The fall of the German Titans

Deutschland

This land consists of 16 states and is the strongest and the largest economy of Europe. A country which is 4th in the world in terms of Gross Domestic Product has beautiful cathedrals, castles, forests, amazing beer and a one hell of a football team. History may have not been very kind to the region but with the completion of World War II, it opened a new world for the society.

German companies have been world famous because of their quality products and superb service. They have been pioneers in the automotive space all over the world with the top 3 automakers — Volkswagen, BMW and Mercedes from there. SAP, one of the biggest enterprise software brands is the uncontested leader in its space. Stuttgart based Bosch is a technology and engineering company that has presence all over the globe and is famous for its products.

Certain small and medium enterprises are market leaders in their respective industries, which are known as Mittelstand in Germany. On an average Mittelstand companies employ around 60% of the workforce and add up to 53% to the German GDP. A majority of these companies are export oriented and this is one of the reasons why their economy is booming because of the specialized focus on small and medium sized firms by the government and financiers.

What makes corporate Germany better than other developed nations?

The western world has been baffled as to how with such a small chunk of natural reserves and low population, Germany can have such an accelerated economy that would produce world class products. It is next to Japan in terms of manufacturing and the trade unions are associated with the businesses on a day to day basis which makes the companies socially responsible and efficient.

The collaboration between management and labor unions is the main reason behind the advancement and evolution of companies in Germany. The education system helps to provide good vocational training to its youth such that they gain a competitive edge among global graduates. The support provided by the economic and monetary system helps to put the focus on long term profits.

But in the last 5 years why are some German companies known for their world class service and products, been in the middle of corporate fraud??

We would be discussing three cases where in the last 5 years these companies were charged with corporate crimes and scandals.

  1. Volkswagen

One of the biggest scandals to hit any automotive brand in the world, Volkswagen in the year 2015 admitted to using a “defeat device” in their diesel engines. The Environmental Protection Agency (EPA) established that certain Volkswagen cars running in USA had preinstalled devices that could anticipate test scenarios and thereby perform efficiently during tests. But in the actual context, each of these cars was polluting up to 40 times the prescribed limit set by the US transport authorities.

“Dieselgate” tarnished the brand image of the VW group

The EPA would test the engines by tracking the speed, air pressure, and also the position of the steering wheel. At this stage, the software would take over the car and exhibit lower levels of pollutants but once these tests were over and the car was back on roads it would switch out of the test modes and pollute with harmful nitrogen oxide gases. These gases would be catastrophic and cause respiratory diseases, heavy smog and sometimes premature deaths. They found that around 500,000 Volkswagen cars in the US had these devices installed in their famous models like Audi A3, Jetta, Beetle, Golf and Passat. The company admitted to fitting these devices in 11 million cars worldwide and 8 million cars in Europe.

The company has had to pay $25 billion in fines to regulators in the US. There are around 60,000 pending cases that have been filed by German customers. There could still be lawsuits being filed by other stakeholders which could make the company pay billions to the regulators in Europe and other countries.

2. Wilhelm Schulz

Wilhelm Schulz had been a manufacturing powerhouse of industrial goods in Germany. If viewed from bare eyes, the privately held company seemed like a profitable and efficient manufacturer of pipes for the oil & gas industry. But even if one was a shrewd investor who would notice the minute details, one could miss out on the actual net worth of the company. Then it wouldn’t be much of a surprise to know that the Oracle of Omaha who is very particular of his investments made a terrible mistake which cost him millions.

Precision Castparts was acquired for $37 billion by Berkshire Hathaway making it the most expensive purchase by the legendary investor. Buffet asked its CEO Mark Donegan to find similar companies and acquire them.

In 2016 an intermediary tried to approach Precision Castparts to acquire Wilhelm Schulz. Company representatives were sent to Germany to spend 6 months to look into the financial records of Schulz. They explored the factory facilities, met with their largest clients, and even questioned their employees. In February 2017 they were acquired for a sum of $870 million. Wilhelm Schulz was seen as a way for Precision Castparts to expand in the German market as well as abroad.

A few weeks after the acquisition was over, a whistleblower sent an email to one of Berkshire Hathaway’s manager claiming there was ‘falsification of data’. The management at Precision Castparts took the allegations seriously and sent a team of auditors and consultants to offices of Schulz to check if there was any foul play. To their horror it was true. Lots of data had been exaggerated and Precision found some of the issues stated below:

a. Fake sales orders from companies who had stopped doing business with Schulz were presented.

b. Forged invoices and delivery receipts created using photoshop software.

c. The companies that were presented as customers were not customers.

d. There were email trails of employees talking about inflated sales figures.

e. Schulz had evaded bankruptcy recently before the acquisition.

All of this information was kept secret and not disclosed during the acquisition talks.

Schulz had taken a step in bad faith and ultimately the actual valuation of Schulz was only one fifth of $870 million paid.

Precision went to courts and filed a case against Schulz for cheating and forgery. The tribunal said that the Schulz management concealed important financial information and awarded €643 million to Precision Castparts. It would be impossible for Precision to get their money back as the 3 holding companies of Schulz have declared bankruptcy. Wilhelm Schulz was a very big mistake for Berkshire Hathaway.

3. Wirecard

It wasn’t just the pandemic that hit the German economy hard in 2020 but it was also the downfall of the massive payments company called Wirecard. Another scandal happening to corporate Germany in the last 5 years. It has been pretty distressing to see a company that was listed at the Frankfurt Stock Exchange and was a member of the DAX, being removed after being charged with fraud.

Wirecard overtook Deutsche Bank’s market capitalization in 2018

Wirecard was founded in 1999 during the dot com bubble and Markus Braun joined the company and became CEO in 2002. They started their operations by providing payment services to businesses in gambling and porn. These sets of clients were being avoided by other payment companies so Wirecard made a niche out of it and setup a name for itself. They got listed in the stock exchange through a reverse IPO and the company opened a banking branch that would issue credit cards. They also took over Citibank’s prepaid card division and penetrated into the North American market. In 2018 they were selected as a blue chip stock of the DAX and replaced Commerzbank.

The company began international expansion from 2011 to 2014 after they raised €500 million from their shareholders, thereby purchasing Asian payment companies and partner merchants. Merchants who were acquired by the company provided retailers with card payment platforms which were then integrated into Wirecard’s system. Such payment systems helped the company gain a large part of revenue and all this money was being deposited in escrow accounts of Wirecard.

From 2008 there were lots of critics who questioned the business model of Wirecard and the authenticity of the rapid growth rate. After Financial Times investigated wrongdoings in Singapore business in 2019, the German financial regulator BaFin banned short selling in Wirecard stock.

The company is accused of overreporting its sales figures and profit numbers and even claimed to have €1.9 billion in its escrow accounts. Wirecard’s businesses were not present in countries like Singapore, Malaysia, Dubai and Indonesia but it was indirectly operating through merchants who deposited money in the company’s escrow accounts.

On 18th June ‘20 the management of the company acknowledged that there was €1.9 billion “missing” from the accounts when EY audited their books. This figure was almost equal to about a quarter of the balance sheet. The next day CEO Markus Braun resigned and the stock value of the company fell 72% followed by the appointment of a new chief executive. The former CEO got arrested and within a few days, the company filed for bankruptcy.

Filling the gaps in corporate governance..

The corporate law in Germany mandates companies to have a management board as well as a supervisory board and the latter is given superiority to inspect all dealings. Some companies still do not disclose information so that investors can take correct decisions.

Certain agencies and administrations need to be given more power to monitor and govern companies in a legitimate manner.

Regulators: European Union (EU) and the European Securities and Markets Authority (ESMA), need to be given more power to overlook the business affairs of companies. The German financial regulator BaFin also needs to be provided more freedom to prosecute companies who are not abiding by the rules and catch frauds at an early stage than waiting for the companies to file insolvency, therefore, hitting the credibility of the business world. If BaFin had acted on the reports by Financial Times on the alleged misconducts by Wirecard then the accounting scandal could have been avoided much earlier.

Rather than protecting the homegrown companies, regulators need to ensure that all enterprises are complying according to the rules set by the government.

Auditors: Accounting firms and auditors are one of the main parties who can detect any kind of suspicious activity. They should ensure strict compliance practices and make sure that financial wrongdoings are reported to the concerned authorities. The auditors in the cases of Wilhelm Schulz and Wirecard could have helped in reporting the crimes much earlier if they acted on time.

Labor unions: The German economy follows the concept of “Soziale Marktwirtschaft” or ‘social market’ which indicates that the economy and the society are interdependent on each other. Therefore, institutions like labor unions and governments are a part of every business, so they also need to make sure that enterprises are running incorruptibly such that the entire community does not get affected by misconduct.

All of the above accounting and operational scandals have been a big upset for the German government and it has hit the image of the corporate community. The authorities need to make sure that the interests of all the stakeholders are taken care of than just the top management and the promoters. The media which is known as a pillar of any democracy needs to expose any wrongdoings rather than adding a cushion over it.

Amendments need to be made in the laws of the German state such that businesses are made criminally liable,and awarded more rigorous punishments on misleading regulators and for causing pollution.

The global economy has been developing drastically each passing year and the German economy needs to make sure that its focus is on technological innovations rather than just rely on their traditional automobile and engineering expertise. The next decade of growth will come from newer innovations and data which would include industries like computers, biotechnology and or optical fiber.

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