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A Volkswagen Golf 7 inside the Autostadt at the companys Wolfsburg headquarters

How Hefty a Penalty Can VW Withstand?

Sept. 27, 2016
The Justice Department is reportedly trying to reach a settlement with Volkswagen by January, with the government assessing how much of a criminal fine it can extract from the German auto giant without putting it out of business.

The U.S. Justice Department is assessing how big a criminal fine it can extract from Volkswagen AG over emissions-cheating without putting the German carmaker out of business, according to two people familiar with the negotiations.

The government and Volkswagen are trying to reach a settlement by January, the people said, before a new U.S. administration comes into office and replaces the political appointees who have been overseeing the process.

The U.S. is sizing up Germany’s biggest carmaker at the same time it’s trying to settle a civil case with the country’s largest bank, Deutsche Bank AG — two companies that, together, directly account for more than 320,000 German jobs. In the case of Deutsche Bank, which is seeking to settle U.S. allegations over its crisis-era mortgage securities business, investors are asking whether the Justice Department would seek a penalty so high that it would leave Deutsche Bank short of capital, forcing it into a rushed sale of assets and stock. As the U.S.’s Volkswagen calculations show, the department is showing that in some cases, it will take a company’s financial health into account.

It’s not clear what penalty range the U.S. is considering in the criminal case against Volkswagen. The company had net liquidity of 28.8 billion euros ($32.28 billion) as of June 30, and Chief Financial Officer Frank Witter said his goal is to keep the target for average net liquidity at 20 billion euros ($22.42 billion) to ensure funding needs and to protect the company’s credit rating. The carmaker generates several billions of dollars of cash each quarter and could tap into a credit line or raise capital if necessary to pay its obligations.

Volkswagen has already agreed to pay an industry-record $16.5 billion in civil litigation fines in the U.S. after admitting last year that its diesel cars were outfitted with a “defeat device” that allowed them to game U.S. environmental tests. The carmaker is also on the hook for outstanding civil claims from several states and as much as $9.2 billion in investor lawsuits in Germany, where it’s also under criminal investigation.

A Volkswagen spokesman didn’t have an immediate comment. Peter Carr, a Justice Department spokesman, declined to comment.

“The department doesn’t pick a number in a complete vacuum,” said William Stellmach, a former federal prosecutor now at Willkie Farr & Gallagher LLP in Washington. “There are a number of cases where it has acknowledged that the impact of a financial penalty on a company was a factor in deciding what that penalty should be.”

In criminal prosecutions, the Justice Department may assess the impact of a charge or settlement on a business’s viability, and the resulting effect on shareholders and employees. A prosecution’s potential collateral damage is one of the factors the department considers under principles for prosecuting businesses laid out in the “U.S. Attorney’s Manual.”

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It’s not clear whether the department is making similar calculations as it negotiates a civil settlement with Deutsche Bank over its dealings in residential mortgage-backed securities. The German lender has been under U.S. scrutiny along with other banks over its role in packaging and selling toxic debt that led to the 2008 financial crisis. Fines by the department for mortgage-backed securities alone total $41 billion for five banks, with five more banks yet to settle, including Deutsche Bank. Press reports that the U.S. began negotiations by asking it to pay $14 billion to settle the case rattled markets as investors grew concerned about the bank’s ability to raise capital.

The ability-to pay assessment doesn’t necessarily result in a lower number, according to Stellmach, who isn’t involved in the VW case. Rather, the department can structure an agreement to soften some of the sting, such as an installment plan allowing for deferred payments, he said. Companies can also receive credit for penalties assessed by other regulators or authorities both in the U.S. and abroad.

Cash Flow Absolves a Lot of Sins

VW has plenty of money to meet further fines, particularly because penalties tend to be paid over long time periods, according to Joel Levington, a Bloomberg Intelligence credit analyst.

“Despite all the damage that its reputation has taken, VW is still a company that might be back to generating $5 billion in free cash flow in 2018, and when you generate that kind of cash, it absolves a lot of sins,” he said. The Justice Department began negotiations on the criminal penalty in August, one person said.

Volkswagen has been doing well, despite all of this. Although sales of VW-brand cars fell in the first half of the year, the German manufacturer has benefited from gains by its Audi, Porsche and Skoda brands, as well as its strong position in China. Volkswagen outsold Toyota Motor Corp. in the first six months of 2016, making it the world’s biggest automaker for the period. The sales gains have brought Volkswagen back to profitability this year and sparked a surge in its net liquidity, which is a tally of cash minus debt.

With the diesel-cheating scandal, Volkswagen has become one of the latest companies subjected to a Justice Department calculation of how severe a penalty needs to be to change corporate behavior and deter other businesses from illegal conduct. That analysis includes the U.S. case against BP PLC after the 2010 Deepwater Horizon offshore oil spill. BP paid out about $25 billion to resolve civil and criminal claims, including $4 billion as part of a guilty plea in 2012. The government is following the Deepwater playbook in the current case, one official said after the government filed its civil claim in January.

Volkswagen, like most carmakers, also has a financing unit, which offers buyers loans or lease packages when they are ready to buy their cars at a dealership. Should the company’s cash level fall too low, it could spark ratings downgrades by credit agencies, which risks increasing the costs of that unit.

Standard & Poor’s Ratings Services said in a note in February that it would consider lowering the carmaker’s rating only if its litigation costs exceeded 40 billion euros ($44.84 billion) or if its legal costs caused a severe negative impact on the company’s liquidity position, a scenario it considers unlikely.

By that measure, after U.S. civil penalties and accounting for maximum damages in German lawsuits, the company would still have a cushion of about $20 billion to absorb other litigation and investigation-related expenses.

Volkswagen is currently rated BBB-plus by S&P, three levels above junk. S&P has warned that it may cut Volkswagen’s rating further. “The negative outlook is still there and that reflects the risks that there could be more charges,” said Alex Herbert, the London-based analyst who wrote the February report.

Alcoa Inc., which the Justice Department said got a benefit of more than $400 million from a foreign bribery scheme, paid a $209 million criminal fine in 2014 after prosecutors considered the effect of the size of the penalty on Alcoa’s ability to fund capital expenditures, research and development and pension obligations, and the company’s “substantial cooperation” and its anti-corruption efforts, court documents show.

By Tom Schoenberg and Alan Katz

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Licensed content from Bloomberg, copyright 2016.

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