Two Left Feet: What went wrong at Reebok India!
-Srijoy Das
Archer & Angel *
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 billion1.
Although the sum was later whittled down to ₹8.7 billion, the fraud nonetheless attracted the attention of various
investigation agencies2. Three years, two investigative reports and chargesheets later, the prosecution continues to build its
case.
Fraud allegations: May 2012
Adidas ADSGn.DE (‘Adidas’), which acquired US rival Reebok International in 2006 for $3.8 billion3, 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.4
Preliminary investigations carried out by the Economic Offences Wing of Gurgaon Police (‘EOW’)5, 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.6 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. 7
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’)8
on May 28, 2012, 9 making it the second agency, in addition to the EOW, investigating the alleged fraud. Both the EOW
and SFIO investigations continued side-by-side.
1
India Today: Reebok India claims Rs. 8,700 crore scam by former MD, COO; files FIR in Gurgaon
Moneylife: The Adidas-Reebok Saga
Adidas may sell Reebok, which they acquired in August 2006 for $3.8 billion
4
Ibid.
5
Gurgaon, an industrial and financial hub, is a city located a short distance from New Delhi, and situated in the National Capital Region, in the State of Haryana.
Many financial institutions and other companies are headquartered here, and Reebok India Company (RIC), is one of them. The Economic Offences Wing of the
Gurgaon Police, having jurisdiction over the area, handles all economic crimes reported to the Gurgaon Police.
6
Livemint: EOW discovers ‘secret warehouses’
7
Livemint: Reebok India - fake sales and secret depots
8
The Serious Fraud Investigation Office (SFIO) is a multi-disciplinary organization under the Ministry of Corporate Affairs consisting of experts in accounting,
forensic auditing, law, information technology, capital markets, etc., for the purpose of detecting and prosecuting, or recommending for prosecution, white collar
crimes and frauds.
9
Livemint: Govt. refers Reebok fraud to SFIO
2
3
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 record10. 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 pleas11 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 years13. 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.14
The EOW chargesheet
Following their own investigations, the EOW filed a lengthy chargesheet against the twelve accused on November 12,
2012,15 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.16 The chargesheet 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.17 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’.18The 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.19
10
The Economic Times: Reebok India - Corporate mismanagement led to scam
Section 438 of the Indian Criminal Procedure Code provides for ‘Anticipatory Bail’, whereby individuals may seek bail in anticipation or expectation of being
accused of having committed a non-bailable offence.
12
Livemint: Govt. refers Reebok fraud to SFIO
13
The Economic Times: Reebok India - Corporate mismanagement led to scam
14
Times of India: Police drop charges against one of the accused, Nikhil Upadhyay
15
Times of India: EOW files chargesheet in Reebok 2012 case
16
Livemint: Gurgaon Police record Reebok loss at Rs. 11.3 crore
17
Ibid.
18
Ibid.
19 Ibid.
11
Adidas and RIC stood firm on their claim of ₹8.7 billion in losses, iterating that a restatement of pre-tax income due
to these financial irregularities could, in itself, result in a loss of up to €125 million for the years leading up to 2011.20
Ernst & Young: the forensic audit
A few months into their investigations, the EOW, SFIO and IT Department indicated that their preliminary findings
pointed more to a systematic mismanagement of accounts, and gross violations of corporate governance standards at
RIC.21 The German arm of Ernst & Young (‘E&Y’) conducted a forensic audit of RIC in October 2012, at the behest
of Adidas,22 and the 66-page report supported this view. Some of the key findings of the report include:
Secret warehouses23
The audit confirmed the EOW’s previous findings in relation to the secret warehouses, which were hired by RIC
between October 2009 and June 2012 (costing RIC ₹14.3 million in rent)24. The goods were reflected on RIC’s books
as having been sold to dealers or distributors, and invoices to this effect had also been generated, but this ruse was
only intended to inflate sales figures: the siphoned off stock never left the warehouses. These figures were further
complicated by RIC’s intentional failure to account for stock returned to them by distributors and dealers: storing
them in such warehouses, but leaving them off the books.
Retrospective pricing25
E&Y’s report indicated that RIC also generated ‘higher’ sales revenue by retrospectively applying price increases to
goods already sold to dealers and distributors, thus increasing both sales revenue and accounts receivable by
approximately ₹860 million.
Circular trading and off-the-books sales transactions26
The audit revealed a series of complex, circular transactions between RIC, and companies owned by Sanjay Mishra
(who also supplied the company with staffing services). RIC reportedly sold goods to be repaired to Mishra-owned
Shivam Enterprises (‘Shivam’) and Oriya Sales (‘Oriya’) for ₹352 million (the actual value of the goods in question
being ₹143 million). The Mishra-owned enterprises only paid ₹30.8 million for these goods, some of which were sold
on to other dealers by Shivam and Oriya for ₹30 million, and the rest were sold back to RIC by another Mishra-owned
enterprise, Om Trading, for 144 million (of which RIC only paid ₹40 million). In effect, RIC paid out ₹40 million,
and received ₹30.8 million, but it was unclear how these transactions were accounted for on the books, or if the stock
in hand reflected any depletion. Mishra was also arrested by EOW for his involvement in the scam, but has since been
released on bail.27
In 2011, RIC entered into a similarly deceptive transaction, purportedly selling ₹215 million worth of defective goods
to a ghost company, called KK Enterprises. The goods were, however, moved to a secret warehouse, and then partially
20
Rediff: Reebok India stands by its Rs. 870-crore fraud allegations
The Economic Times: Reebok India - Corporate mismanagement led to scam
22
The Economic Times: German arm of Ernst & Young conducts forensic audit of Reebok India at Adidas' behest
23
Livemint: Reebok India - fake sales and secret depots
24
Hindustan Times: Reebok fraud accused invested crores in realty
25
Livemint: Reebok India - fake sales and secret depots
26
Ibid.
27
Delhi High Court Order, granting bail to Vishnu Bhagat
21
divested to unauthorised buyers. The unsold products were later marked as returned goods, but the company’s
accounts reflect neither the original unauthorised sales nor the depletion in goods returned.
Properties owned and financial transactions28
E&Y’s report indicated that Prem and Bhagat owned a number of properties across the country, with Prem, owning 20
commercial and residential properties. The forensic audit also highlighted unaccounted-for funds received by Prem
(approximately ₹55.8 million) and Bhagat (₹22.4 million), as reflected by their Standard Charted Savings Accounts.
These figures do not include transactions carried out via the two prime accused’s other accounts with Citibank, Axis
Bank and ICICI Bank.
Prem and Bhagat denied the contents of E&Y’s report. Their counsel further alleged that E&Y had received ₹130
million from Reebok to produce a report that could undercut the previous audit carried out by KMPG’s auditing arm,
BSR & Co., which had cleared RIC of any wrongdoing when engaged to verify concerns over financial irregularities
in 2010. 29 Notwithstanding Agarwal’s allegations, the E&Y report has helped investigative authorities positively
verify their own investigative findings.
The SFIO Investigation
The SFIO, which was expected to submit a probe report in October 2012, did not end up doing so until August 201330,
claiming RIC’s delayed filing of its audited accounts for FY12 had set them back31. 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. 32 N. Narasimhan & Co., RIC’s tax and
statutory auditors, too, gave the company a clean chit in respect of their auditory issues.33
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. 34 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
imprisoned35. 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 policy36.
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
28
Hindustan Times: Reebok fraud accused invested crores in realty
The Economic Times: Prem and Bhagat deny contents of E&Y report
30
The Economic Times: SFIO submits final probe report on Reebok India
31
Rediff: Reebok India probe faces delay on late filings
32
Firstpost: SFIO to grill KPMG officials in Reebok fraud case
33
Firstpost: Reebok's statutory auditors had given the company a clean chit
34
The Economic Times: Reebok India - Corporate mismanagement led to scam
35
Livemint: Two main accused in Reebok case granted bail
36
Delhi High Court Order, granting bail to Vishnu Bhagat
29
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 2013,37
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),38 though both Heckerott and Padath were aware the accounts were
falsified, with Padath even signing the FY10 statements as Finance Director. 39 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.40
The SFIO chargesheet
The SFIO subsequently filed its chargesheet in 2014, naming Prem, Bhagat and some other erstwhile RIC employees,
along with KPMG India’s audit arm, BSR & Co. and statutory auditors, Narasimhan & Co.41
While bearing out the case filed by the EOW against Prem and the other implicated RIC employees, the SFIO report
also noted that the Franchisee Referral Programme run by RIC (under the aegis of Prem and Bhagat), had been used to
collect ₹881 million from over sixty high networth individuals, promising an interest of 16-20% – the funds collected
were instead circulated within RIC to boost cash flow for carrying out the accounting fraud.42
The SFIO charged the KPMG India affiliate, BSR &Co. with ‘criminal breach of trust’, as they had aided the top
management at RIC in falsifying the company’s accounts and financial statements.43 They noted that BSR’s forensic
audit had been cursory, and improperly designed and executed; as a result, they held that BSR had been ‘criminally
negligent’ as auditors, by falsely issuing clean audit opinions, therein misleading the public and the shareholders.44
The SFIO also charged statutory auditors, N. Narasimhan & Co. with ‘pervasive failure […] to detect material
falsification of financial statements [and] weaknesses in control and consequent fraud perpetrated for years’.45
BSR has refuted these allegations, claiming they were not the statutory auditors during the fraud period, and thus
cannot be culpable. Prosecution in the case, however, continues, and the end result is yet to be seen. 46
The ED47 probe
In November 2012, the ED launched an investigation, under the Prevention of Money Laundering Act, 2002, into the
alleged ₹8.7 billion fraud at RIC. Once the ED identifies ‘the proceeds of a crime’, it may move to attach the
concerned properties, or bank accounts.48 The outcome of this investigation remains to be seen.
37
The Hindu BusinessLine: Government starts prosecution proceedings in Reebok fraud case
Ibid.
39 Business Standard: Reebok fraud - Two top execs let off
40
The Hindu BusinessLine: Government starts prosecution proceedings in Reebok fraud case; Business Standard: Reebok fraud - Two top execs let off
41 Business Standard: Reebok fraud - Two top execs let off
42
Ibid.
43
The Indian Express: SFIO names KPMG arm in Reebok chargesheet
44
Ibid.
45
Ibid.
46
Ibid.
47
The Enforcement Directorate (ED) investigates contraventions of provisions under the Foreign Exchange Management Act 1999. The ED also investigates
offences of money laundering under the Prevention of Money laundering Act 2002, and subsequently attaches, and confiscates properties if it is determined that
these were purchased with the proceeds of a crime derived from a Schedule Offence under the Act.
48
Livemint: ED begins money laundering probe into Reebok Fraud
38
The ED has previously investigated RIC for alleged violations of the Foreign Exchange Management Act (‘FEMA’),
and proposed a penalty in 2012 for RIC’s failure to abide by domestic manufacturing commitments made to the
Foreign Investment Promotion Board (‘FIPB’), by importing goods that could have been produced locally.49
Institute of Chartered Accounts of India (‘ICAI’) probe50
While ICAI noted in 2012 that KPMG India, being a consultancy firm, fell outside their jurisdiction, prima facie
auditing discrepancies would require further scrutiny51. Following the SFIO investigation, the ICAI issued a show
cause notice to Bhagat (a member of the ICAI), one of the main accused in the Reebok case in 2013, and subsequently
launched proceedings against him in 2014.52 The Disciplinary Committee of the ICAI has already held one hearing in
September 2014, with a further hearing having been adjourned to a future date.53
The ICAI is also investigating two separate complaints against the concerned auditors of RIC. While one case is being
probed by the Directorate in respect of the Chartered Accountants (Procedure of Investigation of Professional and
Other Misconduct and Conduct of Case) Rules, 2007, the other matter is sub-judice.54
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 currencyneutral basis, attributing the fall in sales to the RIC scandal55. 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.56
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 MD57, 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. 58 To this end, RIC offered a
Voluntary Retirement Scheme to 200 of its Indian employees. 59 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.60 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 to end 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. 61
49
Rediff: ED findings reveal Reebok India in violation of FEMA regulations
The Institute of Chartered Accountants of India (‘ICAI’), India’s national professional accounting body, was established under an act of Parliament in 1949. The
second largest professional accounting body in the world (in terms of membership), the ICAI recommends accounting standards to be followed by companies in
India, and its members (Chartered accountants) are subject to a published Code of Ethics and professional standards, violation of which is subject to disciplinary
action.
51
Firstpost: ICAI clarifies that consultancy KPMG India does not fall under its jurisdiction
52
The Hindu: ICAI issues show-cause notice to Bhagat
53
The Hindu: ICAI starts proceedings in Rs. 870-crore Reebok scam
54
Ibid.
55
The Hindu BusinessLine: Reebok's Q2 sales down 26% due to India issues, says Adidas
56
Pg. no. 19, Reebok India Company Balance Sheet for period 01/04/2013 to 31/03/2014, downloaded from the portal of the Ministry of Corporate Affairs.
57
Firstpost: Reebok India - A fresh start
58
The Economic Times: Reebok turns around its Indian business
59
Firstpost: Here's what Reebok's restructuring plan looks like
60
Firstpost: Reebok India asks unhappy partners to sell items at 50% off and exit
61
Ibid.
50
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.62 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.63 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 2017.64
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. 65 While Adidas
(which now maintains the episode may have cost them up to €153 million, or ₹10.9 billion66) has settled a large number
of these disputes, the process of reconciliation and settlement is a lengthy one.67 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.
**
DISCLAIMER: This report is intended as a general overview and discussion of the subjects dealt with. It is not intended, and
should not be used, as a substitute for taking legal advice in any specific situation. Archer & Angel will accept no responsibility
for any actions taken or not taken on the basis of this publication.
CONTACT: For additional information, please contact Srijoy Das, Partner of Archer & Angel at sdas@archerangel.com. More
information about Archer & Angel can be found at www.archerangel.com
62
The Economic Times: Reebok turns around its Indian business
Ibid.
64
The Economic Times: Reebok plans 15 new format Fit Hub stors in India
65
Pg. no. 15, Reebok India Company Balance Sheet for period 01/04/2013 to 31/03/2014, downloaded from the portal of the Ministry of Corporate Affairs.
66
Firstpost: the Reebok India fraud has cost Adidas
67
Pg. no. 15, Reebok India Company Balance Sheet for period 01/04/2013 to 31/03/2014, downloaded from the portal of the Ministry of Corporate Affairs.
63