Volkswagen emissions fraud

Decisions Influenced by Bias
Volkswagen produced vehicles that were equipped with emissions controls that were designed to shut off once the cars had passed regulatory tests. As s result, not only did the cars pollute more in real life than in those tests, but the company benefitted from these tests financially, because they showed that diesel engines were less polluting than gasoline ones. The result was misleading the public, making the company eligible for subsidies that gave it competitive benefit, and misleading the public, as many people may have chosen to buy a Volkswagen in part based on the emissions performance of the vehicles (Parloff, 2018).
Biases at Play
There were a few different biases at play in the Volkswagen case that can be unpacked. The first of these is the bias towards the optimal motivations of executive action. The company’s senior executive at the time, Martin Winterkorn, was aware of the practice when he ascended to his new role – and had been one of its driving forces during implementation. Further, he continued the practice, and was eventually brought up on fraud charges in the US as a result (Smith, 2018).
The first bias was likely the decision between duty – duty to shareholders to enhance the stock price, and duty to the public and regulators to provide emissions information that was accurate. The duty to regulators was legal. The duty to shareholders is real, but not legal, but it also included a duty to himself, as he would also benefit from an increase in the share price. The duty to the buyers is ethical, but not legal, and can probably be interpreted in a number of ways. Thus, WInterkorn’s actions – and indeed the actions of all at Volkswagen in this case – were influenced by personal gain.
Palmiter (2017) provides some insight into the different ethical conflicts that can arise. One is the conflict between fairness and cheating. In this case, the fairness certainly includes shareholders, who have at least some priority in the hierarchy of stakeholders. The author advances the idea that non-shareholder constituents should have the same level of interests as shareholders, but of course when the CEO’s personal wealth is heavily invested in what is good for the shareholders, the CEO will have a distinctly different perspective on the matter. That bias seems to move away from the concept of enlightened shareholder interest, and certainly away from long-term shareholder interests.
Compounding the issue in this case is the fact that Winterkorn and other executives were unlikely to face trial in Germany, and because of extradition laws were likely to remain free from prosecution for their crimes. A fine, maybe, but at the end of the day the rewards greatly outweighed the risks. Just as Pablo Escobar feared extradition to the United States far more than jail in Colombia, so did Winterkorn and his cronies. Being tried for fraud in the United States offered the only real possibility of harsh punishment for the Volkswagen executives, and they could not be extradited by Germany.
So the risk-reward equation was heavily skewed towards actions that would increase the value of Volkswagen’s stock, and the company naturally then moved towards actions that would increase vehicles sales, especially on the back of a very public competitive advantage (superior emissions performance and corresponding tax incentives). Without this competitive advantage, Volkswagen would indeed struggle much more than it was, with negative impacts on the stock price.
The Path to a Different Path
There are a few ways that this issue could have been resolved before it occurred, by guiding the exeutives to following a different path. The first would have been not to hire Winterkorn in the first place. This is on the Board at Volkswagen, as Winterkorn was involved in the emissions cheating software before becoming CEO – by promoting him to the top job they were rewarding him for his performance, which included the fraud he was already committing. This surely created a sense among Volkswagen’s executives that they had the support of the Board for these actions, and with that alignment it was much easier for them to believe that they would get away with it. At this point, it’s simply a matter of rational choice theory (Ganti, 2019). People do not make decisions with strongly negative consequences unless the expected rewards greatly outweigh the expected risks, and Volkswagen’s Board clearly signalled that this would be the case when it promoted Winterkorn.
But in term’s of Winterkorn’s own decisions to continue with the fraud after being promoted, The other way that this is resolved is that Winterkorn, once in control of the company, puts into motion a plan to halt the program and find the sales elsewhere. That is risky, because it risks exposing the fraud and harming him personally, but it is a decision he could have made at that time. Prior to that, he may have had a more difficult time making such a decision because of loyalty to his superiors, as such loyalty can create conflicts of ethics, but the reality is that Winterkorn was given full control to make this decision without any loyalty conflict and still made the choice, and that was almost certainly because of personal interest.
One of the issues that arises with equity-based compensation is that it creates a conflict between the short-term and long-term interests of the executives. All senior executives either have direct equity-based compensation or they see their bonuses tied to the performance of the company on metrics, which would include revenue figures, which in turn are affected by the performance of the cars on emissions tests and the subsequent subsidies for which those cars are eligible in Europe.
Thus, Winterkorn’s personal bias in the shareholder/non-shareholder conflict was for shareholders and in his role it was short-term share gains which would increase his wealth quickly. Then, in the event that things went south for him, he would have that wealth and in all likelihood risk losing only a little bit of that. So the structure of Winterkorn’s compensation package was likely what created or enhanced his bias towards personal interest in the first place, not to mention his participation in the project initially.
Because moral hazard is often created when there is a gap between the time period for the reward and the behaviors desired, Volkswagen either deliberately or accidentally created moral hazard in hiring Winterkorn to the top job (Cook, 2008). Therefore, the company had the opportunity to reduce the risk of such fraud by removing much of the moral hazard concerned with equity-based compensation and the misalignment of corporate goals and executive goals. This is done at the level of executive compensation structure, because once the moral hazard itself is created, the likelihood of unethical behavior is much higher. This is why in the Untied States, the Sarbanes-Oxley Act build into its structure prison terms for senior executives engaged in fraud, as a means of balancing out the moral hazard associated with equity-based compensation.
Conclusion
The Volkswagen emissions fraud was the result of moral hazard, which in turn was created by bias towards actions that benefit oneself that were not effectively counterbalanced by actions that benefited either the long-term shareholders or by non-shareholder interests. As such, Volkswagen’s Board bears much of the responsibility, though of course not as much as the people who were more directly involved in the fraud.
References
Ganti, A. (2019) Rationcal choice theory. Investopedia. Retrieved January 18, 2020 from https://www.investopedia.com/terms/r/rational-choice-theory.asp
Palmiter, A. (no date). Corporate governance as moral psychology. In possession of the author.
Parloff, R. (2018) How VW paid $25 billion for dieselgate – and got off easy. Business Ethics. Retrieved January 18, 2020 from https://business-ethics.com/2018/02/08/1638-how-vw-paid-25-billion-for-dieselgate-and-got-off-easy/
Smith, A. (2018) Volkswagen ex-CEO charged with fraud in diesel emissions scandal. CNN. Retrieved January 18, 2020 from https://money.cnn.com/2018/05/03/news/companies/winterkorn-vw-diesel-scandal/index.html