Volkswagen Emission Scandal: A Failure of Corporate

Governance?

On September 18, 2015, the US Environmental Protection Agency (EPA) issued a

notice to Volkswagen (VW) alleging violations of the Clean Air Act. The EPA had
determined that VW had manufactured and installed cheat devices (a device that
could sense whether the car was driven on road or tested for emissions, and could
accordingly calibrate the emissions and circumvent the environment-related
regulatory requirements) in its light-duty vehicles from 2009 through 2015. This
resulted in VW cars emitting 40 times higher levels of pollution than the permissible
limits. The device could sense the position of the steering wheel, the speed of the
vehicles and the barometric pressures, and detect when the vehicle was being tested.
When the software detected that the vehicle was being tested, it enabled the emission
control to run at full capability and thus lowered the Nitrogen Oxide (NOX) emissions,
when not under testing, it turned off the emission control and allowed NOX to
increase.

Volkswagen’s diesel-emission scandal came to light as an investigation report of a

project assigned by the International Council on Clean Transportation to West
Virginia University’s Centre for Alternative Fuels, Engines and Emissions in 2014 to
investigate the on-road emissions performance and fuel economy of various light-duty
vehicles under driving conditions in the USA. The committee found and reported that
NOX emissions from two of Volkswagen’s light-duty engines exceeded the EPA’s
permissible limits by a factor of 15-35. These findings were made public, which
sparked further investigations by the regulators.

Upon an explanation call by the EPA, on September 20, 2015, Volkswagen made an
official statement that the board of management was deeply concerned and would
cooperate fully with the requirements of the process. It ordered its own external
investigation into the matter. Additionally, it also set aside an amount of EUR 6.5
billion to cover the service measures. By September 22, VW revealed that the
discrepancies were mainly with vehicles that were installed with EA 189 engines and
that it was intensely working toward eliminating the deficiencies.

On September 23, 2015 Martin Winterkorn, the CEO, tendered his resignation. “I am
shocked by the events of the past few days. Above all, I am stunned that misconduct
on such a scale was possible in the Volkswagen Group. As CEO, I accept
responsibility for the irregularities that have been found in diesel engines and have
therefore requested the Supervisory Board to agree on terminating my function as
CEO of the Volkswagen Group. I am doing this in the interests of the company even
though I am not aware of any wrongdoing on my part.”

On November 2, 2015, a second notice of violation was issued to VW for installing

cheat devices in its three litre engines for cars manufactured in 2014 through 2016 that
were emitting NOx up to nine times the EPA’s permissible limits and later informed
that cheat devices existed in all its US three litre diesel vehicles since 2009. VW
estimated around 800,000 vehicles to be affected by this and put its economic risks to
be approximately two billion euros.
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Volkswagen

In the early twentieth century, the word first began to spread throughout Germany
about a ‘people’s car’ but there were none that fitted into the people’s budget. As an
outcome of Adolf Hitler’s vision and later with his approval, in 1938, Ferdinand
Porsche, an Austrian Engineer and Honorary Doctor of Engineering, designed the
‘people’s car’ or Volkswagen in the town Wolfsburg in Lower Saxony, Germany. As
directed by Hitler, Ferdinand Porsche designed the “Beetle.” Though the car was not
very advanced, it surely was economical and was designed with great attention to
detail.

By the 1950s VW had become Germany’s pride albeit the fact that it was essentially a
one-model car. It experimented unsuccessfully to redesign the car in 1961, 1968 and
1970. By the 1970s when the production of the Beetle had started to decline, VW
bought the Auto Union, the Audi Brand for its technological expertise. It merged its
own setup with Audi’s technological expertise and created the luxury brand Audi.

Over the next two decades, under the leadership of the CEO Ferdinand Piech, there
was no looking back. The VW Group grew manifold to be a large holding company
by signing multiple acquisition agreements that included Seat (Spain), Skoda (Czech
Republic), Bentley (Britain), Bugatti (France), Lamborghini (Italy) and Ducati (Italy).
After a long negotiation and legal battle, VW also bought Porsche in 2012 and made it
VW’s Brand.

VW had been consistently capturing more than 10 percent of the market share of
passenger cars in terms of production volume. It won many awards in various
categories like Car of the Year; New SUV under and over $50,000; Best New family
Car; and World Car of the Year. By 2014, VW had a presence in 153 countries, it was
manufacturing its products in 31 countries and it was the leading automotive
manufacturer worldwide. Its operating profit had touched 12,967 million euros, a 545
percent increase within the eight years from 2006 to 2014.

A Scandal that was in the Making

With many reports and opinions available after the Volkswagen diesel-emission
scandal, it was startling to comprehend how something of such magnitude could go
unnoticed in today’s era of technological sophistication. The CEO of Volkswagen
America testified in December 2015 that the scandal was the wrongdoing of
individual employees and that no board action was taken to approve the installation of
a cheat device.

However, this was not the first time that Volkswagen was alleged of such malpractice.
In 1973, after the Clean Air Act of 1970 was passed, Volkswagen was the first car
company to pay a penalty ($120,000). William Ruckelshaus, an EPA Administrator,
reported that Volkswagen had used temperature-sensing switches.

The CEO’s ignorance of the wrongdoings in the Volkswagen group was equally
astounding. How could it be possible for the CEO, the executive board and the
supervisory board of the company to be ignorant of something of this scale? Was it a
lapse of their fiduciary duties toward the stakeholders or was there something
seriously wrong within the organizational culture that caused the employees to act in

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an unethical way? Given the magnitude and scale of the scandal, could it have been
the doing of only some employees? Was there no mechanism to monitor and check
the internal control processes to ensure value for various stakeholders? Were the
interests of various stakeholders being taken care of or was there a compromise on
one against the other? The precipitating events, which started with the tampering of
the technology, had snowballed into issues of deliberate cheating and failure of good
governance.

Global Automobile Industry

The first automobile originated out of Europe in the nineteenth century but during
most part of the twentieth century it was the USA that dominated the production of
automobiles. Western European and Japanese companies, however, picked up sales by
the beginning of the twenty-first century and dominated the production and export
scene, worldwide. In terms of millions units of cars sold, from 39.2 million cars sold
over a period from 1990 to 1999, the sales of cars sold had increased to 71.17 cars per
year in 2014. As of 2014, Volkswagen, Toyota, Daimler, General Motors and Ford
were the leading automotive manufacturers worldwide in terms of revenue in billion
euros. In terms of leading car manufacturers worldwide, Volkswagen (Germany),
Toyota (Japan) and Hyundai (South Korea) were market leaders.

However, the automobile industry was facing unprecedented challenges. The new
environmental constraints, changing consumer demands, continuous innovation, and
the outcomes of continuous research and development were offering new technologies
that were dramatically changing vehicles. The industry was constantly attempting to
develop diesel engines that provided more power and were more fuel
efficient and eco-friendly. However, there was an inherent trade-off and only two of
the above three features could be effectively offered. In an interview, the director of
the Energy Systems center of research at Argonne National Laboratory, Don
Hillebrand stated that one could have power, energy and emissions, but gets to choose
only two of these stated three features.

The engines designed to provide more power caused the fuel to spontaneously
combust at an ideal pressure and temperature, resulting in greater gas expansion and,
thus, leading to greater power. However, under these conditions of pressure and
temperature, nitrogen and oxygen convert to form NOX and Carbon Monoxide,
respectively. NOX reacts with sunlight in the atmosphere and results in the depletion of
the ozone layer, which is a big threat to the environment. The car companies
constantly built and experimented to offer better engineering solutions and pursued
different strategies to tackle this trade-off.

Clearly, the triad problem (power - fuel efficiency - clean diesel engines) was
incredibly challenging and these challenges had to be tackled by reconciling
conflicting interests of the planet. However, of the triad conundrum typical to the car
industry, i.e., power, energy and emissions, VW appeared to have compromised on
emissions.

Crisis Following the Scandal

The scandal in September 2015 shook Volkswagen. It not only resulted in financial
penalties, but also in impending lawsuits, recall of vehicles and reputational loss.

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Financial penalties

Volkswagen’s stock sank and almost 23 percent of its market capitalization in

Frankfurt eroded, taking nearly 15.6 billion euros with it. A fine of up to 18 billion US
dollars stared in its face, which had the capability to wipe out profits and push the
carmaker back by years. The company also had to set aside around $7.2 billion to pay
for its emissions violations.

Lawsuits and recall of vehicles

Many countries like the USA, Italy, France and South Korea launched their own
investigations into the scandal surrounding Volkswagen. Many criminal enquiries
were also filed against the company.

Reputational loss

In April 2015, MSCI ESG’s Index reported an overall decline in Volkswagen

Governance score to the 28th percentile, meaning that 72 percent of the companies
covered by the index had economic-social and governance practices better than that at
Volkswagen. In September 2015, MSCI further downgraded VW from BBB to a CCC
rating for economic, social and governance practices. The MSCI ESG impact monitor
also moved VW from a yellow to a red flag, which meant a significant reputational
loss.

Corporate Governance in Germany

In general, a country’s governance code-of-conduct and ethical behavior directives for

businesses play an important role in avoiding occurrences of fraud, violations and
bribery and other serious compliance breaches. In Germany (Grosse), the larger firms
(i.e. those with more than 500 employees) are required to have a two-tier board
system consisting of the supervisory board and the Management Board. The
supervisory board is expected to perform the role of strategic oversight and the
Management Board is expected to oversee the day-to-day operational issues of the
organization. No overlap between the two tiers of the board system is allowed. The
supervisory board is expected to be the watchdog.

However, the occurrences of several scandals in Germany indicate weak governance

directives and non-adherence as major issues. These directives do not emphasize
enough upon the corporate culture that promote accountability and transparency. The
German guidelines on governance are very loosely laid on dual board structure, board
size, and proportion of employee representatives and independence of board
requirements. Exhibit 1 presents the three major issues that surfaced in corporate
governance codes in Germany as compared to other developed European markets with
two-tier boards. In Germany, the allowed size of the board is the largest, the
representation of the employees is typically 50 percent of the board size and the
requirement of the independent board members is very vaguely stated.

Corporate Governance at Volkswagen

The corporate governance practices at VW clearly provided for the two-tier board
system as per the German Code of Governance. The major shareholders at

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Volkswagen were the Porsche and Piech families, State of Lower Saxony, Qatar and
others (Exhibit 2). The Porsche and Piech families held 52 percent of the
shareholding and controlled the entire decision making on VW’s supervisory board.
The organization had multiple equity classes with unequal voting rights.

The supervisory board had 20 members (Exhibit 3). In total, 10 of the 20 members
were employee representatives from VW. Of the remaining ten members, there was
only one independent member, Anna Falkengren from a Swedish bank. The other nine
members (Volkswagen Group Management) had major shareholding in the company
and constituted 45 percent of the representation on the supervisory board. In total, 17
of the 20 supervisory board members were either Germans or Austrians, 2 were from
Qatar, and 1 from Sweden (Exhibit 4).

Corporate governance involves ensuring that the Board is doing a proper job of
overseeing the executive management. Good governance is not only influenced by the
country’s governance directives, but also by a strong supervisory board and a robust
culture within the organization. Effective control mechanisms, independence of the
CEO and well-diversified, experienced board members go a long way in building a
strong culture in the organization. The structure of the senior management team at
Volkswagen along with the roles and responsibilities of the supervisory board and
board of management was as follows.

Supervisory board

A team of 20 members of the supervisory board was responsible for monitoring and
approving decisions taken by them. It was responsible to recruit the members of the
board of management. It conformed to the German Co-determination Act, which
extends the right to the workers to participate in the management of the company they
work for.

The supervisory board had five committees, namely the Executive Committee, the
Mediation Committee, the Audit Committee, the Nominating Committee and Special
Committee on Diesel Engines. The primary responsibility of the executive committee
was to discuss and prepare decisions to be made by the board, and to deal with
contractual matters concerning the senior managers; and that of audit committee was
to consolidate financial management, manage risk, and ensure compliance. The
nomination committee proposed the right candidates for the supervisory board.

Board of management

With the prime responsibility of managing one or more functions, the nine
management board members at VW were supported by the heads of various brands
and regions. The business units of the groups and their holdings also worked very
closely with the board.

In VW, the personnel holding senior management positions in the company (i.e.
chairman of supervisory board, chairman of the board of management, chief financial
officer and chairman of the board of management of the Audi AG group) held these
positions for a very long tenure. The history of persons along with their tenure in the
office is presented in Exhibit 5, which highlights that not only that they held the office
for long, but also that when they stepped down from a specific role, it was

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simply to assume another role in the senior management. Mr Ferdinand Piech, for
example, chaired the board of management from 1993 to 2002. After retiring from
this position in 2002, he became the chairman of the supervisory board chair and held
the office for 13 years (i.e. 2002-2015) resigning when the aforementioned events
unfurled in September. Similarly, Dr Martin Winterkorn became the Chairman of the
board of management of the Audi AG group in 2002 for almost four years till 2006
and thereafter chaired the board of management of the company for eight years before
stepping down in 2015, in the face of this fiasco.

Corporate governance reports and exceptions made

The Company released corporate governance reports each year, declaring conformity
to the German Governance Codes. The highlights of the VW corporate governance
reports were that the company gave the highest priority to transparent and responsible
corporate governance. They regarded good corporate governance to be the key pillar
to strengthen the trust of their customers and investors.

However, they did make some exceptions to it. Brief excerpts from the corporate
governance reports of the last three years highlight that in order to retain concentrated
ownership in the board of management and supervisory board, the permissible age
limit for retirement was revised every year to accommodate the aging senior members
of the team on the management board (Exhibit 6) and on the supervisory board
(Exhibit 7).

Organizational leadership and work culture

Mr Ferdinand Piech, the grandson of the founder and supervisory board chair since
the last 13 years had a single minded vision – to make VW the world’s largest
carmaker by sales. Nothing else mattered. He was the oldest-ever director of a listed
German firm and the best-paid supervisory board chair. Directors at other German
firms promoted open culture and were available for meetings with investors. Mr
Piech’s availability to the investors, however, was very limited. In his autobiography –
Auto Biographe, published in 2002, he wrote that his desire for harmony was very
limited. His conduct was reported to be ruthless and one that fired employees
pitilessly. He was considered to be dictatorial and threatened people with termination if
they did not perform.

Bribery and kickbacks

In 2005, when VW was suffering from high labor costs and low productivity, the
management wanted to maintain profit margins. It knew that the worker
representatives would reject stricter norms, and therefore it bribed the employee
representatives and government officials to get the employee and staff-restructuring
plan passed. Mr Cromme, the author of Germany’s Corporate Governance code quit
VW’s board in 2006 because Mr Piech elevated a trade unionist as the head of the
personnel using the votes from employee representatives to push the case.

A corruption trial including a seamy testimony was reported in 2008 wherein VW was
alleged to have created a multimillion fund to bribe the employee representatives. The
funds were to be used to arrange for prostitutes, to organize pleasure trips to Portugal
for the employee representatives and to present expensive gift vouchers to their wives.

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The case concluded with Mr Klaus Volkert, who represented employees on the
company’s supervisory board, found guilty. He was sentenced to almost three years of
imprisonment. He was held to be guilty of having received special bonus payments of
close to €2 million ($2.9 million) from the company’s former personnel director, in
order to secure favorable votes in important company decisions taken by the
supervisory board.

It was not only the employee representatives on the board who were bribed but this
practice extended to luring government officials also. German MP – Juergen Uhl – was
the government official responsible for approving the proposed reforms in worker’s
committee and staff norms in Wolfsburg. He was held guilty of attending sex parties,
which were given for worker’s council directors. He confessed his guilt and told the
court that his conduct was inexplicable and accounted it to the general atmosphere at
VW.

Board composition

In 2012, the board composition required VW to have at least two women on the
supervisory board. Ms Ursula Piech, a former Kindergarten Teacher and wife of Mr
Piech, was appointed to its supervisory board. She had no expertise or experience of
running the business.

Ethics and organization culture

Michael Horn, President and CEO, the USA, made a statement on October 8, 2015
that – “This was not a corporate decision. No board meeting or supervisory meeting
has authorized this”.... “This was a couple of rogue software engineers who put this in
for whatever reason.”

Mr Hans-Dieter Potsch, who took over as the Chair of the supervisory board in
December 2015, after the fiasco, stated that the cheating took place because of a
climate of lax ethical standards, and that, “It proves not to have been a one-time error,
but rather a chain of errors that were allowed to happen.” He also said that, “There
was tolerance for breaking the rules”.

Matthias Müller, who took over as the CEO of VW after Martin Winterkorn resigned
in October 2015, said on December 10, 2015 – “We are doing everything to overcome
the current situation, but we will not allow the crisis to paralyze us. On the contrary,
 we will use it as a catalyst to make the changes Volkswagen needs.”

What could be the possible reasons referred by Michael Horn (in “This was a couple
of rogue software engineers who put this in for whatever reason”) that might have
resulted in software engineers to indulge in such malpractices? Do you think it could
be anything to do with VW’s very centralized culture where dissent was intolerable
and the junior managers generally feared speaking their mind? Do you think it could
be anything to do with the environment that had “tolerance for breaking the rules” or
an environment that forced the employees to resort to such malpractices? What could
be the “chain of errors” mentioned by the Chair of the supervisory board and could it
have been avoided with good governance practices? What could be the changes that
the CEO of VW, Matthias Müller, might have indicated to when he stated, “[...] to
make the changes Volkswagen needs”?

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Exhibit 1 Two-tier Boards: Select Countries in Europe vis-à-vis Germany

Exhibit 2 Volkswagen - Shareholding

Exhibit 3 Volkswagen – Supervisory Board

Exhibit 4 Supervisory Board Members’ Nationalities

Exhibit 5 Board Chairmanship at VW Since 1993

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Exhibit 6 VW’s Management Board - Exceptions
Highlights of Stated Exceptions to German Corporate
Corporate Governance Code
Governance Reports
(2012, 2013, 2014)

All the three reports a) Exceptions were made to the clause on severance
highlighted the importance payment, by not capping the payments to board members
of transparency and who were commencing their third or subsequent term in
responsible corporate order to protect their existing rights
governance at VW. (b) Exceptions were made to the upper age limit of board
Each report stated that the members stating that age factor is not appropriate to
future of the group measure the ability of an individual to lead an organization
depended on its ability to and that a fixed age limit could have discriminatory effect.
continually strengthen the In the interests of the company, it had made an exception to
trust of the customers and allow board members beyond the stated age limit of 65
investors years (c) Exceptions are made in appointing only
independent members to the audit committee sighting the
reason that as long as relation did not have a conflict of
interest or it impaired chair’s ability to perform his/her
duties, it was all right to have business relations with other
members of the Porsche and Piech family
(d) A precautionary declaration was made regarding the
performance-related remuneration as the variable
component related to sustainable growth of the business,
which could be subject to different interpretations
(e) Exceptions were made to report various conflict of
interest and their handling of the annual general meeting

Exhibit 7 VW’s Supervisory Board - Exceptions

Declaration made Stated exceptions to German Corporate
each year regarding Governance Code
the
composition of
VW’s supervisory
board
1. To induct at least The first 2 statements were adhered to. However, from 2012
three board members to 2014, changes were made to the third statements, each
internationally year

2. To have at least 2 In 2012, the third statement was changed to: ‘normally
female boards members elections would not be sought for individuals more than 70
in the supervisory board years of age’ (CG Report, 2012)
with at least one of them
representing shareholders In 2013, the third statement was further changed to: ‘as a
rule, persons more than 75 years of age will not be
3. Not to seek elections considered for elections’ (CG Report, 2013)
for persons who will
have reached an age of In 2014, the third statement was again modified to increase
70 years the age of the board members to 75 years (CG Report, 2014)