Opening Decision Point: "Volkswagen Diesel Fraud"

In September 2015, the U.S. Environmental Protection Agency (EPA) announced that it was ordering a recall for more than 500,000 Volkswagens sold in the United States. The EPA reported that VWs diesel engine cars contained software code that manipulated emission tests and allowed the cars to meet required emission standards. The software defeat devices activated emission controls only while the car was undergoing testing; however, while driving under normal conditions, the cars emitted nitrous oxide pollution that was more than 30 times higher than what was allowed by law. Investigations followed in other countries and eventually some 11 million vehicles were recalled globally. Within days, Volkswagens stock price had dropped almost 40%. It is estimated that VW had already paid out more than $30 billion in repairs, fines, and legal settlements as a result of the scandal. This figure does not include lost sales, or the heavy financial losses suffered by thousands of independent VW dealers and suppliers.

For at least one year prior to the EPA announcement, VW and the EPA had discussed apparent discrepancies in the testing data, which VW initially dismissed as the result of testing anomalies. Only after the EPA took steps to withhold approval for all the upcoming 2016 VW diesel cars did VW acknowledge that a real problem existed. Upon the EPA recall announcement in September, VW officials admitted that the problem involved intentional fraud and took responsibility for the scandal.

Volkswagen CEO Martin Winterkorn apologized for the terrible mistakes of a few people and, while denying any knowledge of or involvement, resigned within weeks. In a statement accompanying his resignation, Winterkorn said, I am stunned that misconduct on such a scale was possible in the Volkswagen Group, I am not aware of any wrongdoing on my part. Speaking at a corporate event, VW of Americas president Michael Horn admitted that Our company was dishonest with the EPA and the California Air Resources Board and with all of you.1 Horn resigned in March 2016.

In March 2019, the U.S. Securities and Exchange Commission charged both Volkswagen and Winterkorn with defrauding American investors and raising money through deceptive claims. In April of the same year, German prosecutors charged Winterkorn and four others with fraud.

But how did it all happen?

Initial reports coming from VW placed responsibility with a small number of engineers, acting under managerial pressure to meet corporate goals for both engine performance and fuel efficiency. But later evidence suggested that as early as 2006, VW management had indications that they were not able to achieve emission standards within established cost targets.

For decades, government regulators across the world have worked with automobile manufacturers to develop environmental and fuel-efficiency standards that would meaningfully improve air quality by reducing pollution, yet still be technologically achievable. Manufacturers chose various strategies to meet these standards. Technological and design advances in engines, body aerodynamics, pollution control devices, and materials all contributed to increasingly fuel-efficient cars. Some manufacturers chose to develop smaller cars, some moved in the direction of hybrids and electric vehicles, and others, like VW, worked to improve diesel technology.

The scandal struck at the heart of the VW brand. Improved diesel engines had become a hallmark of the VW brand of German engineering. Diesels have always had performance benefits over gas-powered engines. Diesel engines last longer, get better fuel mileage, provide more torque and power, and are more dependable than gasoline engines. Yet, historically they emitted more pollution, especially nitrous oxides and particulate matter (the black soot often seen coming from truck or bus exhaust). VW, a brand long promoted for its engineering skill, marketed its turbocharged direct injection (TDI) engines as a new generation of smart diesels, able to maintain all the high-performance benefits of diesels while also meeting stringent new environmental standards.

Given the centrality of the new-generation diesels to the VW brand and to its global sales, many observers found it difficult to believe that a widespread fraud involving such a crucial element of its key product could have resulted from the terrible mistakes of a few people. How could a major scandal involving the fraudulent design and promotion of a core product, especially a product that everyone knew would be subjected to extensive governmental testing and regulation, occur? Even if the decision to insert the defeat device rested with only a few engineers, the scandal could only have occurred if there were widespread failures of oversight and control at every level, from the shop floor to the corporate board room. In the opinion of many, this widespread failure of oversight and control, especially at the management and board levels, was as great a corporate failing as the fraud itself. Where were the oversight and supervision?

A plausible description of the realities leading up to this scandal is that engineers were expected to achieve a balance among three factors that were in tension: They were to develop a diesel engine that met high performance standards while also meeting environmental emission standards. Importantly, they were expected to accomplish this while also meeting cost targets. Later evidence revealed that earlier proposals that would have achieved this balance had been rejected by management because they would have added costs of a few hundred dollars to each vehicle. One option, of course, would have been for management to conclude that this balance could not, therefore, be achieved. However, by most reports the VW corporate culture was such that there was little tolerance for work teams that failed to meet goals and little willingness among management to encourage questions or challenges to their decisions.

Professional codes of ethics can sometimes function to shield engineers from pressures to compromise professional standards in order to meet employer or client goals. Professionals such as lawyers, accountants, and engineers have ethical duties that should override the demands of ones employer. But engineers in Germany do not have the level of professional licensing and training requirements as engineers face in Canada and the United States, for example. In any case, there is little evidence that any VW engineer, the individuals who had direct and firsthand experience of the fraud, stepped forward to take a stand against the fraud. There have been no reported cases of whistle-blowing by anyone within the organization.

VW management would have had many opportunities to prevent the fraud, mitigate its damage, or, at the very minimum, acknowledge and report it sooner. Senior executives failed across the board in their oversight responsibilities. They failed employees by setting unfeasible expectations and being inflexible in the face of evidence that these were unattainable. VW had no internal mechanisms that encouraged or even allowed reporting of malfeasance.

As the scandal unfolded, VWs largest union criticized management for having a rigid hierarchy that was authoritarian and unwilling to listen to bad news. Matthias Mller, Volkswagens new chief executive appointed after the Winterkorn resignation, acknowledged problems with the previous managerial style and promised a more open management style.

One might expect the VW board to have set high expectations and to have held management to them. But, according to press reports, the relationship between the VW board and senior executives had been contentious for a long time. As the scandal became public, board members criticized Winterkorn for failing to keep them informed. Three board members, including government officials and union representatives, revealed that they learned of the scandal only by reading about it in the media. Critics pointed out that either senior executives were unaware of the fraud, in which case they failed in their managerial duties, or they did know and neither fixed the problem nor kept the board informed, in which case they failed other duties.

In a statement released after VW admitted the fraud, Stephan Weil, a board member who is also prime minister of the German state of Lower Saxony, where Volkswagen is based, claimed, Talks took place for a full year before Volkswagen admitted the deception. This confession should clearly have occurred much earlier. Weil described the failure of senior executives to inform the board a grave mistake.

Despite these criticisms, the VW board had extended Winterkorns contract as CEO just two weeks before the public recall announcement from the EPA. Winterkorn certainly knew of the pending EPA action at this point, but most board members claimed that they did not.

But there is evidence that the VW board was in disarray at this time. Winterkorns contract extension came just four months after a failed attempt to oust him by board chair Ferdinand Piech. Piech, the grandson of VW founder Ferdinand Porsche and often described as the patriarch of VW, had held senior leadership positions including CEO or board chair for decades. Peich was well known for his authoritarian management style, which had resulted in similar dismissals of other senior executives. When the attempt to oust Winterkorn failed, Peich resigned as board chair and stepped away from all other roles with VW.

But there were other structural issues with the VW board that might also help explain some of the governance disarray. In the United States and Canada, for example, corporations are governed by a single board of directors, which has the ultimate legal fiduciary responsibility to company shareholders. In Germany, however, corporations are governed by two boards, a supervisory board with general oversight responsibility and a managerial board, which is comprised of senior executives who are responsible for operational oversight. Further, the German workplace democracy model of codetermination legally requires that half the board seats go to representatives of workers.

The VW board is comprised of twenty members. The board chair is former VW corporate finance director. Ten of the remaining nineteen seats are held by representatives of VWs union workers. Four other seats are reserved for members of the Porsche and Piech families, who own 52% of the corporate stock. Prior to the failed attempt to oust Winterkorn, Ferdinand Piech and his wife Ursala held two of the four family board memberships. Two seats are held by representatives of the German state of Lower Saxony, the region in which the VW plant is located and holder of 20% of the corporate stock. Two seats are reserved for representatives of the country of Qatar, which owns 17% of VW stock.

Thus, only 10% of this publicly traded companys stock is freely floating in the marketplace. Of the twenty-person supervisory board, only one member could be classified as independent. Critics suggest that this structure is at the root of VWs dysfunctional governance. Members of the supervisory board have split loyalties that can conflict with the duties for corporate transparency and integrity. For example, the VW facility is reputed to be a highly inefficient production plant. It manufactures slightly more cars than its competitor Toyota but employs almost twice as many workers to do it. It would be difficult, for example, to get approval for job cuts or production transfers from a board with 60% of its membership in the hands of unions and local governments. The split board system can also shield management from oversight from the supervisory board.

In April 2016, in anticipation of its annual stockholders meeting, the VW supervisory board announced that investigations had concluded that VWs executive management was not responsible for the fraud. As a result, the board would recommend that executives receive end-of-year bonuses for 2015. It was also revealed that Martin Winterkorn had received $8 million in compensation for 2015, only half of his 2014 compensation. Union leaders angrily denounced these recommendations, pointing out that employees would be receiving little or no bonuses for 2015 due to the financial losses associated with the scandal.

1. Who are the stakeholders in this case? How were the interests of each stakeholder represented?
2. Is it fair to expect any employees, including professionals such as engineers and accountants, to confront management over directives that they believe are unethical?