Volkswagen has cheated regulators, customers, shareholders and other stakeholders by installing software devised to cheat on emissions tests in its diesel cars. The software could recognise when a car was undergoing emissions tests and set temporary pollution controls. During normal operation, the cars would emit as much as 40 times the allowed amount of nitrogen oxides, a class of harmful pollutants. The company was selling the vehicles as 'clean-diesel' vehicles, which meet the environment norms while being economically efficient and high in performance.
According to media reports, the new diesel engine (EA 189), which was developed after R&D efforts for seven years, failed to meet the emission standards of the US and some other countries. Developing the engine was a big bet as the company's strategy was to grow fast by selling 'clean-diesel' technology-driven vehicles in these countries. Therefore, the engine failure was a big blow to its aspiration to grow fast. There were two options: either to invest money, time and other resources to modify the engine design and revise the growth target or to cheat. The company has admitted that the 'cheating software' was installed in 11 million vehicles worldwide.
The fraud has a huge cost on the company. It has earned shame by perpetrating the fraud and it will take long to regain the trust of stakeholders. It is facing a potential fine from a US Investigation that may go up to $18 billion. It has estimated that it will have to spend 6.5 billion euro towards service costs and "other efforts" meant to restore public trust. The cost might go up. In addition, the company might face 'class action suits'.
As reported by Reuter, Volkswagen CEO Matthias Mueller, who replaced Martin Winterkorn after the scam came to light, told German newspaper Frankfurter Allgemeine Zeitung (FAZ) that manipulations of emissions readings in diesel cars came from company's headquarters in Wolfsburg, Germany, and that he believed only a few employees were involved in it. Mueller's statement gives the impression that the top management was not involved in the 'cheating'. The decision to 'cheat' might not be a board-level decision. It is possible that the CEO did not have an idea of what was going on. But it is difficult to believe that it did not have the approval of the senior management.
Corporate governance system at Volkswagen, particularly the internal control and risk management systems failed. This kind of corporate governance failure can occur in any company, which is successful and aspires to win in the market place continuously. In a highly ethical company, every individual in the organisation holds 'ethical values' even when holding those values might have significant adverse impact on individuals and the company. In those companies making tough decisions is easy. For example, in Volkswagen-like situations, 'cheating' would not be a choice for such a company. But, in a company that could not develop 'highly ethical' culture making such decisions is very difficult. It is more difficult at the individual level or at the team level.
Violation of standards of conduct is common in companies where the top management shows significant intolerance for failures. Business firms cannot survive with repeated failures at different levels. Therefore, they build capabilities, invest in technology and develop 'standard operating procedures' to reduce failures to almost at zero level. But, failures are a part of life, and more so in business. Therefore, business firms should develop the culture of accepting and discussing failures with a positive attitude to reduce the motivation to violate ethical standards. Perhaps, the top management of Volkswagen, which is known for technological excellence, could not accept the fact that it would have to severely cut its growth target because of failure to develop the right engine.
Building an ethical company requires that the board and the top management demonstrate their commitment to hold 'ethical values' in every situation and the company should implement a policy of 'zero tolerance' for violation of ethical standards. The top management cannot take one view when compliance with ethical standards would cost the company huge and another view when the cost would be insignificant. One cannot create an ethical company by following policies such as 'do not tell a lie, unnecessarily'.
Formulating policies, developing standards of conduct and intensive training are not enough in building an ethical company. Policies regarding setting targets, rewarding and penalising employees, balancing variable and fixed pay, and other human resource management policies have a bearing on the organisation culture. For example, unachievable targets or high percentage of variable pay in the total compensation motivates managers to commit accounting fraud and manipulate performance metrics. It is the responsibility of the board to ensure that policies formulated by the management are appropriate.
In the absence of right culture (often referred as internal control environment), the internal control system is not effective. This leads to corporate governance failure. I believe corporate governance in Volkswagen failed due to the absence of right organisation culture. Weaknesses in the culture showed up when the company decided to grow faster than before.