Volkswagen and the Culture of Silence

Since the Volkswagen story first broke in September 2015, most observers have just scratched their heads and muttered to themselves in amazement: “What were they thinking?  How could you place ‘defeat devices’ in 11 million cars worldwide and expect that you were going to escape detection for long?”  There is, however, an answer to this question—one that says much about what is wrong with current priorities and practices for the enforcement of white collar crime.  This column begins with an assessment of the Volkswagen case and then turns to an analysis of white collar crime strategies.  Finally, it proposes remedies that criminal and civil enforcers could utilize to break down the culture of silence that surrounds many large organizations (and especially foreign corporations that often view U.S. regulators with deep suspicion).

1. The Volkswagen Story

The first (and simpler) point to make about Volkswagen is that the stakes involved were enormous for it, enough to justify taking a huge risk.  Volkswagen had bet its future on “clean diesel” (whereas other automakers had largely bet on hybrid or electric models to gradually replace gasoline).  As events began to unfold, Volkswagen learned to its horror that the California Air Resources Board (“CARB”), and, later, the Environmental Protection Administration (EPA) were about to impose standards with which Volkswagen did not believe it could comply without sacrificing performance and much of its competitive advantage.

The second (and more important) point is that Volkswagen believed it could safely take the risk of engaging in a massive deception of U.S. regulators.  Why?  Simply put, it had done so in the past.  Even more importantly, other manufacturers had just done so and escaped relatively unscathed.  Here is where journalists and other critics have failed to connect the dots.  The Volkswagen scandal was preceded by very similar conspiracies to rig the testing for auto emissions only a few years earlier, and the participants in these conspiracies experienced only a mild slap on the wrist.

The following faces are in the public domain, but have been largely ignored.  In 1998, federal authorities discovered not one, but two, independent conspiracies to install “defeat devices” that reduced the nitrogen oxide (or, more technically “NOx” levels) of motor vehicles under laboratory testing conditions (but then turned off these controls under highway conditions).  In the more notable episode, seven producers of heavy-duty diesel trucks acknowledged that they had installed these defeat devices in some 1.3 million diesel vehicles.[1]  The defendants entered into a consent decree with the Department of Justice and paid a fine of $83.4 million.[2]  In the second case, Ford resolved claims with the Department of Justice and the EPA that it had installed similar defeat devices in over 60,000 Econoline vans.  Under this settlement, Ford paid a $2.5 million civil penalty.[3]  Now, do the mathematics.  The $83.4 million paid by the seven diesel truck manufacturers divided by the 1.3 million vehicles affected comes to $64.15 per truck.  Ford’s $2.5 million penalty divided by 60,000 van comes to only $41.66 per van.  Folks, these are bargain prices!  But there is even more: ironically, the first (and cheapest) use of a “defeat device” dates back to 1973, just after the EPA was created, when Volkswagen was discovered to have installed such a device and paid a civil penalty of $120,000.[4]  Wow!  That certainly taught Volkswagen a lesson.  Unfortunately, the lesson learned was that crime did pay.

Next, let us assume that all professionals regularly talk and gossip with their peers.  Doctors do; lawyers do, and so, almost certainly, do automotive engineers, particularly ones in as specialized a field as diesel engineering.  Thus, Volkswagen’s diesel engineers should be assumed to have learned the tricks of installing defeat devices from their colleagues at other manufacturers.  Also, Volkswagen knew that its U.S. sales of diesel vehicles was relatively modest (less than 600,000 vehicles are alleged to have been sold in the U.S. during the six-year period of the conspiracy).  Thus, those wishing to rationalize the use of “defeat devices” could argue that they would face no more than half the $83.4 million penalty that the seven diesel manufacturers paid in 1998 for installing similar vehicles in 1.3 million trucks—or about $41.7 million.  Finally, at the time that the Volkswagen conspiracy began in 2007-2008, there was not yet any working technology in place for detecting NOx emissions under on-the-road driving conditions.  That came only later (and was the key development that lead to the detection by researchers in West Virginia of the huge disparity between Volkswagen’s road performance and its laboratory test results).  Thus, those seeking to cheat could rationalize that the risk of detection was low.

To sum up, the hard-nosed realist could argue that the likely penalties were very low as was the risk of detection.  It should not surprise us then that, faced with the prospect of exclusion from the U.S. market if it could not bring its “clean diesel” technology into apparent compliance with upgraded EPA standards, Volkswagen decided to take the risk.  Nor was Volkswagen necessarily alone in this decision.  Growing evidence suggests that other auto manufacturers may have behaved similarly, and Mitsubishi, Fiat and Daimler have all been reported to be under investigation.

In due course, investigative reporters will get access to the documents and tell us the lurid details about how high the conspiracy went.  But that is beside the point for policy purposes.  The critical policy issue is: why are penalty levels so low?  Why do enforcers settle so cheaply?  Sometimes, the answer may be that there are problems of proof or that a trial would be both risky and expensive.  But that it is not the case here, because the installation of “defeat devices” is not an innocuous or merely negligent act.  Instead, the thing speaks for itself (or, as tort lawyers like to say—“res ipsa loquitur”).  Such conduct bespeaks willingness and makes the trial outcome highly predictable.

But there is another deeper problem that may better explain why penalty levels are so low.  When a corporate defendant seeks to settle, its able lawyers will investigate all similar examples of misconduct by other corporate defendants over the last decade or more.  Then, under the standard defense playbook, they will prepare a chart showing the penalties imposed in those prior cases.  In all likelihood, the impact of inflation will make these prior penalties look modest indeed.  Zealous advocates can then argue that the current prosecutors (civil or criminal) are being unreasonable in seeking to impose a record penalty that is a multiple of the past penalty levels.  This line of argument seems to work very well with the SEC, which usually stays reasonably near its past penalty levels.

In part, the problem here is that law is shaped by precedent, even as to penalty levels.  But the goal of the law is adequate deterrence, and that requires much more.  Economically, deterrence requires that the “expected penalty” exceed the “expected gain” (Gary Becker won the Nobel Prize in Economics largely for formalizing this point).[5]  This means that the expected penalty must impose an amount that, when discounted by the low risk of detection, still exceeds the expected gain.  Accordingly, if the expected gain is $1 million, but the risk of detection is only 10%, the actual penalty must be at least $10 million so that, after discounting it by the 10% likelihood of non-detection, it still cancels out the expected gain.  But both courts and some regulators shy from this mathematical truth and look instead to precedent.

Still, even if it appears that low penalties in earlier similar cases may have been a leading factor in Volkswagen’s decision to break the law, this does not mean that the answer is simply to escalate corporate penalties.  Why not?  That is the next topic.

2. The Problem with High Corporate Penalties.

A theoretical problem is that for the “expected penalty” to exceed the “expected gain” the defendant must have sufficient corporate assets.  That is not really an issue for a large corporation, but the implication here is that a corporation which is near the brink of insolvency is effectively undeterrable.[6]

Even when an adequate corporate penalty is possible, there may be serious and perverse side effects in relying principally on heavy penalties on the corporate entity.  Since the 2008 financial crisis, regulators have levied extraordinary penalties on the major global banks.  One study, prepared in October, 2015, estimates that the “biggest global banks” have incurred legal costs of at least $306 billion as a result of enforcement since the 2008 crisis.[7]  This study, prepared by the CCP Research Foundation, focuses on just sixteen global banks and undoubtedly understates because it stops at the end of 2014.  Another study limited its focus to tabulating simply the fines imposed on U.S. banks since the 2008 crisis and placed this number over $200 billion as of October 2015.[8]  No tears are here shed for global banks, but two striking facts are underscored by these statistics: (1) Enormous corporate penalties aggravate the systemic risk problem that these banks (and the U.S. economy) face; and (2) These high penalties imposed on the corporate entity are in stark contrast to the near absence of penalties imposed on senior financial executives.  That is, if the Federal Reserve wants to increase the capital reserves of the “systematically significant” major banks, the Department of Justice is working at cross-purposes when it imposes multi-billion dollar penalties on these same banks.

This is said not to justify low penalties (which large corporations can and do absorb as a cost of business), but to recognize the potential desirability of other alternatives.  Not only do high corporate penalties fall on the innocent, but they simply do not deter well.  Why?  The structure of shareholder ownership in the United States is that the vast majority of the stock in a public corporation is normally held by highly diversified institutional investors, which own only small percentage stakes in individual firms to preserve their liquidity (and to avoid Williams Act disclosures).  Many are indexed and hence relatively passive as shareholders.  To the extent that heavy penalties fall on diversified passive shareholders, they do little good and seldom provoke an active response from shareholders that disciplines management.  To be sure, this is not the case with Volkswagen, which does have controlling shareholders (the Porsche family and the State of Lower Saxony) who will bear a high cost and could take responsive actions.  But Volkswagen is the exception, not the rule.  Even if the CEO is sometimes forced to resign when a major scandal breaks (as happened in Volkswagen), other senior corporate executives generally survive.

All this points to the desirability of federal enforcers focusing more on individual accountability.  Of course, this point has been made by a long succession of commentators (perhaps most notably by Judge Jed Rakoff).[9]  Nonetheless, no significant shift towards individual accountability is occurring.  With only modest changes, the SEC still sticks to its standard policy of “neither admit nor deny settlements” (which protect senior officers from having to acknowledge responsibility).  Why has there not been more change?  Various reasons can be given: (1) Given the decentralized managerial structure of the large public corporation in which division heads make most operating decisions, it is difficult to prove that senior corporate officers had the requisite intent or even sufficient knowledge to satisfy the high mens rea level of most federal criminal statutes; (2) Enforcers prefer to win easy and quick victories by entering into deferred prosecution agreements with public corporations; (3) Jurisdictional issues or the difficulty of extradition may protect senior officers who are outside the country; (4) Juries may refuse to convict lower level officials if they can present themselves as “scapegoats;” and (5) Enforcers face severe logistical and resource constraints, need quick victories to appease Congress and the public, and cannot risk taking a case to trial that they might lose.

This is said not to justify prosecutorial reluctance to pursue individuals, but only to explain that a major shift in prosecutorial behavior cannot be expected.  So what then should be done?

3. Ending the “Culture of Silence.”

If corporate penalties are low (and may not deter even when they are higher) and if a major shift to individual prosecutions is unlikely, some third alternative must be found.  It can, of course, be used in combination with higher corporate penalties and more individual prosecutions.

This third alternative needs to focus on the internal dynamics within the organization to design penalties that will deter.  This can be done in at least two ways.  First, the law could impose a collective penalty on all corporate managers regardless of their individual culpability.  For example, a corporate conviction on a non-trivial charge could result automatically in the suspension of all stock option, stock bonus and similar incentive compensation plans for a period of years.  This threat of collective responsibility should deter corporate executives at all levels and give them a common interest in corporate law compliance.  Indeed, under such a legal regime, the individual corporate executive who did cause the corporation to commit a crime would be seen as disloyal to his fellow executives (because he was subjecting them to serious financial loss).  The key attraction of this approach is that it uses peer pressure (both to cause the individual executive not to violate the law and to motivate all executives to monitor for conduct that could result in a law violation).

To a modest extent, we today have an embryonic form of this collective penalty in the “clawback” provision that the Dodd-Frank Act introduced.[10]  But that provision leaves too much to corporate discretion and is limited in its application.  The goal should be a collective penalty that falls on managers, not shareholders, and imposes on managers a stern civil penalty that motivates them to see corporate law-breaking as a very dangerous course of action.  Obviously, Volkswagen’s officials had the opposite perception of whether violating the law was an acceptable strategy.

A second proposal starts from the premise that Volkswagen was protected by a culture of silence.  Implanting a “defeat device” into eleven million cars cannot be done by a sole engineer or executive; the cooperation of many (probably hundreds) was required.  Perhaps, they saw this strategy as justified because of the U.S.’s imposition of strict emission standards that especially prejudiced Volkswagen.  Whatever the perception of U.S. regulation and whatever the rationalization, the real issue here is how to break down this culture of silence.

The most direct means to this end is to reward officers, employees and other agents to reveal corporate law violations.  The strategy here is to bribe employees to reveal what their company wants to hide.  This approach requires an expanded and redirected system of bounties for whistle-blowers.  Even if the U.S. has much law that protects whistle-blowers from retaliation, these rules do not create any incentive to blow the whistle in the first place.  Although both the IRS and the SEC do reward whistleblowers, this incentive system depends on the agency to pursue the wrongdoer and recover a penalty.  Here, there is a problem. Successful as the SEC’s whistle-blower bounty system has been, the SEC may become so overloaded with useful tips that it can only prosecute a minority of them.  Over time, this may dull the incentive to blow the whistle.  Also, serious misbehavior does not necessarily violate the federal securities laws (indeed, Volkswagen’s stock was not listed in the U.S., although its ADRs are).

The superior alternative then is a defendant-funded system for rewarding the whistle-blower that does not depend on a specific violation.  Consider this alternative: If as little as 5% of the total penalty that Volkswagen eventually pays to U.S. agencies were contributed instead by Volkswagen to a trust fund set up by the settlement agreement to reward whistle blowers, this fund could be administered by trustees selected by the regulators and used to reward whistleblowers at either Volkswagen or any other auto manufacturer. That is, if the total penalty to be paid by Volkswagen were to be hypothetically $2 billion, 5% (or $100 million) could instead be subtracted and paid voluntarily by Volkswagen to this independent trust, whose trustees would have the sole discretion to reward whistle-blowers (perhaps up to some maximum amount per individual—say $2 million) for information they deemed valuable and reliable about misconduct involving auto emissions or other environmental or safety violations by auto manufacturers.  Not only would Volkswagen be deterred, but so might Takata, Toyota and GM (to mention only recent cases).

The beauty of this approach is that Volkswagen is paying to fund the system that will penetrate its culture of silence.  There would be no need that the information produce a conviction or any adjudication at all.  The trustees would be instructed to pass the information on to enforcers and reward those that the enforcers believe provided reliable, useful information.  Eventually, after, say, twenty years or more, any undistributed funds could be given by the trustees to an appropriate charity.

The deterrent value of this approach would lie in the fact that the fund’s existence would be widely publicized.  All Volkswagen employees would know that they could enrich themselves by blowing the whistle, and Volkswagen executives would understand that they could no longer rely on a culture of silence.  Against this backdrop, would they dare ask a hundred or more employees to install defeat devices on 11 million vehicles?

ENDNOTES

[1] For more detailed accounts, see Environmental Enforcement, 28 Environmental Law Reporter 10753 (Dec. 1998). The seven firms were Caterpillar, Inc., Cummins Engine Company, Detroit Diesel Corp., Mack Trucks, Inc., Navistar Int’l Corp., Renault Vehicles, Inc., and Volvo Truck Corp. Given that these firms amounted to most of the industry, knowledge of this practice and its technology must have become widespread.

[2] The complaints and pleadings can be found at ELR Briefs and Pleads. 66601.  For a good journalistic account of the diesel trucks case, see Jeff Plungis, “Carmaker Cheating on Emissions About As Old as Pollution Tests,” Bloomberg, September 23, 2015.  The $83.4 million civil penalty was then the largest on record in an environmental enforcement action.  See “Environmental Enforcement,” supra note 1.

[3] See Plungis, supra note 2, and Joby Warrick, “EPA: Volkswagen used ‘defeat devices’ to illegally skirt air-pollution controls,” Washington Post, Sept. 18, 2015 (discussing Ford settlement). General Motors also used a “defeat device” between 1991 and 1995 to defeat carbon monoxide controls.  See Plungis, supra note 2.

[4] See Rena Steinzor, How Criminal Law Can Help Save the Environment, 46 Envtl. L. 209 (2016).

[5] See Gary S. Becker, Crime and Punishment: An Economic Approach, 76 J. Pol. Econ. 169 (1968)

[6] For example, suppose Company X made a gain of $100 million from illegal misconduct engaged in between 2012 and 2014, but subsequently encountered economic reversals and now has a net asset value of only $80 million. Assume further that the risk of detection is only 10%. On these facts, there is no way an “expected penalty” can be imposed on this entity that exceeds the expected gain from crime. The more its asset value declines, the greater the temptation there is to engage in crime.

[7] See Ben McLannahan, “Banks’ post crisis legal costs hit $300 bn,” The Financial Times, June 6, 2015 (estimating costs at $306 billion since 2010 through the end of 2014).

[8] See Jeff Cox, “Misbehaving banks have now paid $200B in fines,” CNBC.com, October 30, 2015 (the exact figure was $204 billion.

[9] For example, see Brandon L. Garrett, TOO BIG TO JAIL: How Prosecutors Compromise With Companies (2014); Steinzor, supra note 4. This list is endless.

[10] Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act added Section 10B to the Securities Exchange Act of 1934 to mandate “clawbacks” of excess pay in cases involving financial statement restatements.  The proposal here made would not require a financial restatement and would also cover those mass tort cases involving a corporate criminal violation.  Thus, even if no individuals were prosecuted, corporate officials receiving incentive compensation would bear a sharp cost.  To be sure, this might encourage greater use of cash compensation, but here proxy advisors could restrain excess.  For a general review of clawbacks, see Jesse Fried and Nifaan Shilon, Excess-Pay Clawbacks, 36 Iowa J. Corp. L 721 (2011).

The preceding post comes to us from John C. Coffee, Jr., the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.

2 Comments

  1. Tuzoner

    Many software experts suggest that VW didn’t have the technical expertise to write emission defeat software (code) – surmising that Bosch was contracted to write it for VW.

  2. Chris Bonner

    We can expect that such a trust fund will be politically-connected and a source of patronage. Will its regulatory benefit justify its corrupting influence?

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