Exhausted by Scandal: ‘Dieselgate’ Continues to Haunt Volkswagen

Wharton's John Paul MacDuffie and David Zaring discuss Volkswagen's ongoing struggle with its emissions cheating scandal.

Volkswagen can’t seem to shake off its “Dieselgate” scandal, even as it has cost the company more than $30 billion in fines, penalties, restitution and settlement of lawsuits since September 2015. The U.S. Securities and Exchange Commission (SEC) last week charged Volkswagen AG, two of its subsidiaries, and its former CEO, Martin Winterkorn, “for defrauding U.S. investors, raising billions of dollars through the corporate bond and fixed income markets while making a series of deceptive claims about the environmental impact of the company’s ‘clean diesel’ fleet.”

The German automaker had faked emissions levels in some 580,000 vehicles it sold between 2006 and 2015, using a “defeat device” or software intended to pass regulatory lab tests, whereas in real-world driving, the emissions were several times the permissible limits. The scandal has thus far sent a senior executive on a seven-year prison term, cost Winterkorn his job and led to suspensions of several top executives.

For the most part, the SEC in its complaint poked holes in Winterkorn’s insistence that the cheating occurred at lower levels of the company, and that Volkswagen’s top management learned of it only from media reports. The regulator stated that from April 2014 to May 2015, Volkswagen issued more than $13 billion in bonds and asset-backed securities in the U.S. markets “at a time when senior executives knew that more than 500,000 vehicles in the U.S. grossly exceeded legal vehicle emissions limits.” By concealing the emissions scheme, “Volkswagen reaped hundreds of millions of dollars in benefit by issuing the securities at more attractive rates for the company,” the complaint added.

Volkswagen has denied the SEC’s charges, and in a statement to CNBC said the bonds in question “were sold only to sophisticated investors who were not harmed and received all payments of interest and principal in full and on time.” It added that even after it struck a major settlement with the U.S. Department of Justice, 44 states and nearly 600,000 consumers, “the SEC is now piling on to try to extract more from the company.” Under the June 2016 settlement, Volkswagen agreed to spend up to $14.7 billion to settle allegations of cheating with its emissions defeat device.

Rough Road Ahead?

The outcome of the SEC complaint could bring new trouble to Volkswagen in Europe, according to Wharton management professor John Paul MacDuffie, who is also director of Wharton’s Program on Vehicle and Mobility Innovation at the School’s Mack Institute for Innovation Management. MacDuffie said that although Volkswagen faced lawsuits in Germany after the diesel emissions scandal, there have been few consumer-driven claims against the company for payment.

“A company is doing a bad thing and it unsurprisingly doesn’t tell the world about this bad thing. And the bad thing it is doing is hurting consumers and people who are breathing the air.”–David Zaring

Volkswagen has carried out software updates in its cars in Germany and elsewhere in Europe after the cheating scandal, but in the U.S., it has replaced the vehicles it sold, he noted. “If there’s a convincing piece of evidence [that clinches the SEC’s claims], that will open up a lot of new legal action in Germany and in Europe,” MacDuffie said.

“I find these kinds of fraud cases to be somewhat strange,” noted David Zaring, Wharton professor of legal studies and business ethics. “A company is doing a bad thing and it unsurprisingly doesn’t tell the world about this bad thing. And the bad thing it is doing is hurting consumers and people who are breathing the air. Then, the SEC comes in and says that because it didn’t disclose that to its investors, they were hurt, too.”

MacDuffie and Zaring discussed the reasons behind the company’s compounding woes on the Knowledge@Wharton radio show on SiriusXM. (Listen to the podcast at the top of this page.)

Zaring noted that the SEC complaint “spends a lot of time” focusing on how much Winterkorn may have known of the cheating well before the bond issues beginning 2014, given that he was Volkswagen’s head of R&D in the mid-2000s, before he was promoted as CEO in 2007. He highlighted the regulator’s effort to establish that the cheating was not some unauthorized work carried out by a low-level employee. “Winterkorn and other Volkswagen executives were made aware of the defeat device as early as November 2007, during a meeting with Volkswagen engineers, to discuss the emissions problems with Volkswagen’s ‘clean diesel’ vehicles,” the SEC states in its complaint.

According to Zaring, the bonds Volkswagen sold come under the SEC’s Rule 144a, which governs sales to qualified institutional buyers. “The 144a bonds are unregistered and only available to experienced and very liquid investors,” he said.

Zaring pointed out the difference between the U.S. and Europe in how consumer protection and investor protection work. While American securities shareholders and bondholders usually file class-action lawsuits, it is hard to take that route in Germany for several legal reasons, he noted.

Seeds of Trouble in the U.S.

MacDuffie traced Volkswagen’s current state to its desire to become the No.1 automaker in the world in terms of volume. In order to achieve that goal, they had to “greatly increase their U.S. market share — it was the one market in the world where they were very underrepresented,” he said. “They decided to do that with clean diesel. We now know that the only way they could actually do clean diesel was with this defeat device, with cheating on the way the emissions were being reported.”

Volkswagen tried to replicate in the U.S. the success diesel powered vehicles had had in Europe, but the way the company went about that led it to its current mess. MacDuffie noted that diesel-powered vehicles were popular in Europe, and commanded between 50% and 60% of the market in Germany and in France. It helped that diesel is taxed more favorably in those countries, and also that diesel technology was invented in Europe. “Most of the important diesel technology patents are held by companies like Bosch,” he said.

“If Volkswagen had not decided to put on a big push for market share in the U.S. and had not settled on diesel as a way to do it, this [scandal] would probably not have come to light.”–John Paul MacDuffie

In the U.S., Volkswagen sensed a market opportunity as its competitors in the U.S. seemed to have trouble with implementing diesel technology. “The U.S. auto companies tried releasing diesel products. They were poorly engineered. They smelled bad. They didn’t work well. It drove diesel out of the market,” MacDuffie noted. “Volkswagen decided, ‘Here’s our chance — we’re going to make a big push on diesel.’ They had ads with engineers dressed up as white angels because they’re ushering in this glorious, green future.”

The overwhelming desire to dominate the U.S. market with diesel-powered vehicles turned out to be Volkswagen’s undoing. “It is probably true that if Volkswagen had not decided to put on a big push for market share in the U.S. and had not settled on diesel as a way to do it, this [scandal] would probably not have come to light,” said MacDuffie. “It would have been a smaller and more slippery sub-scandal, which eventually would have violated some things in Europe but would probably not have [developed] in exactly this way.”

MacDuffie recalled that around 2007, Volkswagen was in an alliance with Mercedes and BMW to lower diesel emissions. The alliance produced a technology that required vehicle owners to add an ammonia derivative to their fuel every few months, but had to get that done at dealerships. Volkswagen didn’t think that approach would work for its customers or its brand positioning, and pulled out of the alliance, saying that it would be able to develop clean diesel technology on its own. “Then, they found they couldn’t. Presumably it was at a point that they felt so committed to this big push in the U.S. that they then started looking for a technical fix, which we now know was cheating with software.”

Initially when its engineers used the defeat devices, Volkswagen wasn’t breaking any laws in Europe in terms of compliance with emissions standards, MacDuffie said. However, as those standards got tougher in Europe year after year, “at some point they crossed the line from being technically in compliance — although with misinformation — to violating the law there, too,” he added.

Rebuilding a Reputation

All that tarred a carefully built reputation over decades in the U.S. According to Zaring, in years past, U.S. car buyers saw Volkswagen as “a company that made cute cars like the Volkswagen Bugs and the Jettas … [with] decent gas mileage.” The company didn’t have a large customer base, but it did appeal to those who were environmentally conscious, he noted. “Of course, they got the opposite of that [with the emissions scandal],” he said. “You could imagine how this would have just destroyed Volkswagen’s reputation in the American market.”

“Volkswagen has had a shock to their strategy, and to their culture.”–John Paul MacDuffie

Of late, Volkswagen has been trying to rebuild its brand image in the U.S, including through Super Bowl commercials and other sponsorships. As part of its settlement, it has also undertaken to invest in education and infrastructure for electric vehicles. In its effort to reclaim its brand image, Volkswagen also must have strong encouragement from the German government, MacDuffie said. “In Angela Merkel’s Germany, there is a clear message that its auto industry is too important to let it suffer from this. And to Volkswagen, [the message is], ‘We’re not going to cover this up. We’re going to push you to rehabilitate your reputation.’”

Volkswagen has been trying hard to redeem itself after Dieselgate. The company under its new CEO, Herbert Diess, has been aggressively pushing ahead with electric vehicles, MacDuffie said. In fact, two days before the SEC filed its complaint, Volkswagen committed itself to producing 22 million electric vehicles across 70 models in the next decade. China happens to be the biggest market for electric vehicles, and Volkswagen, with a strong presence there, is well positioned to compete in that market, MacDuffie said.

“It makes them look perhaps a bit like they’re cleaning up their act in several ways, leaving the ‘Dieselgate’ embarrassment behind them and pioneering this new clean technology,” MacDuffie noted. “Volkswagen has had a shock to their strategy, and to their culture.”