Anderson Economic Group Work

Auto Dealers and the VW Emissions Crisis: Some Early Advice from a Damages Expert

By Patrick L. Anderson
Originally published in the National Association of Dealer Counsel (NADC) “Defender” newsletter, October 2015

The revelation that Volkswagen had systematically evaded emissions regulations on certain diesel-engine vehicles sold in the U.S. and Europe stunned the auto industry. For many auto dealers—particularly Volkswagen dealers—it was more than a shock; it was an event with potentially severe economic consequences.

Given the structure of the franchised automobile industry in the United States, it is almost certain that an event that causes this much damage to the brand equity of the franchisor will also affect negatively the franchisees. Furthermore, there are already unambiguous costs that VW’s actions have imposed upon its franchised dealers. Thus, it is not premature to consider how dealers might be damaged, and how counsel to auto dealers might prepare for claims regarding these damages that might be made in the future.

Of course, at this early stage, much of the information needed to estimate damages properly is not yet available. However, based on our experience in estimating commercial damages for franchisees, as well as observing how U.S. courts have approved damages awards, we can suggest some critical factors to watch and a few steps that some dealers will want to take immediately. In addition, we can identify a small set of past damage cases that might provide a model for compensating both consumers and businesses over the next several years.

Here are five such recommendations to dealers and their attorneys at this early stage:

  1. Do not jump to conclusions yet about the scope of the scandal, the remedy for the affected parties, or the way in which dealers will be treated. 

The EPA issued a Notice of Violation to Volkswagen, specifically accusing it of violating U.S. laws (two provisions of the Clean Air Act) that carry potentially ruinous total penalties. The evidence for at least a narrowly defined violation of the law appears incontrovertible at this point; the EPA flatly asserts that VW has “admitted that the cars contained defeat devices.” Furthermore, Volkswagen’s board has now both implicitly and explicitly accepted responsibility for evading U.S. emissions standards.

However, there are still quite a few key facts that are not known. These include:

  • Will more vehicles be found noncompliant? 

The EPA’s September 18, 2015 Notice of Violation lists 4-cylinder VW (Golf, Jetta, Beetle, and Passat) and Audi (A3) vehicles with “TDI” diesel engines. However, the portfolio of diesel-powered vehicles that contain VW engines, engine management software from VW’s supplier, or related components is larger. Furthermore, the “defeat device” the EPA cited in its Notice is actually a “software algorithm.” Because there are many “software algorithms” that affect emissions in a vehicle, and as these algorithms are designed to maximize performance within some kind of mileage or emissions constraints, more affected vehicles could emerge from the intense scrutiny now facing VW and potentially other manufacturers. In fact, at least a small increase in the number of affected vehicles has already occurred: the use of an “auxiliary emissions control device” on some 2016 models was acknowledged in mid-October by VW, which decided to delay the introduction of the models while it examines the software.

  • What will be VW-owners’ reaction to VW’s noncompliance?

Public reaction to the scandal has been swift, negative, and harsh. VW’s iconic brand image has clearly been tarnished, if not seriously damaged.  Its classic 1970’s-era advertising (such as the “lemon” ad) have now been parodied by cartoonists (such as Henry Payne of The Detroit News) and by magazine editors (such as those of The Economist, which put a smoke-belching Beetle on its cover.)
However, public reaction is not the same as the reaction of car owners that have already selected that brand. Recall that some widely-criticized vehicles (such as GM’s Hummer, the Pontiac Aztek, “gas guzzling” large SUV’s, and, yes, the VW Beetle back in the 1970s) remained popular among a small group of consumers. Many VW owners are clearly unhappy, if not outraged. These owners will probably be selling their VWs, and buying another brand. What everyone else will do is not yet clear—partially because of the next question.

  • What will be the mechanical fix proposed by VW, and how will it affect vehicle performance?

VW is under intense pressure to recall, and fix, its nearly half-million vehicles covered by the EPA notice in the U.S. At the same time, the number of VW vehicles on the road worldwide with similar problems is at least 20 times larger (and has been estimated at 11 million). The future recall and repair effort will be a huge undertaking; VW’s U.S. CEO, in October testimony to congress, indicated he felt it could take more than one year.
However, it is important to remember that it is consumers, not the manufacturer, that decide whether to participate in a recall. In the past, a significant fraction of consumers simply ignored recall notices, even though the promised repairs would be done free of charge. (Such consumers, of course, also valued their own time, so they did not view the repairs as truly “free.”) In this case, a substantial share of owners may refuse to have a “fix” installed if they perceive that it would improve emissions, but reduce the vehicle’s performance.  Indeed, VW’s congressional October testimony suggests that the forthcoming repair will affect performance at least slightly.

The answers to all these questions will affect VW dealers as well as VW owners.

  1. Start keeping records now regarding any “stop sale” vehicles; related floor plan, storage, and related costs; and any reimbursement from VW.

One unambiguous cause of damages to dealers is the cost of holding vehicles covered by the “stop sale” order on 2015 and 2016 TDI vehicles listed in the EPA notice. The EPA asserts that sale of the new vehicles covered by its Notice of Violation is not allowed, but advises owners of vehicles sold in the past that “the cars remain legal to drive and resell.”

For VW and Audi dealers that hold such “stop sale” vehicles in inventory, we advise that they record related storage, floor-plan, and other costs for use in any future damages claim. Dealers should also keep track of any assistance or payments received from VW in the aftermath of the diesel scandal. Such records should, wherever possible, be compiled using the same practices as the dealership normally follows.

  1. Dealers should be prepared to identify any changes in value of used-car inventory, new-car inventory, or service revenue that appears to have been caused by the VW emissions scandal.

Because of the unknown factors listed above, we can’t yet confidently predict that VW dealers will suffer significant damage in the future on their inventory of vehicles that are not directly affected by the current (and any future) EPA notices of violation.

However, it is likely that car buyers will, at least for some time, demonstrate a reluctance to buy any VW diesel, and indeed any diesel vehicle. In October, Kelly Blue Book estimated a 13% drop in resale value of used VW TDI models. Thus, it is almost certain that VW dealers (and others holding VW diesel models covered by the EPA notice) have suffered at least some short-term financial losses.

We can observe that this occurred during widespread media coverage, which may or may not signal a persistent loss in value of used VW products. However, to the extent this signals a persistent loss in customer willingness to buy diesels; it will affect VW, Audi, BMW, and even Porsche and Chevrolet dealers, in addition to some truck dealers.

VW’s U.S. CEO, in October testimony, has already acknowledged that the company may compensate owners for a loss in value of their diesel vehicles. It is possible that dealers may ultimately be compensated for loss in inventory value, and if so, it will be important to be able to demonstrate that loss. We discuss the quantification of such losses further below.

  1. Dealers should remember to represent the brand and the products and services their local customer’s desire, consistent with laws and the franchise agreement. This imperative will mean different decisions to different dealers.

The genius of the franchise system is that local dealers are incentivized to sell products that their local customers need, which varies considerably across the country. In this unusual situation, we should expect that some customers will react differently than others. Dealers must take action to ensure they serve their customers and stay in business. For some dealers, that will mean moving quickly to reduce diesel vehicle inventory and focus on other vehicles; for other dealers, their local customers may just want the diesel problem fixed.

Franchise agreements require a dealer to represent the brand in its local area. That will be challenging for many VW dealers in the near future, especially with new car sales. Dealers should be ready to recognize the reaction of their local customers to this evolving situation, and take the appropriate course of action.

  1. Attorneys should closely watch a handful of significant cases where damages were awarded to franchisees and consumers.

Volkswagen will undoubtedly be forced to pay a large penalty for its actions, and indeed has already set aside over $7 billion (USD) for this purpose. Attorneys who represent dealers, consumers, and others affected by VW’s actions may want to consider how damages were awarded in a handful of significant cases that provide some guidance for upcoming VW cases. Although we acknowledge again the questions that remain unsettled for the VW matter, there are a handful of signal cases worth noting for potential claimants against VW:

For consumers owning VW vehicles, potential damages could follow one of these models:

  • A first candidate is the 2013 settlement in the Toyota case, in which “sudden acceleration” was alleged to have affected some vehicles, and where the resulting negative publicity reduced the resale value of many Toyotas. Toyota denied that sudden acceleration was caused by its products, and agreed in a settlement to pay for “alleged diminished value.” Toyota set aside (in addition to other amounts) a specific payment of $250 million was made into an escrow fund for payments to consumers. Expert testimony on the effects of “adverse publicity” was used as the basis for diminished value estimates.
  • A second candidate is the settlement in the overstated fuel-economy case involving Hyundai and Kia vehicles. A 2014 tentative settlement agreement proposed payments to current and past owners, based on a formula that implicitly assumed the owners kept the same vehicles for a very long time. The “lifetime reimbursement program” in the tentative settlement agreement allows a motivated owner to request reimbursement multiple times over multiple years, or receive a lump sum payment.
    As has been pointed out by an Anderson Economic Group expert, this approach provides compensation to owners that are only partially related to their actual loss. Some owners sustained minimal damages (those driving few miles or who sold their vehicles without any loss in value), and others sustained much higher losses. Furthermore, it ignores the fact that owners can choose to retain, or sell, such vehicles, and their own mileage expectations will play into those decisions.
  •  A third candidate is the settlement, scheduled to be approved in late October 2015, of the Beck’s beer case, which involves misrepresentation of the country of origin of the iconic German brand of beer, Beck’s. In this matter, the court is likely to approve a settlement based on the damages theory that consumers should be compensated for the difference in the retail price between a premium U.S. beer and a premium German beer. Expert testimony (in this case, given by me) provided the basis for these damages estimates.

This is analogous to a similar theory for VW diesel owners: they are damaged by the difference in the resale value of the vehicles.

These three recent cases suggest forms of reimbursement that may ultimately be available to VW dealers and VW owners, and also underline how careful work in establishing the basis for actual damages can have a strong effect on the equity of the resulting remedy.

There will be much more to occur in the VW emissions saga. These recommendations should help forward-thinking attorneys and their clients take some positive steps early in the game.

Patrick L. Anderson is Principal & CEO of Anderson Economic Group, a consulting firm with expertise in the automotive franchise industry and in commercial damages. Their experts have assisted hundreds of auto franchisees and their attorneys, as well as selected franchisors in multiple industries, across the United States. Extended and additional information on the VW matter, including additional references on topics discussed in this article, is available from the Anderson Economic Group website.