germany, by contrast, a lot of thetrouble has to do with bribery.

"One thing that makes these scandals so profound and shocking -- why they have created the earthquakein Germany that they have -- is that Germans are typically tight on corporate controls," Donaldsonexplains. "You have some dramatic failures to control in each of these cases. Hundreds of millions ofdollars were flowing out the door without being accounted for."

Germany's legal system long viewed bribes paid by companies to foreign officials as a cost of doingbusiness. Indeed, German law once permitted companies to write off such payoffs. But that changedwhen Germany adopted anti-corruption guidelines promulgated in 1999 by the Organization forEconomic Cooperation and Development, which were adapted from provisions in the U.S. ForeignCorrupt Practices Act, according to Donaldson.




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The attitude among German business people that bribery is sometimes necessary still exists, according toDonaldson. "You find it today when you talk with German executives. They say, 'Germans have highstandards, but when we're out there in the world, which is rougher and dirtier, it's nave to say we can playby the rules of soccer.' I think that sentiment is much more widely shared in Germany than in Sweden oreven the U.S. But when you're paying money to the head of VW's works council over a period of yearsand when you're providing prostitutes, that strikes at the heart of German integrity."

Labor-Management Relations

Schneider, the specialist in international labor relations at Wharton, says there is a key governancesimilarity that contributed, to some degree, to the embarrassing problems at Siemens and VW -- theunusual way that corporate boards are set up in Germany and the influential role played on those boardsby organized labor. German company boards have a two-tier structure: a small management board, whichreports to and is appointed by a supervisory board.

There are three different types of employee representation on company boards. A 1952 law, the WorksConstitution Act, provides for one-third employee representation on the supervisory boards of allcompanies with over 500 employees. The Codetermination Act of 1976 provides notional parity -- that is,50% shareholders' representatives and 50% employee representatives -- in companies with over 2,000employees. However, the shareholders' representatives retain a majority in the event of disagreementthrough a tie-breaking second vote of the supervisory board's chairperson who always hails from the

shareholders' side. Up to three members from the labor side on the supervisory board may be trade unionofficials from outside the company. These controversial "external" representatives are not necessarilyconnected to the firm and do not directly represent the employees at the company.

A third type of employee representation, albeit limited to the coal and steel industry, provides genuineparity on the supervisory board and gives employee representatives a veto over the appointment of thelabor director who acts as a de facto representative of the employees on the management board. Today,this special codetermination law only plays a minor role because of the decline of the coal and steelindustries. However, since it provides the most extensive form of codetermination ever established inGermany, it is of huge symbolic significance to the trade unions.

"Germany is the only country in the European Union with such a far-reaching system," Schneider says."No other country wants such a system. What you have is trade unionists and employee representativeshaving a say in crucial decisions, including the appointment and dismissal of members on themanagement board" says Schneider. "As a result, many German managers defend codetermination to theoutside world because they themselves are subject to hiring and firing through the supervisory board. Thisdual-board system is really blurring the lines and has been criticized by many for creating conflicts ofinterest. Codetermination was created to provide employee interest representation on a body at the toplevel of a company. Employee representation is one thing; managerial decision-making in a largecorporation is another."

Labor-management coziness "is what led to the problem at Volkswagen," Schneider adds. "In order toreceive support from the employee representatives on the supervisory board for Volkswagen's request forlonger work hours and corporate restructuring, the company's management began to offer money,vacations and bribes to union people to get votes. If Volkswagen didn't have such a system ofmanagement, it wouldn't have been forced into playing this kind of game."

Chancellor Angela Merkel has appointed a commission to look into the system of codetermination andrecommend whether it should be modified. One possible option, supported by the Federal Association ofGerman Employers Confederations, would be to limit employee representation on supervisory boards toone-third. This is the arrangement that was in effect at all large German firms until the 1976 law required50-50 codetermination for companies with more than 2,000 employees. The employers face strongopposition from union leaders, who actually are demanding an expansion of the country's codeterminationsystem. Meanwhile, and not surprisingly, the commission's report sees no need for substantive changes inthe system.

Differences in the Scandals




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Joerg Himmelreich, senior transatlantic fellow at the German Marshall Fund in Berlin, says it isimportant to note what makes scandals at VW and Siemens different. At VW, the alleged wrongdoingrepresents an abuse of the system of codetermination, which helped propel Germany to its economicmiracle of the 1950s and 1960s when its economy rose from the ashes of World War II. Despite thescandal at VW, Himmelreich says a "majority of the German people are not ready to give up this system."

The Siemens scandal, on the other hand, grew out of competitive pressure to seek foreign business. Insuch cases, managers often feel they have no alternative but to pay bribes "to make governments happy,"Himmelreich says. Such payments are often needed because infrastructure and utilities projects typically

require the permission of government officials.

If the system of labor-management codetermination can lead to trouble, Himmelreich adds that dual rolesheld by top executives can also lead to conflicts of interest and create a climate for wrongdoing. AtSiemens, the former CEO, von Pierer, was also the head of the supervisory board. "He had limitedinterest in clearing up things," Himmelreich says. "This is a main issue at stake: Should the present CEObecome the chairman of the supervisory board?"

Himmelreich points out that Ackermann ran into legal trouble in his dual role as chief executive ofDeutsche Bank and as a member of Vodafone's supervisory board -- an example of the longstandingpractice in Germany of bank officials playing key roles in large companies to whom they providefinancing.

Indeed, the close ties between banks and companies can be as problematic as the relationship betweenunions and management, according to Wharton's Donaldson. He says Germany has an "insider-controlled,stockholder-oriented" system of governance. German companies have a different set of relations aroundfinancing than do U.S. firms.

"Banks play a huge role in Germany," Donaldson says. "In light of the movement toward mergers andacquisitions that has been going on for a long time in the U.S. and is now slowly reaching Europe, peopleare realizing this inside-dominant approach has problems. A hostile takeover in Germany would probablybe financed by banks that sit on the boards of German corporations. It's not only an ethical problem; it'sjust not an efficient system because you have no guarantee that it will be an arm's-length transaction."

Impact on the German Psyche

INSEAD's Kogut says it would be hard to overstate the impact on the German psyche caused by the

difficulties that have befallen icons like Siemens. "The Siemens case is shocking because Siemens is sucha major player in Germany and has been for more than a century," says Kogut. "You think of the greatGerman companies, and Siemens is one of them. To find out that they knew about secret accounts thatwere used for paying bribes is stunning. This is a critical event."

Yet Kogut adds that one positive development to emerge from the various scandals is that they are beingopenly aired in public, which could mark the first step toward meaningful reforms. "To be honest, howclean have German companies -- or any European companies -- been over the past 30 or 40 years inselling products to governments? There have been, historically, a lot of things that people knew weregoing on, but what we didn't know were the details. Maybe the good news is that the bad details are nowcoming to light."

Donaldson says the scandals have been so embarrassing and detrimental to Germany's self-image that

substantial corporate reforms are needed. "Some people feel that so much trust has been squanderedamong the relevant parties -- investors, corporate management, banks, etc. -- that the old system can't beput back together in a way that would create good governance."

Any reforms that are undertaken by the government and corporate sectors would probably not attempt toreplicate the Anglo-American model, he adds. "But it's almost inevitable that Germany will adopt someAnglo-American elements, especially in giving more voice to stockholders and to outside investors --investors other than banks."

The recent scandals also cry out for beefing up the role of audit committees and for changes infinancial-reporting requirements, according to Donaldson. "In 2007, we still have a Germany with an




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insider-controlled, shareholder-oriented system. The system tends to do pretty well for large shareholdersand the people who run corporations; it does not do well for the average investor. Stockholders havemuch less say in the German system than in the Anglo-American system. I still think the generalperception is that there's a crisis at this point in corporate governance in Germany."

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