Investors Finally Get a Glimpse Into the Details of Volkswagen’s Diesel Scandal Settlement

The word of the day is "settlement" for Volkswagen (VWAGY 1.26%). Last week, the auto company settled in court for a number of fines, which ultimately boil down to "don't use test-sensing software to cheat your way out of regulations compliance."

In this industrials segment from the Industry Focus podcast, Sean O'Reilly and John Rosevear talk about what exactly Volkswagen was doing to cheat on the tests, why it's such a huge deal (especially in the U.S.), just what the company is settling on, what it is doing to offset the damage it did, how much this is ultimately going to cost the company, and more. 

Sean O'Reilly: Joining me on-air via Skype is Motley Fool's senior auto specialist John Rosevear. John, what is the good word? 

John Rosevear: The good word today is "settlement," as in Volkswagen's. 

O'Reilly: Yeah. We're not talking about energy like we always do, it seems, on this show. We're talking about something that I don't think we did on the energy, materials, and industrials show enough, which was the Volkswagen scandal that came out -- was that, what, six months ago? 

Rosevear: Yeah. It was in September that the world first learned about it. There'd been an investigation and a back-and-forth going on for a long time. What happened was the EPA and CARB, the California Air Resources Board, which is a powerful regulatory agency, charged Volkswagen with using what they called "defeat devices" in certain of their diesel engines that they sold in the U.S. "Defeat device" is a technical term under the Clean Air Act. It means basically you're skirting emissions controls somehow. What VW was doing was they had programmed the car's software to turn on the emission controls connected to the engine only when the car detected that a government emissions test was happening, and there were certain ways where they could reasonably do that. 

This is a huge thing. This affects, in the U.S., about 482,000 VW and Audi vehicles sold from 2009 to 2015. I mean, there are millions of these things worldwide, about 11 million in total. The issue, and the reason, it's such a big deal in the U.S., is the specific flavor of emission controls that are relevant to diesel. Diesel engines that don't have clean-air systems on them cause smog. They emit nitrogen oxides, and that's what causes smog. This is why California hates it so much. If you're of a certain age like me, you'll remember when L.A. was a smoggy mess. Now it's only lightly smoggy. That's because the California Air Resources Board has been so militant about cleaning all this stuff up. They're furious, the EPA is furious, it's a flagrant violation. They went back and forth for months with VW to get to a settlement, and that's apparently what we got this week. 

O'Reilly: Yeah. When this came out, I was like, "You cannot make this stuff up." It's staggering! John, why'd they do it? 

Rosevear: Well, think about a top-down hierarchical German company, and almost in some movie stereotypes here, where they came in and told the engineers, "You will design clean diesels, they will hit these performance and fuel economy targets, and it will cost this much." The engineers went round and round and round, and decided they couldn't do it. Somebody -- and it is still months after all this broke, it's still unclear who exactly authorized this and how high up the decision went inside VW -- somebody decided, "All right, we'll create a workaround, a cheat." 

O'Reilly: No heads have rolled. 

Rosevear: Some heads have rolled. The CEO, Martin Winterkorn, left a couple days after this broke. He was replaced by Matthias Mueller, who had been Porsche's CEO, and Mueller has been trying to get his arms around this thing, and it's been quite something. He seems pretty capable, but there's a lot here. 

O'Reilly: I don't know if anybody could handle this. Just got the settlement very recently. What is in there? What does Volkswagen have to do to make this right? 

Rosevear: First and foremost, it's a ton of money. They're going to make it right with...Well, let's back up a second. What they're settling, first of all, are the charges from the EPA, the charges from the California folks, a separate set of charges from the Federal Trade Commission, who said: "Hey, you were advertising clean diesels. Now we've got you on false advertising." 

O'Reilly: Oh my gosh! 

Rosevear: Most of it was a series of class action suits that were consolidated all together with all of these civil claims from the government in one giant court case in California -- suits by the owners basically saying: "Hey, now my car's worthless. What the heck?" 

O'Reilly: Yeah! 

Rosevear: "I bought it on these premises." First and foremost, VW is setting up a settlement fund that will have a maximum value of just over $10 billion. This is to compensate owners. All owners will get a cash payment of between around $5,000 and around $10,000. 

O'Reilly: That almost doesn't seem enough. 

Rosevear: Yeah, well, wait, wait...But wait, there's more! In addition, VW will offer to buy back the cars at their book values as of mid-September, the day before the scandal broke, basically. 

O'Reilly: Oh, wow! 

Rosevear: Whatever they were worth before this news hit the world wires. They will buy back the cars. Alternatively, if customers say, "Well, I want to keep their cars!" VW will come up with some way to fix them so that they comply with the Clean Air Act. It is notable that VW and the feds and California have not yet agreed on any sort of fix that will actually fix the cars. 

O'Reilly: Hold on...How are they going to...Why didn't they just do that in the first place? 

Rosevear: Right. 

O'Reilly: That doesn't make any sense to me! 

Rosevear: Yeah! 

O'Reilly: Now, is it true that these, the diesel engines and everything, is it true that they are actually so good with their fuel efficiency that everybody was so impressed and that's kind of how this came about? They were like: "Wow, this is really awesome! How did they do this?" 

Rosevear: It's not just the fuel efficiency. Those of us who are old enough to remember the first round of Volkswagen diesels in the 1970s, those cars were really slow. They were way fuel-efficient, but they were really slow, and they were stinky and noisy. 

O'Reilly: Got you. 

Rosevear: These cars are not slow. They drive like German sedans. My neighbors have a Jetta, a 2015 Jetta, with one of these engines. It's a nice car to drive, actually. It's smooth, it's-- 

O'Reilly: What have they said? Do they want the buyout? What are they doing, your neighbors? 

Rosevear: They have it on a lease. Alternatively, people who have leased the cars can just turn the car back in. 

O'Reilly: As they should. 

Rosevear: No penalty, nothing, done. That's what they're going to do pretty much the moment they get the form in the mail or whatever. That's what they're going to do. 

O'Reilly: Got it. 

Rosevear: That's the big chunk of it. There's also some other parts. VW has agreed to pay $2.7 billion over the next three years essentially as a fine, but the fine will go into what they call an environmental trust. What this will do is make grants to clean-air projects that are sponsored by state governments or something like that. The idea is that that will help offset the impact of all the excess emissions from these 482,000 cars that have been spewing into the U.S. air since 2009. 

They also agreed to invest $2 billion over 10 years in zero-emissions vehicle infrastructure access and awareness initiatives. This is interesting. Some people are looking at this and saying: "OK, so VW is being forced to build a competitor to Tesla's supercharger network," which -- VW doesn't have much of an electric car program yet. They've got a lot coming, but it's-- 

O'Reilly: This is hilarious! 

Rosevear: It is hilarious. Meanwhile, General Motors (GM 0.69%) is about to roll out the Chevy Volt. Next year there will be a new Nissan Leaf with...Next year or the year after. Sometime soon, there will be a new and improved Nissan Leaf with similar range to the Volt, like 200 miles. Tesla's Model 3 is coming. They've got to build out this recharging infrastructure, basically, in the U.S., $2 billion worth. 

There are also another set of payments that total around $600 million that settle claims filed by states attorney general as well as Puerto Rico and the District of Columbia, you know, the usual stuff that the attorney generals hop on when this stuff happens. 

If everybody opts for the buyback, it costs $15.3 billion, give or take a few million. 

O'Reilly: Wow! 

Rosevear: Yeah. 

O'Reilly: That is a chunk of change. 

Rosevear: That's a big chunk of change. 

O'Reilly: That's BP Deepwater Horizon money right there. 

Rosevear: Yeah. It's far more than GM had to pay for its recall scandal, it's far more than Toyota (TM 0.70%) paid for the unintended acceleration mess several years ago. The differences here, there are a couple differences between those. One of them, of course, is there was criminal intent here. 

O'Reilly: Yeah. 

Rosevear: They set out to violate the Clean Air Act, whether that's a crime or not. There was intent to break the law. Whether it's a civil violation or criminal violation has yet to be fully litigated. Whereas GM some people blundered, and likewise at Toyota, it seems like some people blundered. That's the difference between a mistake and intent before the act. 

It's also simply a fact that they can't fix the cars, they've got to buy them back. 

O'Reilly: Got it. 

Rosevear: Right? 

O'Reilly: Yeah. 

Rosevear: You know, if there was an easy way to just recalibrate the software that kept most of the good virtues of the cars and cleaned up the air, first of all, they would have done that before 2009 when they released them. Second of all, they could just do that.