RPT-SPECIAL REPORT-Inside Toyota's epic breakdown

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* Recall of 8.5 mln cars raises questions about Toyota Way

* Critics blame rapid expansion for carmaker's woes

* U.S. regulators urged action during December visit

By Nathan Layne, Taiga Uranaka and Kevin Krolicki

TOYOTA CITY, Japan/DETROIT, Feb 9 (Reuters) - Toyota Motor Corp, the world's most dominant and profitable automaker, was not accustomed to outsiders telling it what to do, let alone some obscure bureaucrat from the United States, whose own car industry was on taxpayer-funded life support.

But in the middle of December, on a cloudy day in the middle of the Japanese archipelago's main island, Ron Medford, the acting head of the U.S. agency that regulates auto safety, was reading Toyota executives the riot act.

Medford had been quietly dispatched by the Obama administration to deliver a firm message: Toyota, he told them, had better get its act together, according to U.S. regulators.

By the time Medford arrived in Japan, Toyota was working through a recall that would involve over 5 million vehicles in the United States. The problem was mundane but potentially lethal: floor mats were trapping the accelerator pedal.

U.S. safety regulators had tied five deaths to accidents where that seemed to be the cause, and there were growing doubts about whether the Toyota floormat and pedal design -- a relatively cheap fix -- was the only flaw that needed to be addressed.

Over the prior seven years, the number of U.S. consumer complaints about unintended acceleration in Toyota cars had been steadily climbing, hitting 400 reported cases for the 2007 model year, according to an analysis of National Highway Traffic Safety Administration (NHTSA) data.

But five previous investigations into Toyota opened by NHTSA under the Bush administration had hit a dead end, with no action taken. Two safety probes resulted in relatively cheap floormat recalls by Toyota in 2007 and early 2009. Neither attracted much notice.

In the closed-door meeting in Nagoya, Medford told four Toyota executives that the automaker was moving too slowly in addressing safety defects under investigation by U.S. authorities. He said he wanted changes, and he wanted them fast.

NHTSA regulators, who face new scrutiny for the agency's response to consumer complaints about Toyota vehicles, provided an account of the watershed meeting to Reuters.

One of the Toyota officials in the room, Chris Santucci, had spent two days the week before in a deposition room being grilled by lawyers for the family of a 77-year-old Michigan woman who was killed in 2008 when her Camry took off uncontrollably and slammed into a tree just four blocks from her home.

Medford's warnings went unheeded. By late January, Toyota's safety problems would explode into a crisis that has battered its finances and shaken consumer confidence in one of the world's best-known brands and an icon of Japan's spectacular post-war economic success.

Since the American team's visit, an additional 4.7 million Toyota cars have been recalled globally, the largest safety action ever for the automaker. Reported problems with acceleration now shadow the Camry, the plain-vanilla sedan that powered Toyota's success in the 1990s, and braking glitches threaten to unplug the Prius, Toyota's green "halo car" for a new era.

What's more, critics charge that the automaker still has not come to terms with the root causes of the safety issues and it has only just begun to acknowledge how badly it has lost its way.

"Anybody working on the Toyota assembly line can pull the cord and stop the line if there's a problem that needs to be fixed," said Ed Hess, a business consultant and professor at the University of Virginia who has studied the risks of growth for big companies. "Why did it get to where we are now? Why didn't somebody at Toyota pull the cord?"

Versions of that same question are being asked on Wall Street and on Capitol Hill -- as well as in Toyota City, a company town where veteran workers confronted the crisis with a sense of shared responsibility that the carmaker has prided itself on fostering.

"We are not sitting on our hands in Japan," said a 30-year veteran production manager at Toyota at a bar in Toyota City where the automaker's recalls dominated the chatter. Said another worker: "We have a sense of crisis. How can we not with all the media attention? Everyone feels that way."

On Feb. 24, the U.S. House of Representatives Oversight Committee is set to grill U.S. Transportation Secretary Ray LaHood and Toyota's senior U.S. executive, Yoshi Inaba, about why Toyota's safety complaints appeared to have spiraled out of control and whether the causes have been fully identified.

A day later the House Energy and Commerce Committee will hold its own hearing on the Toyota safety crisis.

"I just don't accept that Toyota couldn't put the dots together," said Joan Claybrook, former administrator of the National Highway Traffic Safety Administration and one of the expert witnesses called to testify in Congress.

In a sense, insiders say, Toyota has become a victim of its own dizzying success.

Consultants, suppliers, dealers and analysts say fast growth strained the company's resources to breaking point. The additional stress of achieving near constant cost reductions in parts added to the pressure.

Others say a hint of complacency crept into dealings with outsiders as Toyota moved toward taking over the industry's top spot by sales in 2008 from General Motors. The protracted back-and-forth with U.S. safety regulators on the acceleration complaints also suggests an organization hunkering down against change, critics say.

"Toyota used to be a great listener," said one consultant who asked not to be named because he still has business with the company. "But about three to five years ago, there was something that suddenly shifted. There was a view that nobody outside Toyota had the answer. It got to the point where the organization was hearing, but not listening."

When crisis hit in late January, Toyota stumbled to provide a clear message to consumers and investors. The company's secrecy and tendency to centralize decision-making in Japan contributed to the public relations debacle, experts say.

"Toyota had the perfect model for the 1980s and 1990s, but its approach now looks outdated," said Stefan Lippert, a business professor at Temple University in Japan. "The concentration of decision-making at headquarters is one of the factors behind Toyota's problems right now."

GETCHA BOOTS ON

One of the organizing principles of Toyota's industrial ideology is that you have to "genchi genbutsu" a problem. In Japanese that means you have to go to the place, to touch the thing itself. You have to meet the customer, lift the hood, get your hands dirty. Walk, don't talk, Toyota instructs its workers.

It is a phrase that Akio Toyoda, grandson of the company's founder, is fond of trotting out. "Quality is Toyota's lifeline," he said in his first public appearance in the United States after becoming Toyota's president in June.

In its relentless quest for quality, said Toyoda, the company had to live and breathe the two big ideas that had made it great: "customer first" and "genchi genbutsu."

Some of Toyota's first U.S. production workers hired for its flagship plant in Kentucky two decades ago joked that they heard that latter phrase differently in English. To them, it sounded like "Getcha boots on."

After three months of busy and sometimes frustrated exchanges with Toyota's U.S. staff on safety issues, the U.S. Department of Transportation decided last December to try a very Toyota tactic to get the automaker's attention. Medford got his boots on and headed to Japan.

In a crowded meeting hall in Toyota's headquarters on Dec. 15, Medford and two other senior NHTSA officials first delivered what amounted to a remedial lesson in U.S. safety regulation for about 100 Toyota engineers and executives, a primer in how the system is supposed to work.

Then the Americans retired to a conference room to hammer home the no-nonsense warning to a smaller group.

Across the table was Toyota's top officer in charge of quality, Hiroyuki Yokoyama, and the head of the engineering team that handled consumer complaints, Shinji Miyamoto. In a company that built its reputation on an almost paranoid obsession with quality, Yokoyama and Miyamoto were the keepers of the flame.

Toyota knew that NHTSA officials were also scheduled to meet with Honda and Nissan and Japan's transport ministry so they were blindsided by this kind of tough meeting.

"At that point we weren't expecting the discussions to have any deep meaning because at that point we had already dealt with the floormat issue," Toyota Executive Vice President Shinichi Sasaki said.

Toyota officials in the room with Medford suggested that perhaps the placement of floormats was responsible for the unintended acceleration cases that had drawn tougher scrutiny from the U.S. side.

NHTSA officials chastised Toyota for "still talking in those terms," Sasaki recalled.

The irony of the moment was rich. This was a little-known U.S. official in an arm of the government most Americans could not identify lecturing Toyota about quality. The same U.S. government that had bailed out General Motors and Chrysler just four months earlier was excoriating Toyota for falling short.

Santucci, a former NHTSA investigator who joined Toyota in 2003, had flown to Japan from Washington for the tense meeting.

He had been expecting the same broad presentation that officials had given to automakers in China and Russia, both risk-heavy newcomers without a sales presence in the United States, he had said in his deposition a week before.

But this was Toyota. This was the auto company that revolutionized factory production in the 1960s, launched a luxury brand in the Lexus against the odds in the late 1980s, and then confounded skeptics again in the 1990s by delivering the Prius and turning itself into a byword for environmental stewardship.

By 2009, Toyota had become an economic powerhouse with over 300,000 employees. In the United States, where it employed over 35,000, it stood at the center of a web estimated at over 380,000 auto sector jobs including dealers and suppliers.

For all the company's success, Toyota workers were still being rallied to achieve the impossible. Toyota president Katsuaki Watanabe, who held the top job until June 2009, would tell them to build a car that can go from New York to California on a single tank of gas. Build a car that makes the air cleaner or one that makes the driver healthier, he would say.

Fast-forward a few months and the picture could not be more different. By February, Toyota was in full retreat. After two weeks largely out of the spotlight, Toyoda called a hasty press conference in Nagoya to apologize.

Toyoda, who earned an MBA from Babson College and had worked for Toyota in California, struggled to provide an English-language soundbite when prompted. "Believe me, Toyota's cars is safety but we try to increase our product better," he said. "This kind of procedure is good for the customers." The awkward clip played on CBS News and cycled through YouTube.

By Super Bowl Sunday, two days later, Toyota had refined the message in a TV commercial. The spot harkened back to Toyota's more than 50-year-history in the U.S. market with images of happy families. "In recent days, our company hasn't been living up to the standards you've come to expect from us -- or that we expect from ourselves," an announcer said.

On Tuesday, the Washington Post ran an editorial comment by Akio Toyoda, a day before the first congressional committee had been scheduled to meet. "As the president of Toyota, I take personal responsibility," he said, promising a "top-to-bottom" review of the company's operations.

What he didn't answer is how this had happened. The company's dictum holds that workers have to ask why ("naze" in Japanese) at least five times to get to the bottom of a problem. It is not yet clear how many "nazes" have been asked by management.

CRACKS IN THE ARMOR

In October 2007, Dave Champion, director of auto testing for Consumer Reports in Connecticut, was confronted by a shocking result from the magazine's influential survey of subscribers. "After years of sterling reliability, Toyota was showing cracks in the armor," Champion recalled. In a bombshell, the non-profit magazine dropped the V6 version of the Camry and two other vehicles from its recommended list.

About the same time in Bloomington, Illinois, a team of number-crunching accident investigators was seeing a worrying pattern. A team known as CRASH at privately held insurer State Farm had noticed a spike in accidents involving Toyota vehicles including the top-selling Camry.

State Farm, the largest U.S. auto insurer, notified U.S. regulators of the pattern. "If we believe a vehicle played a significant part in causing damages, we go back to the manufacturer," said spokesman Kip Diggs. "We tell them 'We believe your product is faulty and you need to pay us for the damages.'"

"When you start to see significant claims activity that indicates there may be widespread problems with a product, that's when you go to NHTSA," said Diggs. "There had to have been significant activity, a noticeable trend for that to happen."

Elsewhere, Toyota insiders and rivals had also begun to note other signs of distress in an organization that had started the decade with a goal to double its global market to 15 percent. The implicit outcome was understood by everyone in the industry: overtaking GM as No. 1.

On the cusp of hitting that benchmark, some inside Toyota began to worry. To their minds, the goal had always been intended as one of Toyota's audacious stretch targets, like Watanabe's vision of a car that would clean the air. Toyota had even dropped it as a target, but now it was happening. "We feel more comfortable being behind someone else and not No. 1," said Yoshi Inaba, who was summoned out of retirement to set right U.S. operations.

By 2007, Toyota's U.S. sales had rocketed by 80 percent from the start of the decade. Market share had almost doubled from just under 9 percent to 16 percent. In unit sales terms, it was as though Toyota had absorbed a second automaker the size of Honda and the bulge was still moving through the snake.

"The checks and balances started to break down," said Vikas Sehgal, an auto industry expert and partner at Booz & Co. "At some point, the dis-economies of scale come into play."

At the same time, Toyota found itself struggling to inculcate newcomers in the company's unique culture -- The Toyota Way. Kazuo Akatsuka, 55, saw the generational change first-hand and worried at the signs of change at the Tsutsumi plant where they build the Prius.

Akatsuka worried that a new crop of temporary workers, some sporting piercings and dyed-hair, might just be working for a paycheck. They might not have bought into the Toyota Way, he said.

"The people that were so precise, the people that sweat and built this company are no longer here. And to a certain degree I feel that passion has not been passed on," he said. "I feel like that attention to quality is gradually being forgotten."

To keep the Toyota Way alive, workers have long carried booklets that include distilled wisdom from Sakichi Toyoda, a self-taught inventor who founded the textile equipment maker that preceded Toyota, and his son, Kiichiro, who drove it into the auto industry in 1937.

Over the years, the Toyota Way evolved as an odd mix of the homespun and the borrowed. Some advice -- "be faithful to your duties ... be practical and avoid frivolousness" -- seemed a relic of hardscrabble Japan. The constant battle to kill waste ("muda") produced the company's legendary frugality.

Other insights arrived from abroad. Eiji Toyoda, Kiichiro's cousin and the Toyota leader who steered its first big wave of U.S. sales growth, toured Ford Motor Co and returned home with the idea for improving a worker's suggestion box he had seen. And so, the company legend goes, was born "kaizen," the ethic of constant improvement.

The inspiration for Toyota's just-in-time production system was a post-war visit to the American grocery chain Piggly Wiggly, where self-taught engineer Taiichi Ohno watched shelves restocked as soon as consumers emptied them.

Five decades later, The Toyota Way became a culture unto itself, deeply Japanese but even more deeply Toyota. By 2007, the company ran a Toyota University in California and a Toyota Institute in Japan to teach Toyota how to be Toyota.

Jim Press, the first non-Japanese to be appointed to Toyota's board, had mused in 2006 that the focus on culture made the automaker "kind of like a country ... sort of a society within itself." At the time, Press was seen as an embodiment of Toyota, a soft-spoken man from Kansas with a self-effacing style. "Thank you for your interest in our little car company," he liked to say in greeting reporters.

In September 2007, in a move that shocked industry watchers but now seems to have underscored the pressure on Toyota to hold it all together, Press defected for a chance to help run Chrysler. "It's great to be back on the home team," he said.

PAYING FOR A SCREW-UP

Toyota knew how to run a textbook recall. When Toyota launched its Lexus brand in 1989, the long-awaited LS400 was hit by a series of glitches, including a tail lamp prone to overheating. The recall threatened to kill the luxury brand in its cradle.

Toyota suspended production and ramped up output of replacement parts. Its California-based sales arm sent representatives out to pick up every one of the 8,000 LS400s that had been sold and provide owners with a free loaner while repairs were under way. The cars were returned washed and with a full tank of gas.

Lexus dealers and customers were impressed by the attention and the brand went on to outsell BMW and Daimler AG in the U.S. market over the next two decades.

That record of success made Toyota dealers deeply loyal -- and rich. It also drew investment from listed dealership groups that bet Toyota franchises would continue to outsell and out-service the rest of a wildly cyclical industry.

As of end September, 2009, Houston-based Group 1 Automotive drew 39 percent of its new-car sales revenue from its Toyota stores. At Fort Lauderdale-based AutoNation it was 21 percent. For Bloomfield Hills, Michigan-based Penske it was 20 percent.

"Toyota is struggling with being the largest automaker in the world. It certainly has issues, but you have to give them credit. They face reality. They deal with it," AutoNation CEO Mike Jackson said in September, before the first of two massive recalls.

In part because Toyota had kept a tight lid on the number of its dealerships, the franchises remained far more profitable than U.S. car dealerships. In 2008, during a recession, the average Toyota dealership sold four cars a day. The average Ford dealer sold one.

In a pep talk last month partly aimed at its dealers, Toyota pledged to contain the damage to its brand from the recall announced in September for the risk that floor mats could trap accelerator pedals.

"A product recall is an opportunity to reconnect with customers in ways we haven't before and to re-prove ourselves in their eyes," Inaba said on Jan. 12 in a speech in Detroit.

But four days later -- a Saturday -- Toyota's safety staff in Washington called NHTSA to let the agency know it had discovered a flaw with an accelerator manufactured by CTS Corp, an Indiana supplier that the automaker had begun to use in 2005 during its fast-growth phase.

The problem: the CTS-built accelerator -- a $15 part -- could become stuck in some cases due to wear and moisture, Toyota had found. The bigger problem: the flaw affected over 2 million vehicles and the automaker had not yet fully figured out a way to fix it quickly.

On Tuesday, Jan. 19 Inaba, Toyota U.S. sales chief Jim Lentz and others were summoned to Washington. NHTSA officials say they said they wanted prompt action. Toyota's executives called back several hours later to say that they were launching a recall.

The announcement on Thursday, Jan. 21 looked bad for Toyota. But the situation turned dire the next Monday. U.S. safety regulators told Toyota it would have to take the unprecedented step of suspending sales of eight models while it rushed to find a fix.

In one stroke, Washington stranded $2.5 billion in unsold inventories of cars and trucks at the automaker's dealerships. Worse, the negative publicity was driving away shoppers in the last week of the month, typically the peak for showroom traffic.

Toyota rushed to keep dealers informed with daily updates and conference calls. But frustrations were starting to boil over.

The lines of communications also got tangled. Sometimes Toyota's California-based sales arm seemed not to know what its Kentucky-based manufacturing arm was doing or what its Washington regulatory team had heard in the fast-evolving talks with NHTSA. Sometimes it spun the other way.

In one example, Toyota representatives told dealers on the morning of Wednesday Jan. 27 that the company would be expanding its floormat recall by 1.1 million vehicles. Toyota had determined that five additional models including the 2010 model-year Corolla, Venza and Matrix were at risk of having their accelerators held open by floormats stuck underneath them.

But the move had not been announced to an increasingly jittery public and would not be for hours, a gap that made some dealers immediately uneasy. "Our jaws dropped when we heard that," said one, who said he thought the episode showed how the company was slow to come to terms with the stakes of the safety crisis.

When asked to comment that afternoon, Toyota spokesman Brian Lyons said talk of the recall was "an unsubstantiated rumor." Just before 8 o'clock that night on the East Coast, Toyota's Washington office filed the paperwork making the expanded recall for floormat risk official.

In a similar move that has prompted criticism and drawn at least one lawsuit in California, Toyota quietly fixed a problem with the brakes on the Prius for vehicles still on its Japanese assembly line in January.

But consumers were not informed that Toyota had found the flaw or developed a fix for the software controlling the Prius brakes until safety engineer Yokoyama told reporters in Tokyo on Feb. 4.

Analysts say Toyota's wild ride has brought it back to a crossroads. It has a chance to start to win back trust the old-school way but it also faces the risk that the congressional inquiry will open a second act of the crisis.

"The damage to the reputation has been done," said Jeff Hess, a professor of marketing at California Polytechnic State University and former auto industry analyst with J.D. Power. "It's not about the message now. It's about hundreds of dealers and millions of customers."

Sean Kane, founder of Safety Research & Strategies and an expert witness who has been called to testify in the upcoming congressional hearing, said Toyota has to confront the possibility that it has problems with unintended acceleration in its vehicles that go beyond models that have been recalled and beyond the fixes it has described.

Back in Toyota City, there was evidence of the quiet resolve the automaker will need a lot more of in the weeks ahead.

"The difficulty when a company -- any company -- becomes big is that employees become detached from the problems," said one Toyota manager, who like most others asked not to be named. "When you can't do anything about this, that's how companies fail. But our job is to drill this sense of crisis into as many employees as possible."

(Additional reporting by John Crawley in Washington, Soyoung Kim, David Bailey, Bernie Woodall and Nick Carey in Detroit, Chang-ran Kim, Chikafumi Hodo, Nobuhiro Kubo in Tokyo, Yuriko Nakao in Toyota City, Japan, Tim Gaynor in Georgetown, Kentucky, Steve Gorman and Sue Zeidler in Los Angeles, editing by Jim Impoco and Claudia Parsons)