Commentary: The Real Scandal At Volkswagen

Behind the fraud and corruption probe is a company that has lost its way

Just When Volkswagen's fortunes looked like they couldn't fall further, a scandal has erupted that could shake Europe's biggest auto maker to its foundations. German state prosecutors confirmed on June 30 that they have opened an investigation into possible fraud and corruption by managers and labor representatives at the car giant. Alerted by VW's legal department, prosecutors are looking into a series of front companies that insiders may have used to wring kickbacks from suppliers and government officials for doing business with VW. They're also investigating Lustreisen, or pleasure trips, to Brazil allegedly taken by VW's labor representatives and expensed to the company with individual tabs as high as $36,000. Already two senior managers have quit, including VW's chief employee rep, Klaus Volkert, one of the most powerful figures in IG Metall, the all-important metalworkers' union. Volkert denies any wrongdoing.

The big question is whether prosecutors will find evidence linking any misdeeds to VW Personnel Chief Peter Hartz, the architect of VW's unique four-day workweek model, which saved tens of thousands of jobs in the early 1990s. He is also author of the important but unpopular labor market reforms that bear his name. German press reports allege that Hartz, a close friend of Volkert, signed off on the pleasure trip expenses and the cost of flying prostitutes from Brazil to Germany. ``I sharply reject these calumnies,'' Hartz said in a statement. But if Hartz is ensnared in the prosecution, it will look bad for Chancellor Gerhard Schröder, who has long relied on Hartz as a close adviser.

Volkswagen's burgeoning scandal exposes a deeper problem for Corporate Germany than alleged fraud. It highlights an underlying cause of the country's economic stagnation -- Germany's co-determination law, which gives workers' representatives 50% of the seats on the supervisory boards of all large companies. What started out conceptually as a law to ensure a balance between the interests of management and labor in many large companies has morphed into an insidious alliance aimed at not rocking the boat. CEOs and top managers depend on votes from the labor reps to be reappointed. Instead of making tough decisions on restructuring or job cuts, German managers are inclined to delay or avoid change and instead curry favor with union bosses sitting on their boards, often to the detriment of their companies. ``The implicit dialogue is: 'If you are nice to me [the labor representative], I prolong your [CEO] contract,''' says Theodor Baums, a corporate governance expert and professor of finance at Frankfurt's Goethe University.

The ties between management and labor are more intense at VW than at other German companies because the carmaker is controlled by the traditionally left-leaning state of Lower Saxony. The state owns a controlling 18% of VW's shares (Schröder once served on the VW board), and a special law prevents hostile takeovers by limiting the voting rights of any single shareholder to 20%. State control has seemingly ensured that maintaining jobs in the region is a goal at VW that supersedes growth or profits. ``Volkswagen is the last enclave of communism'' in Europe, says one German CEO.

VW once leveraged Germany's engineering prowess to build a global champion. But it has lost its way. The detour started in the early 1990s as VW losses ballooned. Then-CEO Ferdinand Piëch encouraged Hartz to reach out to labor leaders and make them feel like co-managers of VW. Co-opting labor was vital to adopting measures quickly that would save the company. It worked, but longtime execs say the tight links among labor, management, and politicians have become so interwoven that they paralyze the company. ``The cozy system functioned well within national borders, but the global economy has changed everything,'' says a VW insider.

As details of the scandal emerge, the real challenge for VW CEO Bernd Pischetsrieder will be to abolish the culture of mutual back-scratching. The European Union has already taken Germany to court to challenge the legality of the law limiting shareholder voting rights at VW. Forcing VW to operate as a real company, instead of a market-insulated puppet of labor bosses and politicians, would help deliver the kinds of jobs and prosperity that officials and union leaders have failed miserably to produce. Then VW could become a model for the best practices of Germany Inc., not the worst.

    Before it's here, it's on the Bloomberg Terminal.