Home Research PapersCorporate the operation of Reebok India have detected a

Corporate the operation of Reebok India have detected a

Corporate governance begins with power that holds the
power in an organization, how it is delegated and exercised, its purpose, and
what control mechanisms the power holder’s use. With power comes the
responsibility of decision making, the right to choose, and the option to
delegate. Power in a company is not absolute because it is always exercised
within guidelines or constraints. In public corporations, the purpose of power is
the creation of value, and the structure of shareholder owned corporations
means that the value created must be shared. Therefore, a comprehensive
definition of corporate governance will cover all the activities involved in
creating and sharing value.The brief

Shockwaves ran through corporate India in May 2012,
when Reebok India (a subsidiary of
Germany-headquartered Adidas ADSGn.DE since 2005) filed a complaint alleging
criminal conduct on part of its former Managing Director, Subhinder Singh Prem,
and former Chief Operating Officer, Vishnu Bhagat. The criminal complaint,
which was filed by Reebok India’s Financial Director, Shahin Padath, on behalf
of the company, alleged a fraud to the tune of a whopping ?87 billion .
Although the sum was later whittled down to ?8.7 billion, the fraud nonetheless
attracted the attention of various investigation agencies. Three years, two
investigative reports and charge sheets later, the prosecution continues to
build its case.

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Agencies probing the alleged Rs 870 crore corporate frauds in the
operation of Reebok India have detected a systemic “mismanagement” in the
business planning and running of the company reportedly done by some of its
officials and employees.

Three different agencies – the I-T department under Finance Ministry,
the Serious Fraud Investigation Office (SFIO) under Corporate Affairs Ministry
and the Economic Offences Wing of Gurgaon police – have recorded the findings
almost four months after a criminal case was filed by Reebok India against two
of its former employees.

How the allegations
unfolded?

Adidas ADSGn.DE (‘Adidas’), which acquired US rival
Reebok International in 2006 for $3.8 billion, only merged its Indian
operations in 2011. The May 2012 criminal complaint alleged that Prem and
Bhagat has set up secret warehouses, doctored the company’s accounts, and
generated fictional invoices, thus falsifying the balance sheets. The accused,
whose services had been terminated in March 2012, denied the allegations. Prem,
subsequently filed a suit against Adidas for defamation and abrupt termination
of services, claiming damages of ?150 million. Bhagat, in turn, followed suit. Preliminary
investigations carried out by the Economic Offences Wing of Gurgaon Police
(‘EOW’), uncovered four secret warehouses (engaged by Prem and Bhagat, without
the knowledge of their managers), where diverted goods were being stocked: to
be allegedly supplied to genuine dealers. The EOW, however, noted that although
it was still in the early stages of the investigation at the time, Reebok
India’s (‘RIC’) estimated value of the alleged fraud appeared to be inflated,
given the company’s inability to substantiate the figure, beyond offering the
following breakdown: ?5.3 billion for parallel accounting; ?1.47 billion for
inflated sales; ?0.63 billion in goods returned and pending inspection; ?9
million on account of secret warehouse bills; ?148.2 million in interest lost
on a franchisee referral programme and ?0.98 million on account of payments to
and from customers. Following a preliminary review of the company’s books by
the Registrar of Companies (‘RoC’), the Government referred the case to the
Ministry of Corporate Affairs’ (‘MCA’) investigative arm, the Serious Fraud
Investigation Office (‘SFIO’) on May 28, 2012, making it the second agency, in
addition to the EOW, investigating the alleged fraud. Both the EOW and SFIO
investigations continued side-by-side.

 

Investigating
Agencies, and their take on Reebok: EOW, SFIO, the Income Tax Department (‘IT
Department’) and the Enforcement Directorate (‘ED’)

 

In the months following the lodging of the criminal
complaint, three investigative bodies began to probe the case: the EOW, SFIO
under the MCA, and the Income Tax Department under the Finance Ministry (‘IT
Department’). The three investigative agencies recorded in September 2012, four
months after the criminal complaint was filed, that they had detected
‘systematic mismanagement’ in the running of the company, and the keeping of
its accounts. The mismanagement, it was held, included violations of business
procedures (over-invoicing and overvalued invoicing, for instance), which in
turn could have led to income tax violations.

 

The IT Department

The IT Department alleged a ?1.4 billion tax evasion,
and asserted that they would ensure that the company could not later claim ‘bad
debt’ (debt written off by a creditor as a loss due to inability of
recuperation), since Reebok India did not appear to have any serious borrowings
or lending on record. The outcome of the IT Department’s review process remains
to be seen.

 

The EOW Investigation

The EOW stepped into action following the filing of
the criminal complaint in May 2012. Anticipatory bail pleas lodged by Prem and
Bhagat were quashed by a Gurgaon Court in May 201212, and by September, the duo
along with three others: Sanjay Mishra, Prashant Bhatnagar and Surakshit Bhatt,
had been arrested on charges of fraud and criminal conspiracy (amongst others
under the Indian Penal Code or ‘IPC’) for allegedly siphoning off company money
by creating ghost distributors, and forging invoices for a period of 5 years.
They subsequently arrested other managers at the company, later releasing one
of them, Nikhil Upadhyay, having found no evidence to sustain the allegations against
him.

 

The EOW charge sheet

 Following their
own investigations, the EOW filed a lengthy charge sheet against the twelve
accused on November 12, 2012, alleging the loss incurred due to alleged
financial irregularities at RIC to be ?113 million: a figure much lower than
the ?8.7 billion loss alleged by RIC in their criminal complaint. The charge sheet
puts this loss down to ‘theft through secret warehouses’ (?18.7 million),
likewise fixing the loss on account of the ‘franchisee referral program’ and ‘falsification
of accounts’ at ?94.2 million. They were unable to substantiate claims of
cheating through fake sales, and ‘in and out’ transactions, and were similarly
unable to estimate losses due to ‘overstated accounts receivable’, ‘maintenance
of parallel accounting records’ and ‘fraudulent retrospective price increases’.
The SFIO, which was given four to five months to file its report in the case
(but submitted its final report on the matter in August 2013), noted that the
diminished sum could also be the result of the EOW’s more focused investigation
of the criminal aspects of the case; the accounting aspects could reveal other
pieces of the puzzle.

 

The SFIO
Investigation

 The SFIO, which
was expected to submit a probe report in October 2012, did not end up doing so
until August 2013, claiming RIC’s delayed filing of its audited accounts for
FY12 had set them back. Echoing the EOW’s concerns over RIC’s estimated loss of
?8.7 billion, the SFIO agreed that the sum appeared inflated, but clarified
that this did not negate the wrongdoing in any way. While the SFIO initially
clarified that KPMG India (which conducted the RIC audit at the behest of
Adidas in 2010), were not likely to come under scrutiny, the forensic audit
carried out by KPMG India’s audit arm, BSR & Co., raised some important
questions, in relation to whether or not the KPMG India-issued clean bill of
health was wrongly given, and if so, what the surrounding circumstances might
have been. N. Narasimhan & Co., RIC’s tax and statutory auditors, too, gave
the company a clean chit in respect of their auditory issues. The SFIO report
filed in August 2013, however, suggested that it was impossible for such
systematic mismanagement to have taken place without the knowledge of RIC’s
accounting officials, and its auditors. Prior to the release of the SFIO
report, the two main accused, Prem and Bhagat, were released on bail in July
2013 after spending 10 months imprisoned. The two former Reebok executives
maintained that they had notified their German managers of the need for extra
warehouse space, refuting the allegations in relation to the secret warehouses.
They also refuted allegations levied against them in regard of the infamous
‘Franchisee Referral Programme’, suggesting that neither of them could be held
liable for implementing a programme that was part of the company’s business promotion
policy. The August 2013 report, however, subsequently concluded that the two
former executives had committed conspiracy and falsified and manipulated sales
numbers to overstate the company’s health. The SFIO concluded that the accused
had committed violations under the IPC as well as company law, and suggested
that action should also be taken against the German national who was a
signatory to the accounts, and Adidas’s representative on RIC’s board. After
referring this point to the Law Ministry, the Government began prosecution
proceedings in December 2013, although the MCA clarified that it would not be
seeking to prosecute Shahin Padath, the Finance Director and RIC official who
filed the May 2012 criminal complaint on behalf of Adidas, or Claus Heckerott,
the Adidas India Managing Director (March 2012 – January 2013), though both
Heckerott and Padath were aware the accounts were falsified, with Padath even
signing the FY10 statements as Finance Director. The leniency meted out to the
aforementioned officials is said to be a result of a Law Ministry directive,
which exculpates whistleblowers from prosecution, where they are also the
complainants in the case.

 

Reebok India: life
after fraud

In August 2012, Adidas announced a 26% decline in
global sales for Reebok in the April-June quarter on a currency neutral basis,
attributing the fall in sales to the RIC scandal. As per RIC’s Balance Sheet
for the Financial Year 2013-2014, the company asserted that it had used a
portion of its working capital loan to finance operating losses, before
implementing corrective measures to boost profitability at the company. Adidas,
Reebok’s parent company, which had already been planning to overhaul RIC’s business,
model prior to the May 2012 criminal complaint, announced plans of downsizing
RIC’s franchisee network in India in May 2012, as part of these measures. Under
the aegis of a new MD, RIC’s restructuring plan aimed to introduce a new
business model. Aside from large-scale downsizing, the restructuring plan aimed
at giving the brand a much-needed facelift, shifting RIC’s focus from
‘cricket-based’ advertising to the more fitness-focussed market.  To this end, RIC offered a Voluntary
Retirement Scheme to 200 of its Indian employees. Also keen on moving away from
the Minimum Guarantee business model in use thus far at RIC, the company’s new
management sought to introduce a new, comprehensive performance-based model,
therein trimming the unprofitable fat.  Aware that it was likely that at least a third
of their franchisees would not be comfortable with this change, RIC offered
them a phase-out period, which allowed for a November-end exit for those
seeking ending ties. In support of this phase-out period, RIC authorised ambivalent
franchisees to sell its products at a 50% discount, offering to support this
sales pitch with an additional discount of 40% on the wholesale price,
furthermore offering to buy back unsold stock at the end of this period, but
for no more than 10% of the wholesale price.

The implementation of
these corrective measures, led to RIC’s franchisee network shrinking to a
third, as well as a 25% price hike in its merchandise. While RIC has had to
work hard to regain the loyalty of its customers, it has also been keen to
attract a newer, broader fitness-oriented customer base since the change in its
business strategy. Keen to emphasise rebranding efforts, RIC also boosted their
marketing expenditure and launched a number of new formatted ‘Fit Hub’ stores
across the country from 2012 onwards, aiming to sell its customers premium
products, while also providing fitness consultation. RIC has since turned its
business around, aiming to build further on its growing market value as a
fitness brand. In February 2015, RIC went so far as to announce its intention
to convert all its existing stores into ‘Fit Hub’ stores by 2017. Despite these
positive changes at RIC, the liabilities that go lock-step with fraud charges
continue to haunt RIC and its parent company Adidas. As RIC announced in its
Business and Financial Performance Review, as part of its Balance Sheet for the
Financial Year 2013-2014, the fraud perpetrated by its erstwhile management has
left it with several disputes to settle with business partners in regard to
receivables/payables against the Company.  While Adidas (which now maintains the episode
may have cost them up to €153 million, or ?10.9 billion) has settled a large
number of these disputes, the process of reconciliation and settlement is a
lengthy one. In the meantime, the sportswear giant is still waiting for the
other shoe to drop insofar as the outcome of the Reebok 2012 case goes.

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