Corporate governance begins with power that holds thepower in an organization, how it is delegated and exercised, its purpose, andwhat control mechanisms the power holder’s use. With power comes theresponsibility of decision making, the right to choose, and the option todelegate. Power in a company is not absolute because it is always exercisedwithin guidelines or constraints. In public corporations, the purpose of power isthe creation of value, and the structure of shareholder owned corporationsmeans that the value created must be shared.
Therefore, a comprehensivedefinition of corporate governance will cover all the activities involved increating and sharing value.The briefShockwaves ran through corporate India in May 2012,when Reebok India (a subsidiary ofGermany-headquartered Adidas ADSGn.DE since 2005) filed a complaint allegingcriminal 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 behalfof 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 nonethelessattracted the attention of various investigation agencies. Three years, twoinvestigative reports and charge sheets later, the prosecution continues tobuild its case. Agencies probing the alleged Rs 870 crore corporate frauds in theoperation of Reebok India have detected a systemic “mismanagement” in thebusiness planning and running of the company reportedly done by some of itsofficials and employees.
Three different agencies – the I-T department under Finance Ministry,the Serious Fraud Investigation Office (SFIO) under Corporate Affairs Ministryand the Economic Offences Wing of Gurgaon police – have recorded the findingsalmost four months after a criminal case was filed by Reebok India against twoof its former employees.How the allegationsunfolded?Adidas ADSGn.DE (‘Adidas’), which acquired US rivalReebok International in 2006 for $3.8 billion, only merged its Indianoperations in 2011. The May 2012 criminal complaint alleged that Prem andBhagat has set up secret warehouses, doctored the company’s accounts, andgenerated 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 terminationof services, claiming damages of ?150 million.
Bhagat, in turn, followed suit. Preliminaryinvestigations carried out by the Economic Offences Wing of Gurgaon Police(‘EOW’), uncovered four secret warehouses (engaged by Prem and Bhagat, withoutthe knowledge of their managers), where diverted goods were being stocked: tobe allegedly supplied to genuine dealers. The EOW, however, noted that althoughit was still in the early stages of the investigation at the time, ReebokIndia’s (‘RIC’) estimated value of the alleged fraud appeared to be inflated,given the company’s inability to substantiate the figure, beyond offering thefollowing breakdown: ?5.
3 billion for parallel accounting; ?1.47 billion forinflated sales; ?0.63 billion in goods returned and pending inspection; ?9million on account of secret warehouse bills; ?148.
2 million in interest loston a franchisee referral programme and ?0.98 million on account of payments toand from customers. Following a preliminary review of the company’s books bythe Registrar of Companies (‘RoC’), the Government referred the case to theMinistry of Corporate Affairs’ (‘MCA’) investigative arm, the Serious FraudInvestigation Office (‘SFIO’) on May 28, 2012, making it the second agency, inaddition to the EOW, investigating the alleged fraud. Both the EOW and SFIOinvestigations continued side-by-side. InvestigatingAgencies, and their take on Reebok: EOW, SFIO, the Income Tax Department (‘ITDepartment’) and the Enforcement Directorate (‘ED’) In the months following the lodging of the criminalcomplaint, three investigative bodies began to probe the case: the EOW, SFIOunder the MCA, and the Income Tax Department under the Finance Ministry (‘ITDepartment’).
The three investigative agencies recorded in September 2012, fourmonths after the criminal complaint was filed, that they had detected’systematic mismanagement’ in the running of the company, and the keeping ofits accounts. The mismanagement, it was held, included violations of businessprocedures (over-invoicing and overvalued invoicing, for instance), which inturn 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 ‘baddebt’ (debt written off by a creditor as a loss due to inability ofrecuperation), since Reebok India did not appear to have any serious borrowingsor lending on record. The outcome of the IT Department’s review process remainsto be seen.
The EOW InvestigationThe EOW stepped into action following the filing ofthe criminal complaint in May 2012. Anticipatory bail pleas lodged by Prem andBhagat were quashed by a Gurgaon Court in May 201212, and by September, the duoalong with three others: Sanjay Mishra, Prashant Bhatnagar and Surakshit Bhatt,had been arrested on charges of fraud and criminal conspiracy (amongst othersunder the Indian Penal Code or ‘IPC’) for allegedly siphoning off company moneyby creating ghost distributors, and forging invoices for a period of 5 years.They subsequently arrested other managers at the company, later releasing oneof them, Nikhil Upadhyay, having found no evidence to sustain the allegations againsthim. The EOW charge sheet Following theirown investigations, the EOW filed a lengthy charge sheet against the twelveaccused on November 12, 2012, alleging the loss incurred due to allegedfinancial irregularities at RIC to be ?113 million: a figure much lower thanthe ?8.7 billion loss alleged by RIC in their criminal complaint.
The charge sheetputs this loss down to ‘theft through secret warehouses’ (?18.7 million),likewise fixing the loss on account of the ‘franchisee referral program’ and ‘falsificationof accounts’ at ?94.2 million. They were unable to substantiate claims ofcheating through fake sales, and ‘in and out’ transactions, and were similarlyunable to estimate losses due to ‘overstated accounts receivable’, ‘maintenanceof 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 thediminished sum could also be the result of the EOW’s more focused investigationof the criminal aspects of the case; the accounting aspects could reveal otherpieces of the puzzle. The SFIOInvestigation The SFIO, whichwas expected to submit a probe report in October 2012, did not end up doing sountil August 2013, claiming RIC’s delayed filing of its audited accounts forFY12 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 clarifiedthat this did not negate the wrongdoing in any way. While the SFIO initiallyclarified that KPMG India (which conducted the RIC audit at the behest ofAdidas in 2010), were not likely to come under scrutiny, the forensic auditcarried out by KPMG India’s audit arm, BSR & Co.
, raised some importantquestions, in relation to whether or not the KPMG India-issued clean bill ofhealth was wrongly given, and if so, what the surrounding circumstances mighthave been. N. Narasimhan & Co., RIC’s tax and statutory auditors, too, gavethe company a clean chit in respect of their auditory issues. The SFIO reportfiled in August 2013, however, suggested that it was impossible for suchsystematic mismanagement to have taken place without the knowledge of RIC’saccounting officials, and its auditors. Prior to the release of the SFIOreport, the two main accused, Prem and Bhagat, were released on bail in July2013 after spending 10 months imprisoned.
The two former Reebok executivesmaintained that they had notified their German managers of the need for extrawarehouse 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 heldliable for implementing a programme that was part of the company’s business promotionpolicy. The August 2013 report, however, subsequently concluded that the twoformer executives had committed conspiracy and falsified and manipulated salesnumbers to overstate the company’s health. The SFIO concluded that the accusedhad committed violations under the IPC as well as company law, and suggestedthat action should also be taken against the German national who was asignatory to the accounts, and Adidas’s representative on RIC’s board. Afterreferring this point to the Law Ministry, the Government began prosecutionproceedings in December 2013, although the MCA clarified that it would not beseeking to prosecute Shahin Padath, the Finance Director and RIC official whofiled the May 2012 criminal complaint on behalf of Adidas, or Claus Heckerott,the Adidas India Managing Director (March 2012 – January 2013), though bothHeckerott and Padath were aware the accounts were falsified, with Padath evensigning the FY10 statements as Finance Director. The leniency meted out to theaforementioned officials is said to be a result of a Law Ministry directive,which exculpates whistleblowers from prosecution, where they are also thecomplainants in the case.
Reebok India: lifeafter fraud In August 2012, Adidas announced a 26% decline inglobal 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 Sheetfor the Financial Year 2013-2014, the company asserted that it had used aportion of its working capital loan to finance operating losses, beforeimplementing 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 downsizingRIC’s franchisee network in India in May 2012, as part of these measures.
Underthe aegis of a new MD, RIC’s restructuring plan aimed to introduce a newbusiness model. Aside from large-scale downsizing, the restructuring plan aimedat 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 VoluntaryRetirement Scheme to 200 of its Indian employees. Also keen on moving away fromthe Minimum Guarantee business model in use thus far at RIC, the company’s newmanagement sought to introduce a new, comprehensive performance-based model,therein trimming the unprofitable fat. Aware that it was likely that at least a thirdof their franchisees would not be comfortable with this change, RIC offeredthem a phase-out period, which allowed for a November-end exit for thoseseeking ending ties.
In support of this phase-out period, RIC authorised ambivalentfranchisees to sell its products at a 50% discount, offering to support thissales pitch with an additional discount of 40% on the wholesale price,furthermore offering to buy back unsold stock at the end of this period, butfor no more than 10% of the wholesale price.The implementation ofthese corrective measures, led to RIC’s franchisee network shrinking to athird, as well as a 25% price hike in its merchandise. While RIC has had towork hard to regain the loyalty of its customers, it has also been keen toattract a newer, broader fitness-oriented customer base since the change in itsbusiness strategy. Keen to emphasise rebranding efforts, RIC also boosted theirmarketing expenditure and launched a number of new formatted ‘Fit Hub’ storesacross the country from 2012 onwards, aiming to sell its customers premiumproducts, while also providing fitness consultation. RIC has since turned itsbusiness around, aiming to build further on its growing market value as afitness brand. In February 2015, RIC went so far as to announce its intentionto convert all its existing stores into ‘Fit Hub’ stores by 2017. Despite thesepositive changes at RIC, the liabilities that go lock-step with fraud chargescontinue to haunt RIC and its parent company Adidas. As RIC announced in itsBusiness and Financial Performance Review, as part of its Balance Sheet for theFinancial Year 2013-2014, the fraud perpetrated by its erstwhile management hasleft it with several disputes to settle with business partners in regard toreceivables/payables against the Company.
While Adidas (which now maintains the episodemay have cost them up to €153 million, or ?10.9 billion) has settled a largenumber of these disputes, the process of reconciliation and settlement is alengthy one. In the meantime, the sportswear giant is still waiting for theother shoe to drop insofar as the outcome of the Reebok 2012 case goes.