Ron Baron Comments on Volkswagen

On September 23, 2015, following discussions that lasted months between U.S. regulators and Volkswagen (XTER:VOW) about the car company’s diesel emission test results, the automobile manufacturer recanted its assertion that it had done nothing wrong. Volkswagen then admitted it had purposely installed “emission test defeating” software in more than 11 million diesel powered cars it had manufactured and sold between 2009 and 2015. Without this software, nitrous oxide emissions by Volkswagen’s diesel powered automobiles would have tested 35-40 times higher than permitted by law! Nitrous oxide is a pollutant that poses significant health dangers. Probably dozens, perhaps hundreds, of Volkswagen’s engineers and executives developed and installed this software. Many more probably knew about it.

“Where were the whistleblowers?”

Volkswagen is the largest automobile manufacturer in Europe. It produces 10 million cars annually. The company employs more than 600,000 workers worldwide, more than 300,000 in Germany alone. Volkswagen is the largest employer in Germany and one of that nation’s most important businesses.

Volkswagen apparently was unable to simultaneously meet increasingly stringent auto emissions and greater fuel economy standards required by regulators without adding materially to the cost of its diesel cars and negatively impacting its performance. Volkswagen’s diesel engines achieved fuel economy, an important feature to consumers, only by cheating with “emissions test defeating” software. The emissions tests were administered by testing companies hired and paid by Volkswagen. The tests took place in laboratories, not on roads, and used different car models than were sold to the public!

The big question, in our minds, is that since many individuals may likely have known that Volkswagen’s software illegally permitted violation of emissions and fuel economy standards, why didn’t anyone say anything? Where were the whistleblowers? Did Volkswagen’s culture, like that of General Motors’ regarding its faulty ignition switches and Toyota’s regarding its faulty braking systems, condition them to obey authority despite understanding they were aiding and abetting business executives to intentionally violate the law?

“It comes from the top.” Steve Cutler. General Counsel. J.P. Morgan. Former Director of Enforcement. U.S. Securities and Exchange Commission. 1993.

In 1993, the former SEC’s Director of Enforcement tried to explain that the culture of a business is created by its senior executives. That is why those executives and their general counsels take such care to outline “roadmaps” for employees’ behavior rather than provide them with explicit “directions.” It is also the job of senior executives to hire individuals having good character. “Character is what you do when you think no one is watching,” according to Roy Furman, the Vice Chairman of Jefferies, the institutional investment banking firm. Roy has been my friend since I met him in 1969 when I applied for my first job as a Wall Street securities analyst…which I didn’t get at his firm. Anyway, every year Roy now welcomes Jefferies’ new employees with a brief talk. “Reputation is what you earn from everything you do,” he tells his recruits. “Most individuals feel their interview ends when they get a job. That is not true. Your interview continues throughout your career. Everyone is watching everything you do every single day. Those actions create your reputation. That is also an ‘interview.’ ” It is shocking to me that at large firms like Volkswagen, General Motors, Toyota, and many others…when many had to know their firm was doing something wrong, no one spoke up!

A friend of mine is a senior partner at one of New York’s top law firms. He recently visited me for lunch. He told me he had significant liquidity and wanted to consider investing some of it with us. As our lunch meeting was ending and he was preparing to leave, he told me that he invests based on his assessment of an individual’s character and a firm’s culture. I was proud when he told me he was going to invest with us. He chose to invest with us for the same reason we choose to invest in businesses…our assessment of executives’ characters and firms’ cultures. We believe this approach provides us with a competitive advantage over passive investors who do not do this.

From Ron Baron (Trades, Portfolio)'s Baron Funds shareholder letter Q3 2015.