Volkswagen Emissions Fraud: Bias and Moral Hazard

Introduction: The Volkswagen Emissions Scandal

Volkswagen produced vehicles equipped with emissions controls designed to shut off once the cars had passed regulatory tests. As a result, the cars polluted significantly more in real-world conditions than in those tests. The company also benefitted financially from the test results, because they made Volkswagen's diesel engines appear less polluting than gasoline ones. The consequences were far-reaching: the public was misled, the company became eligible for subsidies that gave it a competitive advantage, and many consumers may have chosen to purchase a Volkswagen specifically because of the vehicles' apparently superior emissions performance (Parloff, 2018).

Biases Driving Executive Decision-Making

Several distinct biases were at play in the Volkswagen case. The first concerns the motivations behind executive action. The company's senior executive at the time, Martin Winterkorn, was aware of the emissions-cheating practice when he ascended to his new role — and had in fact been one of its driving forces during implementation. He continued the practice after becoming CEO and was eventually charged with fraud in the United States as a result (Smith, 2018).

A central bias involved the conflict between competing duties: the duty to shareholders to enhance the stock price, the duty to the public and regulators to provide accurate emissions information, and a personal financial interest, since Winterkorn himself stood to benefit from a rising share price. The duty to regulators was a legal obligation. The duty to shareholders, while real and deeply felt, was not a legal mandate in the same sense. The duty to buyers was ethical but not strictly legal. Thus, Winterkorn's actions — and indeed those of all involved at Volkswagen — were shaped heavily by personal gain.

Palmiter (no date) provides useful insight into the ethical conflicts that can arise in corporate settings, including the tension between fairness and cheating. In this case, fairness concerns extended to shareholders, who occupy at least some priority in the conventional hierarchy of stakeholders. Palmiter advances the idea that non-shareholder constituents deserve the same level of consideration as shareholders, but when a CEO's personal wealth is heavily tied to what is good for shareholders, that executive will inevitably hold a very different perspective. This bias moves away from the concept of enlightened shareholder value and, notably, away from long-term shareholder interests as well.

The Risk-Reward Equation and Accountability Gap

Compounding the problem was the fact that Winterkorn and other executives were unlikely to face trial in Germany, and because of extradition laws they were likely to remain free from prosecution. At most, they faced a financial penalty — and the rewards of the fraud greatly outweighed those risks. Just as Pablo Escobar feared extradition to the United States far more than imprisonment in Colombia, Winterkorn and his associates feared American prosecution more than anything their home country could impose. Being tried for fraud in the United States represented the only real possibility of harsh punishment, and Germany was not obligated to extradite them.

The risk-reward equation was therefore heavily skewed toward actions that would increase Volkswagen's stock value. The company naturally pursued strategies to increase vehicle sales, particularly on the strength of a very public competitive advantage: superior emissions performance and the corresponding tax incentives available to buyers in Europe. Without this competitive advantage, Volkswagen would have faced considerably more market pressure and negative impacts on its share price.

Conclusion

The Volkswagen emissions fraud was the product of moral hazard, which in turn was generated by a bias toward self-serving actions that were never effectively counterbalanced by incentives aligned with either long-term shareholder interests or the interests of non-shareholder stakeholders. As such, Volkswagen's Board of Directors bears a substantial share of the responsibility — though of course not as much as those who were most directly involved in carrying out the fraud.

References

Ganti, A. (2019). Rational 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