VOLKSWAGEN: THE EMISSION SCANDAL Case overview On 20 September, 2015, Martin Winterkorn, the Chief Executive Officer (CEO) of Volkswagen Group, issued a stalemant admitting that Volkswagen had cheated con emission tests for many years by instaling “defeat devices" in its diesel cars. The statement was made after the United States Environmental Protection Agency (EPA) and the California Air Resources Board (CARB) revealed Volkswagen's ‘manipulations that violated the legal emission standards. Volkswagen had initially bboen given a chance to remedy the issue when EPA first made contact, but thoy cchose instead to continue cheating on the emission tests, Preliminary investigations revealed that a Volkswagen technician had blown the whistle internally on the deception in 2011. However, the warning call went unanswered. The objective of the case is to allow a discussion of the corporate governance issues such as the two-tier board structure in Germany; diversity and independence of the supervisory board: employee and state representation on the board; boardroom infighting: the role of regulators in the emission scandal; the culture created by the top management within Volkswagen; and the effectiveness of the whistleblowing system in Volkswagen, ‘hss the abridge version of «ease prepared by Geraldine Cheng, Gah Lausn, Hen Xiaoming, Loke ¥ Ung and Phau en Wurth sperm of Professor Mae ae Ten he cue was dlp tr ietecve management r governance. The itrpetaions and perspecives mnths cave are not Revestasy those ofthe enganisatone named inthe case, or any of et Grecirs of employees. The “biged erson was eelled by Saran Ho unae he Superision of Prolessor Mak Yoon Teen 22Volkswagen - The people's car Volkswagen is a car manufacturing company headquartered in Wolfsburg, Lower Saxony, Germany. To date, it is the second-biggest automaker in the world, boasting sales in over 150 countries, with 119 production plants in 31 countries all over the world. In 2014, Volkswagen made profits of over €11 billion and produced 10.2 million vehicles worldwide, Notable brands under the Volkswagen Group include Bentley, Bugatti, Lamborghini, Auci, Porsche and Skoda Home of Volkswagen: The German state of Lower Saxony Lower Saxony, the German state where Volkswagen's Wolfsburg headquarters was located, was a significant shareholder of Vokswagen. The state held the second largest stake in Volkswagen in terms of voting power (20.2%). Despite not being a majority shareholder, Lower Saxony was granted various privileges, inchiding the ability to veto decisions such as shutting down or rolocating assombly plants as woll as businass acauisiions. This was because the Volkswagon Law stipulated that voting on major shareholder meeting resolutions required 80% agreement, In 2008, Porsche, which owned 31% of shares, wanted to gain the majority stake in Vokkswagen. They sought to amend the statutes to have a freer hand over Volkswagen. However, even though Volkswagen's directors welcomed Porsche's interest in increasing their stake in Volkswagon’, Porsche's plans were thwarted due to Lower Saxony’s opposition.® Ih 2008, the European Commission took action against Germany on grounds that the Volkswagen Law restricted the movement of capital across European borders, and the Law was amended in 2008. However, the rule requiring 80% majority ‘support was maintained and Lower Saxony’s 20% stake remained high enough to block any decision that needed shareholder approval, such as a takeover. Under normal German corporate law, companies needed at loast 25% of votos.* 768Despite further attempts by the European Commission to revoke the Volkswagen Law, Ferdinand Piéch, the chairman of Volkswagen's supervisory board at that ‘ime, managed to obtain the support of Chancellor Angela Merkel, She made sure thal 80% majorly rule was preserved even with the amended Volkswagen Law. The maintenance of the 80% majority rule resulted in a win-win situation, with Piéch remaining at the helm of the board and Lower Saxony retaining influence in Volkswagen through its velo power Ferdinand Piéch: Dominance or doom-inance? Prior to becoming the chaiman of the supervisory board in 2002, Pigch, a stelar automotive engineer, was the CEO of Volkswagen since 1988. During his nine- year tenure as CEO, he guided Volkswagen to overcome its inefficiencies and tutned a loss of €1 billion into a profit of €2.6 billion, He had also spearheaded Volkswagen's expansion into a 12-brand entity that produced a wide range of Vehicles such as fuel-eticient cars and 40-tonne trucks.” Pich’s vision was to transform Vokswagen into the world’s biggest and best carmaker* Being a member of the Porsche-Piéch family —which controlled 51% of Volkswagen's voting rights ~ Piéch was able to hand-pick exocutives he favoured and terminate those he disliked." Piéch’s autocratic management style made many engineers and executives in Volkswagen fear him as they knew that they might be fired instantly if he was displeased.” In 2012, Piach succeeded in installing his fourth wife, Ursula Plassor, proviously a kindergarten teacher, to the company’s supervisory board, Although many shareholders protested her lack of competence and independence, they had minimal infuence as the Porsche-Piéch family held a majority of the voting shares."* Furthermore, the appointment was supported by David McAllister, the slate Premier of Lower Saxony, who mentioned thal Plasser was well-versed in Volkswagen's inner workings and had close ties with Lower Saxony after Iving there for a decade." 24Volkswagen’s two-tier board structure Under German company law, itis mandatory forall public companies to have two boards ~ a supervisory board and management board. The supervisory board is composed of 20 members, and the board appoints and oversees the members of the management board, and authorises major business decisions, The Co- Determination Act of 1976 stipulates that companies with more than 20,000 ‘omployoos must have 20 soats in thoir supervisory board. “Harmonious” labour relations: Co-determination Labour representation at the board level of German companies is governed mainly boy the One Third Participation Act and the Co-Determination Act. It is almost exclusive to Europe, and to Volkswagen in particular, where employees are highly ‘ompowared to influence top management docisions. The Co-Detormination Act apples to Volkswagen as the company employs more than 2,000 employees. Under this Act, the supervisory board of Volkswagen must consist of an equal number of shareholders’ and employees’ representatives or in other words a 50/50 co-determination."* In addition, the Works Council. formed to protect and defend employee interests, elects employee representatives onto the supervisory board." Members of the ‘works council are elected only by employees for a term of four years ", with most of them also being trade union officials or members."* Are employees kings? 10 of the 20 seats on Volkswagen's supervisory board were held by employee representatives. Being the chairman of the Works Council and a member of the board, Bemd Osterloh was a decisive figure. According to a source close to the supervisory board, none of the employee representatives would vote against Osterloh in a shareholder's mesting,’® 765In August 2014, employee representatives forced management to dismiss MeKinsey & Company (‘McKinsey’) who were previously engaged to advise on a £5 billion cost-savings plan introduced by Winterkorn, Osterloh was conosmned thal McKinsey would propose a plan thal mainly focused on headcount reduction in Germany rather than curtailing spending on surging research and davalooment costs. This move was major setback to Winterkorn’s plans to close the profit gap with is rivals.2 Back in 2008, it was revealed that managers at Volkswagen had endorsed payments for high-class prostitutes, sponsored cash gifts for the mistresses of ‘rade union officials, and even provided free suoplies of Viagra. Klaus Volkert, a former chairman of the Works Council, was found to have received about €2 millon in unauthorised bonuses and to have paid vacations for his Brazilian mistress. Piéch, who had been CEO when the alleged offences took place, referred to the scandals as mere inegularities, An insider revealed that such inappropriate use of company’s resources had spanned over a decade but no action had been taken from within.*| How German uncovered the German scandal twas John German, together with his colleague Peter Mock, who uncovered one of the biggest corporate scandals in history. German was an American enginoor who co-led the International Council on Clean Transportation (IOCT), a small, non- profit organisation that assisted in the reduction of vehicle emissions by providing sciontiic and technical analyses to environmental regulators.** Volkswagen had been struggling to establish a strong presence In the United Stales (US), the second largest automobile market in the world. To appeal to increasingly ervironmentally-conscious Americans and lsoost sales, Volkswagen promised “clean diesel’ vehicles." When Gorman and Mock carried out emission tests on US cars under normal driving conditions on roads instead of simulated laboratory tests, the pair detected regularities in the emission levels of the Passat and Jetta models. The Passat and Jetta models emitted dangerous levels of toxins of up to 25 and 36 times higher than the logal limit rospoctivaly. Thoy informed the EPA and CARB, which thereatter launched an official investigation into the matter. 286‘After several months of talks between Volkswagen and the regulatory bodies, Volkswagen claimed that it had identified the reasons behind the high emissions and subsequently recalled over 800,000 US vehicles in December 2014.7" However, further investigations thereafter showed thal the emission levels stil violated the standards, and both EPA and CARB threatened to withhold certification for Volkswagon's 2016 diesel motels. (On & September, 2015, Volkswagen finally admitted to cheating on US diesel emission tests.** This subsequentlyled to the uncovering of the fact that Volkswagen had installed a “dofeat” software since 2007 to drastically reduce nitrogen oxide emissions when the automobiles were tested by the EPA in laboratories.” Shortly after the news broke, Winterkorn announced his resignation as the CEO. Green or grim car of the year? Volkswagen had a reputation for producing fuheicient and environmentally friendly cars. In 2009, its frst diesel car, the Jetta model, won the "Groen Car of the Year” at the Los Angeles auto show. The same title was also awarded to its ‘Audi A3 modil in 2010.2" Volkswagen's commitment to sustainabilty had always been strongly emahasised by the supervisory and managoment board. Wintorkorn and Osterloh regarded the sustainability report as the group's business card. In 2014, Volkswagen held a leading position in 11 international ratings and relevant indexes, and was ranked highty as a sustainable automakar in the Dow Jones Sustainability Index, which is a renowned benchmark for measuring the development of the world’s most sustainable corporations. However, Vokkswagen was stripped of its accolades after the scandal surfaced. Tho company was also removed from the rankings of the Dow Jones Sustainabslty Index on 6 October, 2015." 27Winterkorn: A sweet corn or a prickly thorn? Winterkor was Piéch’s former protégé who had a strong background in tenginaering with a doctorate in metal physics. In 1993, he joined Volkswagen as the head of group quality assurance and was heavily involved with the technical development, both at Volkswagen and its Audi subsidiary before becoming CEO in 2007." He had a similar goal to Piéch, which was to make Volkswagen the world's largest automaker by 2018." As CEO, Winterkorn led the company to record profits” and the company achieves the tile of the world’s best-selling automaker in 2015, surpassing Toyota, thres years earlier than otiginaly expected.* \Winterkorn had a reputation of being a micto-manager who paid extremely close attention to detail He continued to retain control over engineering details that many other CEOs would relinquish fully to deputies.** His micro-management style had been criticised because it delayed model launches and hampered the company’s ability io adapt to local markets.” Several times a year, Winterkorn would also personally test drive new vehicles during Volkswagen's group approval drive.” Board games Over time, Piéch became increasingly disappointed with Winterkorn as he felt that Volkswagen's performance had failed to break the dominance of Ford, General Motors and Toyota in the US market.” Volkswagen's markt share in the US had declined from three percent in 2012 to 1,9% in 2015," Piéch subsequently bypassed the supervisory board and told Der Spiegel, a German magazine, that he was distancing himself from Winterkorn.* This open display of animosity revealed Volkswagen's infighting and drama to the media, Back in November 2006, Piéch had successfully ousted Bernd Pischetsrieder, who had succeeded Piéch as Volkswagen CEO in 2002. The move came as a surprise to many as the board had just extended Pischetsrioder’s contract for five years in May 2008." Prior to ousting Pischetsrieder, Piéch had undermined his successor in two notable ways. First, he imposed a new human resources director against the wishes of Pischelstieder and most of the board members. Second, hho openly expressed his disagrooment regarding the extension of Pischetsriodor’s contract. 268Ferdinand had come to an end Pisch launched an attempt in Agril 2015 to oust Winterkorn as CEO but his atiompt failed. This time, Lower Saxony, members of the Porsche family and majority of the supervisory board, including Osterloh, backed Winterkorn. They decided thatthe infighting had to come to an end. Piéch acquiesced, and agreed to keep Winterkorn. Soon after, Piéch was given an ultimatum by key shareholders and stakoholders to cithor resign or suffer the humiliation of boing kicked out in a board vote as they had lost confidence in him as chaitman. Piéch and his wife then resigned from their positions on the supervisory board."© “© ‘After Pidch resigned, the supervisory board chairmanship was temporarily transferred to deputy chairman, Berthold Huber” Huber was the former chairman Of IG Metall, one of the largest unions in the world, where virtually all Germany's car workers are members. Whistle fell on deaf ears Robert Bosch GmbH, one of Volkswagen's key suppliers, had warned Volkswagen in 2007 that the engine-control software it supplied to Volkswagen should only be used for company test purposes and not for rigging emission tests. However, Volkswagen proceeded to modify the software so that it could turn the vehicle's ‘emission control system on during emission tests, substantially lowering the levels of exhaust pollutants lke nitrogen oxides released, and tutn it off when the vehicle ‘was on the road to allow for maximum engine performance.** Four years later in early 2011, a Volkswagen technician blew the whistle and roported that the company was violating emission laws by concealing the real ‘omission levels of its diesel vehicles. An internal aucit revealed problems with Volkswagen's diesel engines, but no further action was taken, Probloms in Volkswagen continued to snowball and eventually, the fact that Volkswagen had been cheating on emission tests was discovered by the EPA and CARB, Up to 1 million Volkswagen diesel vehicles around the world that were ‘equiped with the emissions cheating software had to be recalled." 769Financial implications on Volkswagen The day after the scandal was uncovered, Volkswagen's share price plunged by over 16.7% and wiped out more than €20 bilion off its market value, It also faced, fines amounting up to a maximum of more than US$18 billion for fs violations, and a criminal investigation by the US Department of Justice."® The fim had to set aside €6.5 billion in provisions to cover potential costs related to the emission scandal.** Road block ahead The emission scandal prompted authorities in the US, Europe and South Korea to launch their own investigations inte the matter. Customer confidence was severely shaken and many affected dhivers became frustrated because of the lack ofinformation about how their cars would be repaired. Furthermore, arecent survey conducted in the United Kingdom found that more than half of the Volkswagen customers had no intention of buying a Volkswagen diesel car in future." Less of the same In October 2015, Volkswagen appointed Thomas Sedran, former General Motors Co, manager, as head of group strategy, and Christine Hohmann-Dennhardt, a former judge from Germany's top court, to head its legal and compliance division. * Moving forward, Volkswagen announced that it would cut annual investments. made by the group's brand division by over €1 billion alongside its plans to continue manufacturing environmentally-fiendly cars such as electric cars and plug-in hybrids.All eyes on Miller The industry’ attention was now focused on Matthias Miller, the newly appointed CEO of Volkswagan, to see how he would steer Vokswagen out of this crisis. Failure to deliver its promises on providing clean diesel had severely tainted its reputation as a green company. With the odds clearly stacked against the company, only time will tell how long it will take for Volkswagen to regain the trust and! confidence of the public in their brand. Discussion questions 1. Under German company law, all publ companies are required to have two boards - a management board and a supervisory board, Discuss the advantages and disadvantages of adopting a two-tier board structure, and draw a comparison with the one-tier board structure, 2. Comment on the composition of the supervisory board in Vokxswagen. Pigch became the chairman of the supervisory board right after he stepped down, from his position as CEO. Are there any corporate governance issues that could arise from such a transition? Explain, 3, What responsibly does the regulator EPA have in the emission scandal? To what extent can blame be put on the EPA? 4, In 2011, a Volkswagen technician blew the whistle on how the company was healing on emission lests, but the warning went unanswered. Given thal the cheating had begun in 2007, what are the possible reasons for the truth only being uncovered in 20157 5. Going forward, how can Volkswagen improve its corporate governance to prevent a similar crisis from recurring?Endnotes + Deutsche Walla. (2008, April 24) Battle for control at Volkswagen - Porsche vs. the State, Retiaved from: https wwwzcw.comvenibattle-o-contiohat-vokswagen- porsche-vs-the-state/a-3291440 Dowing, S. 2009, May 8). The world from Bein: ‘Porsche's VW plan was pure magalomania’. Reireved trom hitp://ww.spiagal.de/interational/business/ ‘the-world-from-botlin-porsche-s-w-plan-was-pure-megalomaria-a-623705.htl 9 Stevi, M, (2011, November 24), EU to sue Germany again over ‘Volkswagen Law’ ‘The Wall Steet Jounal. Retrieved from http://w. ws) comarticlas/SB 100014240 £82970204630904577057790270544356 « Fuhrmans, Vi, Crawford, ©., & Boston, W, (2012, March 30}, German state fights to rota VW veto power. The Wall Street Jounal. Retrieved trom http:/waw.ws).con! anicles/S810001.4240527023041 771045773137 10807960088 » Hawranek, ©, (2009, July 22). 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