The Road to Hell...

Last week, my class was discussing the Volkswagen Emission Scandal. In case you are not familiar, here is a gist of the case:

In 2015, researchers from the West Virginia University’s Centre for Alternative Fuels Engines and Emissions (CAFEE) began testing the Volkswagen TDI model in the US. They embarked on this review at the behest of the International Council on Clean Transportation who wanted them to help demonstrate the benefits of US diesel technology. ICCT had noticed that diesel technologies in the US appeared cleaner than in Europe and hence wanted to identify what made this technology superior in the US in order to improve emissions in Europe. However, the traditional tests in the lab using a dynamometer (basically treadmills for cars) yielded no insight. ICCT therefore asked the CAFEE researchers to measure emissions with the vehicles on the road. Among the various vehicle brands chosen for this test, it was the VW vehicle which stood out for the huge gap between the emission readings in the lab test vs. those on the road test. ICCT then asked the California Air Resources Board (CARB) to perform a similar test. The results were the same. These results were then forwarded to the Environmental Protection Agency (the US’ environment regulator). That’s how?Dieselgate came out into the open. The VW team had introduced changes into the software that controls the engine to drop emission levels (which in turn reduced the power output of the engine) when it recognizes that the vehicle is on test mode (that is when it senses only two wheels are in motion (on the dynamometer) as opposed to all four). The engineering team ostensibly could not come up with a timely solution to meet EPA emission norms for the US without compromising engine performance. Failure to meet the deadline was as bad as meeting emission norms with degraded engine performance. Either scenario would result in the company missing its financial and industry leadership goals while denting its image as an engineering powerhouse. The team therefore decided to take the slippery path.

The VW incident is yet another in a long list of governance failures that have surfaced in corporate history. While a company is deemed to be an entity in its own right in most legal systems, it’s the people who oversee, manage and operate the company who are responsible for acts of omission and commission. Ultimately it is individuals who perpetrate frauds and individuals who can thwart or prevent fraudulent activity.

There are a few common threads that weave through such cases. Let’s take a look.

1.?????Motive – this is the most important factor that drives an individual. Motive can range from greed to personal financial pressure or pressure from leaders to perform/ deliver. Fear of failure that can result in losing business, losing face, prestige, status in society, power, money etc. is a powerful motivator for an individual (or a group) to consider bypassing the rules. At VW, this was compounded by the inability of the team to break this news to the boss (who arguably had a track record of shooting the bearer of bad news!)

2.?????Opportunity – Equally important. Opportunity for an individual or a group to exhibit undesirable behavior can come in many forms including:

·??????Lack of oversight – situations where the person or team is operating in a remote location. Remember?Nick Leeson?of Barings, stationed in Singapore in the early 1990’s, responsible for both trading and back office activities. His rogue behavior brought down the venerable institution

·??????Lack of internal controls – when the organization does not have a mechanism of checks and balances

·??????Lack of periodic audits and reviews – outside of statutory audits

·??????Combination of greed and a dulled sense of risk-awareness – where organizations and individuals get suckered by scamsters without asking why the proposition is “too good to be true”. Some examples:

?????????? i.?????The Bernie Madoff Ponzi scheme - investors placed blind faith in Madoff without bothering to ask questions. A complete lack of oversight by various regulators at the time did not help

???????????ii.?????Deloitte Australia employee’s scam – read this recent?report?on a potential Bernie Madoff style scheme that pulled in many people including the CEO and other partners in Deloitte Australia investing money into a plan allegedly hatched by a former Deloitte employee that promised risk free returns up to 40% from Indian Government Bonds!

iii. Goldman Sachs and 1MDB – most of you are familiar with this case. 1MDB (1Malaysia Development Berhad) raised around 6.5bio USD in capital from 3 bond deals it executed with GS between 2012 – 2013. GS earned approximately 600mio USD from these transactions (and presumably commensurate bonuses were earned by the GS employees who were involved). This startling fact coupled with the knowledge (or lack thereof) of the source of wealth of one of the principal actors (Jho Low) was not sufficient to trip wires within the various internal controls/ committees that GS has in place (Anti-bribery policy, GS Capital committee etc.) resulting in the transactions getting approved. GS ended up paying penalties/ fines of over 6bio USD to various regulators to settle the various cases filed against it. Read this?Reuters report?for an overview and this Oct 2020?order from the SEC?on GS’ offer of settlement

Controls in banks – given the unique nature of the banking industry (given that banks are safekeepers of individual depositors’ money and also providers of credit), it is no surprise that this industry has been riddled with frauds of various magnitudes (involving employees and customers) and therefore subject to intense regulatory scrutiny across the world. A snapshot below of some of the measures (mostly mandatory to meet regulations) one can see in place in most banking institutions:

3.?????Rationalisation

·??????I wasn’t aware of what was happening

·??????I did this for the benefit of the company

·??????I wasn’t aware this is illegal

·??????I was following instructions

·??????This was the norm

·??????My manager expected me to get this done

·??????I was trying to help the customer/ colleague

·??????This was perpetrated by a rogue engineer/ trader/ officer/ manager with no one else involved

·??????I did not harm anyone (i.e., this was a victimless crime!)

·??????I had no choice – it’s too hard to follow the rules

·??????I was trying to make up for the earlier losses

How often have we heard statements like these in the aftermath of a scam that has been exposed. Deviant behavior in individuals results when there is insufficient resistance from embedded values and beliefs to override the presence of motive and opportunity. For organizations that do not have a strong set of values and ethics embedded in its culture and reiterated by the leadership in words and acts, chances are deviant behavior will keep manifesting itself. The most interesting situation is where an employee bends the rules (including payment of bribes or “speed” money, fudging statutory reports, not adhering to the labor code etc.) for the “benefit” of the company! Some organizations ignore such behavior until it is called out. Once that happens, invariably the firm cuts the employee(s) loose and washes its hands off the incident. I never miss an opportunity to remind people that they should always be aware that employment contracts (for the most part) are structured today in a way that if there is penal action on an employee who may have erred in acts of omission or commission, the firm will not be bearing any costs or liability on behalf of the individual (unless it is demonstrated that the firm was negligent in discharging its risk management responsibility).

4. Hubris – Where the leader (in most cases) believes that she is above it all. Having reached a position of pre-eminence in the organization/ industry, she is not subject to the normal rules of conduct that apply to everyone else. Hubris usually results in poor governance. But when combined with fraudulent behavior, the results are usually disastrous for the organization and its stakeholders.

Deviant behavior is not limited to mature organizations/ industries. It also shows up in new-age startups (belying the generally held view that young people today are more idealistic and startup founders particularly so, therefore these companies are “different”). One only needs to look at FTX and its founder Sam Bankman-Fried. SBF was?charged?on multiple counts including conspiracy to commit wire fraud and securities fraud, money laundering etc. In November 2022, in a spectacular flameout, FTX went from being worth some 32bio USD to filing for bankruptcy!?

In India, GoMechanic, a unicorn with big name backers (Sequoia Capital, Tiger Global etc.) was?exposed when a prospective investor (Softbank) hired EY to do a due diligence. The EY report apparently stated that revenue figures may be inflated, there may be fictitious service centers and some of the service centers may have violated accounting norms. The ostensible driver was the desire of the management team to boost valuations. EY has now been commissioned by various investors to do a forensic audit.

One observes that in many cases, individuals who otherwise lead exemplary lives fall prey to the combination of motive, opportunity, rationalization and hubris and put themselves (and their organizations) on the road to hell. While motive and opportunity are factors that can be consciously addressed by the leadership team in an organization, tackling the tendency to rationalize undesirable behavior and the emergence of hubris needs much more effort and requires a deeper embedding of values and beliefs in the organization and the individuals. It requires the ability to face difficult situations without buckling. This is hard especially when such a stance can result in significant impact to individuals and organizations, not to mention other stakeholders (shareholders, community, customers etc.).

While there are many progressive organizations that are proactively taking steps to create an operating environment which discourages such behavior, we continue to see regulations across sectors evolving to introduce preventive measures that force companies to “do the right thing”. And yet, the forensic audit practices of the large audit firms continue to see increasing demand for their specialist services!

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I hope that you enjoyed The Lateral View!?

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-Shrinath?

Shrinath Bolloju?is an independent management advisor. He has spent over 30 years in the banking and securities services industry and has worked in technology, operations and run a business, in various geographies across Asia, Europe and the Americas.