Volkswagen: Das Auto or Das Broken Auto?

Isabelle Chaboud, Professor in Finance, Accounting and Law at Grenoble Ecole de Management.
http://en.grenoble-em.com/annuaire/isabelle-chaboud

The Volkswagen group has been plunging towards an abyss ever since the discovery of its fraudulent circumventing of antipollution tests for diesel vehicles in the United States. The repercussions of the scandal have been quick and painful: the group lost approximately $25 billion in market capitalization over two days; its stock dropped by more than 20%; and the chairman of the board of directors, Martin Winterkorn, stepped down from his position on September 23^rd. Mathias Müller, who previously worked for  Porsche, was nominated to replace the ex-chairman. The events following this scandal could not only be fatal to the German group, but also have industry-wide repercussions.

In 2014, Volkswagen was neck and neck with Toyota. The group had sold more than 10 million vehicles around the world and had successfully overtaken GM. Mr. Winterkorn proudly announced the group’s financial results in its last annual report. Given the difficult economic period, the ex-chairman was happy to share positive results: sales of €202.5 billion (up 2.8% from 2013) and a net result of €10.1 billion ( up 21% from 2013).

Given these strong results, the now ex-chairman decided to increase shareholder dividends from €4 to €4.80 per share. In addition, his statement to the group’s shareholders declared: “We support (financial) soundness, reliability and long term success, even under these unfavorable conditions.” However, with the current scandal, such lofty goals appear to have gone up in smoke. The breadth of the scandal revealed on September 18^th will likely mark the end of Volkswagen’s ambition to become the industry’s world leader by 2018.

A rapid succession of events

On September 18^th, the American Environmental Protection Agency (EPA) announced that Volkswagen knowingly used software to help improve antipollution test results. On September 21^st, the German group confessed and expressed its “sincere apology” following which an investigation was launched.

On September 22^nd, the group declared that 11 million vehicles worldwide were equipped with this software and therefore called into question their test results. Volkswagen also indicated that in the third quarter of 2015, the group would set aside €6.5 billion to begin addressing this crisis.

A fatal blow to the “Made in Germany” brand

The group has been communicating for years with campaigns built around the German Das Auto slogan. Its slogans and ads, which were delivered in German even in France, helped develop the brand’s image of reliability, security and quality. This scandal however marks the implosion of years of efforts, research and development. By confessing to the use of a software that circumvents antipollution tests for 11 million of its cars, Volkswagen has opened the door to fears in other countries. As a result, Germany, South Korea and Italy have all launched investigations. On September 22^nd, the French Minister of Sustainable Development, Ségolène Royal, requested a thorough investigation of the scandal.

To make matters worse for the group’s leaders, the American Department of Justice launched a criminal investigation. The risks are significant as those held responsible for fraudulent declarations and for cheating the Clean Air Act will face prison time.

At the same time, the EPA has launched an investigation and could fine the German automobile manufacturer up to $18 billion. To top off the crisis, thousands of automobile owners have joined together to launch a class action lawsuit in the United States.

Terrible risk management

This scandal is a perfect example of catastrophic risk management. Either the group’s management was unaware of major flaws in internal controls or they covered for their American teams. If the latter is true, how could the group’s management imagine that such a software would not be detected by a regulatory agency? With such a risk in mind, why did the group equip so many vehicles with this software?

It is possible that management estimated the risk of the software being detected to be minimal, but in any case, they greatly underestimated the magnitude of such a risk. If we take into consideration the fact that Volkswagen sold 10 million vehicles in 2014, then the 11 million vehicles equipped with this software translates to more than a year’s worth of sales!

A breakdown in governance

Given the consequences of such a decision, it is hard to imagine that top management, and therefore the board of directors led by Mr. Winterkorn, was not implicated in the decision-making process. A fact that brings into question the effectiveness of the German dual leadership governance model with its management and supervisory boards. This case would appear to be the epitome of an extreme breakdown in corporate governance. Either there was a massive cover-up from the management or we can point to a lack of independent non-executive directors who could have challenged management. Indeed, only very few directors were hired from countries other than Germany and Austria.

Not only does this scandal have a direct and immense financial impact on the group, it could also be a fatal blow to the brand if lawsuits are filed one after another and Volkswagen is forced to pay fines as well as punitive damages. On top of the impact suffered by the German group, the image of diesel fuel is also at risk. Finally, such a scandal has impacted other European manufacturers and their various stocks have dropped since September 23^rd.

Michael Horn, President and CEO of the Volkswagen Group of America, appeared before members of Congress for more than two hours on October 8^th. His declarations did not appear to convince the Energy and Commerce Committee. Much like Mr. Winterkorn, he stated that it was “not a corporate decision” and that “a couple of software engineers” were responsible for having installed the software in the vehicles. However, Congressman Chris Collins from New York’s 27^th District categorically rejects such a view of the scandal. According to him, the manufacturer was either incompetent or responsible for a “massive cover-up.”

With such a major flaw in governance and risk management, who can this really be pinned on? Mathias Muller, the new chairman of the board of directors at Volkswagen, told the group’s 600,000 employees that “we can and we will overcome this crisis.” Nevertheless, he was unable to answer all of the questions brought up by this scandal and he has no real idea of how much it will really cost to fix everything from modifying the vehicles equipped with this software to recouping lost sales, making up for fines and rebuilding the brand’s image.

As a result, the bill is increasing daily. Volkswagen has already announced the recall of 8.5 million vehicles to begin fixing the issue. In addition, new class action lawsuits are being filed in the UK and the German carmaker will probably be forced to reimburse various government subsidies. The crisis could also lower the group’s credit rating which will increase the cost of financing. Analysts at Exane estimate that the cost will be at least €25 billion, whereas Credit Suisse predicts it to be more like €80 billion.

While we continue to await the verdict on who is to be held responsible, the group’s auditors have a real challenge to overcome as they try to calculate how much the group must set aside by the end of December 2015 in order to face this crisis.