Why the Worst Isn’t Over Yet for Volkswagen

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Wharton's Sarah Light and John Paul MacDuffie discuss the Volkswagen scandal.

Volkswagen now has more clarity on the scope and size of its woes for faking emissions tests on diesel-engine vehicles with the U.S. department of Justice on Monday filing a lawsuit, nearly four months after the scandal broke. In addition to civil fines of more $18 billion, the company faces potential criminal action including against its executives, numerous class action suits and the ripple effect of a U.S. court ruling on actions by European courts and regulators, according to two Wharton experts.

And even though the Justice Department’s case may eventually end in a settlement, the entire episode is a wakeup call for U.S. regulators to find ways to detect similar lapses by automakers, they said.

The justice department’s civil complaint against Volkswagen (including its subsidiaries Porsche and Audi), is based on a discovery of “defeat devices,” or software, that cheat emissions standards in test conditions. The lawsuit covers some 580,000 such vehicles Volkswagen sold in the U.S. between 2009 and 2015. The cheating was unearthed during a study by West Virginia University’s Center for Alternative Fuels Engines and Emissions that was commissioned by the nonprofit International Council on Clean Transportation, and it was conducted in collaboration with the California Air Resources Board. The initial estimate of fines of $18.5 billion is based on the Justice Department’s claim of about $32,000 in penalties for each of the affected vehicles.

Wharton professor of legal studies and business ethics Sarah Light said two aspects of the Justice Department’s move jumped out at her. One was a mention in its press release announcing the lawsuit that the civil complaint “does not preclude the government from seeking other legal remedies.” The second was a mention in the civil complaint that the court could order Volkswagen and Audi “to take appropriate steps including but not limited to mitigation of excess nitrogen oxide emissions.” Light said the wording “suggests that beyond potentially recalling the existing vehicles, somehow Volkswagen would have to make up for the excess NOx emissions that arose as part of this scandal.”

“This is the first of legal actions we can expect to see” against Volkswagen, adds Wharton management professor John Paul MacDuffie, who is also director of Wharton’s Program on Vehicle and Mobility Innovation. In addition to the civil penalties and potential criminal charges, the company faces class action suits around the country, especially in California. He noted that this was the reason the case is being moved to San Francisco from Michigan, where it was initially filed. “Many of these Volkswagen vehicles qualified for subsidies under green and clean subsidy programs — not just in the U.S., but also in Europe, so governments will be suing to recover that potentially,” MacDuffie notes.

Light and MacDuffie discussed the likely course of the actions against Volkswagen and the lessons in the case for the EPA on the Knowledge@Wharton show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)

Light also pointed out some apparent inconsistencies in the company’s positions. In response to the EPA’s concerns over the higher than permitted NOx emissions, Volkswagen had in September insisted that the software represented a technical issue and not an intentional violation. Yet, in October, Volkswagen CEO Michael Horn testified before the U.S. Congress “that this was a problem and … was something Volkswagen knew about,” Light said. That could be treated as a “1001 violation” (making false statements to a federal officer, under the False Statements Accountability Act of 1996), she added. Light also saw the potential for a wire fraud claim based upon the marketing of the vehicles as meeting certain emissions standards but failing to meet those standards.

“In the light of that memo, I suspect that the Justice Department may be considering individual corporate criminal responsibility more actively than it has in the past.”–Sarah Light

Criminal Lawsuits Ahead?

In addition to the civil lawsuit and potential criminal charges against the company, the Justice Department could also bring criminal charges against individual Volkswagen executives, said Light. Both she and MacDuffie noted that the Justice Department has expressed concerns about Volkswagen not cooperating fully in the investigations.

Both Light and MacDuffie noted that the general mood among law enforcers was in favor of going after individuals in cases of corporate wrongdoing, in addition to the companies.

Light added that that in the wake of the 2007-2008 financial crisis, the Justice Department has faced criticism for failing to prosecute individuals.

Light said that last September, Deputy Attorney General Sally Quillian Yates issued a memo titled, “Individual Accountability for Corporate Wrongdoing.” That memo listed six new steps that need to be followed in criminal and civil investigations in which individuals may be implicated criminally. “In the light of that memo, I suspect that the Justice Department may be considering individual corporate criminal responsibility more actively than it has in the past,” Light added.

The Justice Department would like to show “some progress in prosecuting executives and not only having big fines against companies,” said MacDuffie. “One view is that the companies would see it as the cost of doing business and there won’t be a sense of personal accountability.”

Even as Volkswagen is conducting its own internal investigations and some top executives have resigned, criminal charges don’t appear imminent, MacDuffie said. “There simply is just not enough evidence against individuals as yet, and it’s probably because Volkswagen hasn’t helped provide it.”

Volkswagen may have an incentive in providing names of individual executives responsible for the emissions scandal, said Light. She pointed to one of the six new steps in Yates’s memo, which enables corporations to qualify for so-called “cooperation credits” if they provide to the Justice Department “all relevant facts relating to the individuals responsible for the misconduct.”

“There simply is just not enough evidence against individuals as yet, and it’s probably because Volkswagen hasn’t helped provide it.”–John Paul MacDuffie

How Volkswagen Might Respond

MacDuffie expected Volkswagen to “negotiate very  hard in Europe where the scale of their violations are not as large as in the U.S.” He noted that European regulators have ruled that the software installed in the vehicles involved in the scandal are in fact defeat devices, even though Volkswagen tried to claim that some of what it did was not technically illegal.

In the U.S., Volkswagen would have to think seriously “about how and whether to settle the case,” given the size of the potential penalty and the likelihood of criminal charges, said Light. However, Volkswagen would probably avoid initiating a settlement at this stage before ensuring that it provides protection from potential criminal charges as well, she said. MacDuffie said a settlement is a certainty, given that Volkswagen has already confessed to the main violation.

A settlement in the U.S. would still leave Volkswagen vulnerable to actions in Europe, and perhaps bring more trouble. “The U.S. charges are much more serious and more aggressive than in Europe,” MacDuffie said. “What happens in the U.S. could have some ripple effects on what happens in the EU, too.”

Fixing the Flawed Vehicles

MacDuffie said that while “no action is underway in the U.S” to fix the problems in the flawed Volkswagen vehicles, some fixes have been announced in Europe. Some of those are software changes, while others involve installing a simple and inexpensive plastic part, he said, citing media reports. “None of this involves a major overhaul of the engine,” he added.

According to MacDuffie, European Union regulations are laxer on NOx and other emissions from diesel engines. “Given the much tougher standards and therefore the much greater violations in the U.S. to the Clean Air Act, Volkswagen would have to do something much more significant” to bring the vehicles up to standard, he said.

“[The EPA] didn’t find this, and nothing in their methods made it very likely that they would find it. The EPA has a big challenge to do a better job.”–John Paul MacDuffie

As for dealing with claims from vehicle owners, Volkswagen has already hired Kenneth Feinberg, a lawyer who specializes in compensation funds, MacDuffie noted. In addition to the EPA and the Clean Air Act, the company will also have to deal with the National Highway Traffic Safety Administration, which will govern the aspects related to the vehicle recalls, he said.

Among the several proposals circulating on what Volkswagen should do, one calls for it to buy back the defective vehicles and take them off the market, said MacDuffie. He noted that it would be tough to ensure that all vehicles covered by a recall are actually serviced if owners don’t bring them in.

“Many people have blogged that they have enjoyed the performance of their Volkswagen vehicle, citing better fuel efficiency and its peppy acceleration,” MacDuffie said. “They may not share a great concern about the amount of pollution their vehicle is putting into the atmosphere.” Getting such owners to comply with a recall is a challenge, he said. “Remember, they are not driving a car that is dangerous in the conventional sense when you have these safety recalls. They are driving a car that may make them quite happy. It is just pumping out illegal amounts of diesel soot and NOx.”

A Wake-up Call

Light noted that automakers installing defeat devices in their vehicles is not a new problem. In fact, Volkswagen itself faced a similar charge in 1972 and was fined for installing temperature sensing equipment that turned off the vehicle emissions system at certain points in the process, she recalled. Also, in 2014, Hyundai and Kia paid a $100 million penalty to the EPA for greenhouse gas emissions violations, she added.

Clearly, it is time for the EPA to make changes to better manage such violations in future, said Light. “That the EPA didn’t discover the problem [with the Volkswagen vehicles] suggests that there needs to be either more EPA oversight or some reconsideration or revamping of how certificates of conformity are issued by the U.S. government,” she said. MacDuffie agreed with Light. “[The EPA] didn’t find this, and nothing in their methods made it very likely that they would find it,” he pointed out. “The EPA has a big challenge to do a better job.”

Yet MacDuffie said the EPA looks tougher compared to European regulators. He explained that while the EPA conducts independent road tests on vehicle samples, European regulators only do lab tests. “[European] automakers have lobbied successfully for years with all sorts of claims that it is impossible to find a road test that is fair, that compares vehicles equally and doesn’t introduce some driver variable or some other variable that is unfair to them.” He noted that test companies in Europe compete for the business of the automakers “and they are fairly upfront about the fact that they help the companies pass the test.”

Also, European Union standards are inconsistently enforced across the region, MacDuffie said. He added that European automakers are “politically powerful because they provide a lot of employment.” The automakers have also benefitted from subsidies for diesel fuel, which has boosted diesel sales, he added. “For Europe, it is a broader regulatory crisis that gets to the heart of the relationship between the regional and national governments and these automakers.”

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