Month: October 2015

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e Emissions testing scandal threatening Volkswagen’s very existence: an ACG Case Study

The transformation of Volkswagen from number one global car-maker and role model for European auto manufacturer

The transformation of Volkswagen from number one global car-maker and role model for European auto manufacturers to the industry’s bad boy has taken a mere two weeks. Similarly, its highly respected chief executive, Martin Winterkorn, having won a difficult battle in April of this year to retain his position in the face of an attack by the patriarch chairman, Ferdinand Piëch, and made a confident address to the Frankfurt Motor Show on 14 September, resigned ten days later. How could such a catastrophe happen so suddenly?

To answer this question, this ACG case study follows our standard format of history, comment and analysis against our Five Golden Rules of corporate governance:

History of Volkswagen

Impact on the evolution of corporate governance in Volkswagen

What happened recently?

What did they all say afterwards?

What happens next

Performance against our Five Golden Rules

Lessons: could it have been prevented

History of Volkswagen

In 1937, Adolf Hitler determined to provide the German people with a home-grown, cheap motor car of the kind that the American people were benefiting by. So he commissioned an Austrian engineer, Ferdinand Porsche, who had founded his own company in 1931, to design a suitable vehicle and built a new town especially to house the factory workers. The company became known as Volkswagen, or the People’s Car, and the town became Wolfsburg. The war intervened before production got properly under way, and after the war the town and factory were shattered.

The British army acquired the factory and initially got it going again to provide vehicles for the army, then offered it to foreign motor companies, including Ford, all of whom rejected it. So Volkswagen was left to rebuild itself and the intimate relationship with the town of Wolfsburg was firmly established, and the federal state of Lower Saxony and the Porsche family became the main shareholders.

Fast forward and Volkswagen is hugely influential in the town, owning the football team, a theme park and spending large amounts locally. It is important to realise this when looking at the corporate governance of the company. Even when it has grown to be a globally important organisation employing 600,000 people, its culture is firmly rooted in Wolfsburg and Lower Saxony and it is controlled by the founding family and the state, with a major input from the automotive unions who have an automatic place on the supervisory board. Outsiders, even with the right job credentials, are unlikely to get accepted into the controlling circles.

Impact on the evolution of corporate governance in Volkswagen

The regional and family influence on corporate thinking and behaviour is not untypical in German industry, particularly amongst the mittelstand or medium-sized companies. In spite of developing some of the most advanced engineering capabilities in the world, when they grow larger and take these capabilities into global operations, they tend to take the local and family culture with them when establishing their management and organisational structures. Hence the culture of Volkswagen was seen to be highly centralised, with the top and senior management very able and hard-working but brooking no dissenting voices and not encouraging challenges to established policy.

In this environment, the development of unsatisfactory practices and the impact of misguided policies are unlikely to reach the ears of senior management. In this kind of autocratic culture, whistle-blowing by disaffected ex-employees is likely to be the end result. Alternatively the lid will suddenly be blown off a simmering problem, with damaging consequences.

There had been recent warnings of problems in governance in 2005 when, apparently in order to facilitate the introduction of potentially unpopular new employment policies, it was said to have created “honeytraps” to ensnare union leaders. These involved a fund to pay for foreign trips and sex parties with prostitutes for union leaders and MPs through a former personnel manager and council works chief. The managers involved left the company, but arguably the culture didn’t change.

What happened recently?

The events leading up to the recent explosion have been widely reported, so we will summarise them very briefly here.

Volkswagen was forced to admit to the US Environmental Protection Agency (EPA) that for a number of years it had been installing a software program in its diesel cars, which detected the patterns of testing exercises being conducted, compared with the patterns of normal driving. On detecting the testing pattern, the program then changed the engine management system in such a way that the exhaust emissions produced were below the prescribed limit for the nitrogen oxide compounds being checked.

However, under normal road driving conditions the program then reverted to a way of running that improved performance but at the expense of greatly increasing the forbidden emissions. Worse, when Volkswagen was challenged about the inconsistency between test results and consumer experience, it prevaricated for many months until threatened with the removal of its right to sell the cars concerned. At this  point it admitted having installed the software program in up to eleven million vehicles in America.  The lid was then blown off the concealed wrong-doing.

It reminds one of the cartoon figure running off the edge of the cliff, whose feet continue to run for a few moments before he drops like a stone. This really was an accident waiting to happen. Consider:

• In 1998 something similar had been perpetrated by manufacturers of heavy duty diesel-engined vehicles, installing these so-called defeat devices, a case which was settled by the self-same EPA in the US
• Volkswagen were repeating the same deception and surely should have known they would be found out sooner or later
• testers at the International Council on Clean Transportation in California are said to have sent back to Wolfsburg test results of vehicles which had failed their own testing before these results were passed to the EPA; for failed cars a team of VW engineers was even flown in to investigate.
• despite the challenges from the testing lab and regulatory authorities, the company carried on – recalling nearly 500,000 cars and denying any underlying problem – until it was overwhelmed when the EPA threatened to refuse certification and ban it from selling its 2016 models
• Bosche is said to have provided VW in 2007 with defeat software but on the understanding that it was only for test purposes and that it would be illegal if deployed on its cars for sale to the public.

As has happened many times, in many industries, regulators often seem to turn a blind eye to widespread infractions of regulations until someone goes too far or a whistle-blower emerges with an eye-catching tale, then common practice becomes unacceptable and an example is made of one of the players. Thereafter everyone concerned may be punished. Two examples in recent years are banks running with minimum (insufficient) capital before the 2008 financial crisis (in this case a leading player, Lehman, was allowed to go bust), and pharmaceutical companies in China bribing doctors (in this case Glaxo SmithKline was pilloried, though bribery was almost certainly common practice). Now it is the turn of the automotive industry and VW is the company that brings on the attack.

What did they all say afterwards?

After the situation blew up, various comments were made:

• Martin Winterkorn initially apologised, then in his resignation speech said he was standing down in the interests of the company, but was not aware of any wrong-doing on his part. There was naturally some scepticism as to how a hands-on CEO who was famous for his interest as an engineer in the smallest detail, could be totally ignorant of what was going on
• on 21 Sep 15 Michael Horn, VW’s chief executive in the US said the company “totally screwed up” in a way that was “completely inconsistent with our core values”. This, of course, begs the question as to what actually were the core values.
• the Dow, as recently as 10 Sep 15, rated VW as a strong performer on economic, environmental and social dimensions
• however, Vigeo, a French company providing Corporate Social Responsibility analysis to clients, had scored VW 48 out of 100, placing it well below its peers in the automotive industry and saying that its trustworthy public image and good financial performance weren’t matched by a good CSR performance
• MSCI, the world-leading research-based index, says it had VW as a poor Corporate Governance performer for some time, lower than 72% of companies globally on their proprietary ranking, falling since 2014 due to management and board turmoil.
• this doesn’t seem to have been noticed by the global investment community as the non-German owners of VW are quoted as holding 26% of the capital compared with German institutions’ 2%. Perhaps the Germans understood their culture better than foreigners.

What happens next

The actions taken by VW in the immediate aftermath of the admission of guilt are

• the resignation of Martin Winterkorn as CEO saying he is “not aware of any wrong-doing on my part”: His leaving package is estimated at up to $32m
• the resignation of Audi’s head of technical development and Porsche’s head of R & D
• a provision of €6.5bn to cover potential costs of correcting up to eleven million affected vehicles and related fines and legal costs
• the filing by the supervisory board of a criminal complaint with prosecutors
• the appointment of Matthias Müller CE of Porsche to replace Martin Winterkorn: quote “under my leadership Volkswagen will do everything it can to develop and implement the most stringent compliance and governance standards in our industry”
• the appointment of a US law firm to investigate how the emissions cheating happened (the same as BP hired following the Deepwater Horizon oil spill).

Implications for stakeholders are

• the certainty of class actions against VW by parties who deem themselves to have been hurt by this scandal
• specific impacts on key stakeholders:
  • investors
    • VW’s shares are already down by 40% at the time of writing
    • Volkswagen Financial Services, the finance operation, currently providing a significant contribution to profits amounting to one sixth of group profit in the first half of this year, with more than €100bn of customer loans outstanding, and €25bn of customer deposits, could find itself in difficulties funding its operations as the ECB has put a temporary ban on buying loans that finance sales of VW cars
    • Audi suffered in the 1980s in the US with a sudden acceleration problem and took years to recover; something similar looks likely to happen to VW generally in the US and perhaps globally
  • governments
    • those which have provided tax advantages to clean diesel cars are likely to consider big claims for criminal action for cheating the public revenue in regard to illegally representing compliance with tax banding
    • EU governments, having been big promoters of diesel as using less fuel, hence creating less CO2, and encouraging manufacturers to produce them, now are flip-flopping against diesel and may well penalise diesel cars in a big way
  • diesel car industry faces
    • tougher emissions regulation
    • lower profits
    • the potential elimination of small car diesels and the harmful impact on manufacturers of these vehicles
  • campaign groups
    • are likely to extend their suspicion from diesels and NOx tests to petrol cars and tests for CO2 emissions and current discrepancies with road use
  • regulators
    • are likely to update obsolete test procedures, causing serious expense for manufacturers

• The software was very sophisticated, detecting when a car was being run under controlled conditions and when the performance was more random, indicating road use; it then controlled the engine management system to adjust the emissions to favour either the test requirements eg lower emission of NOx but higher operating temperature and shorter engine life, or the normal use conditions eg lower operating temperature and longer engine life but higher NOx emissions. Hardly an accidental infringement of the objectives of the regulation
• Martin Winterkorn was a respected engineer –he must have known, like the rest of the world, about the apparent disparity between tests and road performance; how could he not have taken early action to investigate – at which point he would surely have been alerted to the offending software program and prevented, or terminated quickly the dissembling which went on for twelve months when initially challenged by the EPA over the discrepancies
• one of the challenges in assessing ethical behaviour is the context in which it occurs. Hence the defence that “everyone does it and we can’t compete if we don’t too” may be fortified by the justification, often used in regard to bribery, that the bribes serve a social purpose in the country concerned. The question is most simply answered by what in the UK political establishment is called the Private Eye test. Private Eye is a satirical publication, and the point is simply, what would it look like if the behaviour concerned were to appear in an expose by Private Eye. The answer in the case of VW is surely very clear by now

• Goal: are the aims of the key stakeholders compatible with the agreed goal?
  • The goal appears fairly clearly to be to achieve number one slot in global manufacturing of automobiles, while keeping the base of the company located in Wolfsburg, thereby securing the future of the local workforce and the town
  • since Martin WinterKorn became CEO in 2007, revenue has almost doubled to €200bn and net profit quadrupled, and this year VW eased past Toyota to reach that number one position. Moreover, the base is still securely in Germany, in Wolfsburg, the state still has its shareholding, as do the ruling Porsche and Piëche families, and the unions still have their place on the supervisory board
  • achieving number one slot implies that the customers are also happy with the product
  • so the goal would appear to be what everyone wants

• Strategic management: is there an effective strategy in place which is being implemented by a management which understands the strategic management process?
  • The global strategy process appears to have been broadly very successful in taking VW from world number three to leader during Martin Winterkorn’s tenure as CEO
  • Two decisions seem to have led to the current problem:
    • to focus on diesel in Europe, where there was a political bias towards diesel engines on the basis of their reduced production of CO2 compared with petrol engines, and corresponding financial incentives
    • to build a much bigger presence in the US, where VW had been historically weak, and to do so by marketing the cars which had been so successful in Europe, under the marketing slogan of “clean diesel” – the US market having historically had a very low penetration from diesel cars

• Organisation: is the organisation appropriately structured and resourced to carry out the strategy successfully?
  • the EPA appears to have had a sharper approach to testing than the European regulators, possibly as a result of the earlier experience with heavy duty engines. This seems to have led VW into the trap that, since margins were tight on small and medium-sized diesel cars and installing full NOx-cleaning technology would greatly reduce those slender margins, they could use a cheap software “defeat device” to get the cars certified under test conditions without having to install the expensive cleaning kit. In passing, it seems likely that the full kit is probably installed on more expensive cars where the margin is big enough to absorb this.
  • the conclusion is that a successful strategy was let down by flawed decisions in implementation
  • this has to be a criticism of an organisation which, probably through its Wolfsburg-centric and top-down style, allowed bad practices to develop without a system in place to catch and report back such aberrant behaviour

• Accountability: is there a system in place which provides for reporting back to the key stakeholders in an honest and transparent way?
  • the complaints regarding keeping stakeholders informed all revolve around this particular transgression:
    • the testing and regulatory authorities in the US are clearly unhappy about the dishonesty in the responses to their questions
  • it’s difficult to see how the customers and shareholders (key stakeholders) could have been earlier and better informed about an illegal practice
  • so, on balance, VW has probably been as open as could have been expected in its communications with its key stakeholders, even though all parties will have been rather cross about what has been going on.

In summary, therefore, the failings lie fundamentally in the flawed ethics of VW, notwithstanding the remarks of the US head about the core values of VW. Secondly, and arguably of second order importance, the organisational structure mitigated against an open and fearless transmission of concern about bad practice up the chain of command.

Lessons: could it have been prevented

We would contend that regular surveys, conducted independently and embracing the holistic approach of Applied Corporate Governance, rather than the formulaic assessment of compliance with a strict set of regulations, would undoubtedly have pointed the finger of suspicion at the areas of wrong-doing and organisational weakness.

Thus:

• employees would have (anonymously if wished, but unnecessary in a healthy culture) reported on the questionable practices and through their union representatives pressed for corrective action to safeguard their jobs
• dealers and service centres would have alerted the company to the dangers of using the software
• investors (especially institutional shareholders), financiers, savvy customers, service centres, etc., would have been aware of early warnings such as the 2013 warning by the European Commission’s Joint Research Centre about “test detection” software
• regulators’ concerns would have been registered and not filed away from view of senior management

All in all, we would further argue that unless a system such as ours is implemented, the Wolfsburg “fortress mentality” as it has been described, will continue to dominate corporate governance and policy making, and Volkswagen will be vulnerable to similar embarrassments in the future.