ADIDAS AND REEBOK

SCANDAL

Introduction It was late March and Prem, 44, the former managing

director of Reebok’s Indian entity was in Phoenix, Arizona, for a bi-annual meeting to present the company’s business plan for the fast-growing Indian market.

Reebok’s India businesses were to be downsized in 2012 and, though there were differences between Prem and his boss Ronald Auschel on how swift the downsizing should be, Prem believed he’d managed to do the balancing act

needed to stay at the helm. Instead, he was asked to summarily step aside.

A month later, on April 30, in an earnings release, Adidas would announce exceptional sales and profits in its global

operations. Those results were overshadowed by what the company termed as ‘commercial irregularities’ in its Indian operations. It said the company would be taking a euro 125 million write-off and restating its results for the year 2010. It asked investors to brace for a further euro

70 million write-off. A week later, the company filed a criminal complaint against Prem. Prem hit back with two cases—one for defamation and another for recovery of his past dues amounting to Rs 12.7 crore in the Delhi

High Court.

The Delhi High Court is expected to hear the cases in July. Unless both parties eventually arrive at an out-of-court settlement, there’s every chance that the last has not

been heard on this rather unexpected high-voltage drama inside the world’s second largest sports shoemaker.

So what really led to a sudden escalation of hostilities between the swashbuckling go-getting Indian executive and a highly conservative German multinational? Was it

merely a clash of corporate cultures, given that Prem belonged to the erstwhile Reebok set-up which Adidas

bought out in 2005? Or was he penalised for repeatedly questioning the Adidas system which prided itself on

conformity and discipline?

In what could the second biggest corporate scandal after Satyam, Reebok India has alleged a Rs 8,700 crore fraud by its former Managing Director Subhinder Singh Prem

and former Chief Operating Officer Vishnu Bhagat.Reebok lodged an FIR with the Gurgaon police alleging

that Prem and Bhagat had 'stolen' products by setting up 'secret warehouses', fudged accounts and indulged in

fictitious sales to cause a multi-crore dent to the company.

When the alleged scam came to light in March 2012, Singh, who had been made the Managing Director of Adidas India in 2011 as a part of an integration of the

businesses of both Adidas and Reebok brands, was dismissed from the company. Bhagat's services were

terminated too.The company's financial director, Shahim Padath, later

lodged a formal complaint against the duo. The economic cell of Gurgaon police conducted a probe and found that Singh and Bhagat had allegedly rented four warehouses without informing their seniors and used them to store

goods and claimed they were supplied to genuine dealers.

They also allegedly siphoned off goods to ghost companies and distributors across the country, claiming

they were defective pieces.

Before we delve into the answers, let’s first start at the beginning

what happened exactly?

Reebok’s rise in India reads like a fairytale success story. Globally, the brand ranks a distant fourth after Nike,

Adidas and Puma, but in India it had built up an impressive network of over a 1,000 stores by 2012 and is the market leader. As Prem explains in an interview with Forbes India, “The reason why we grew was that yes we were looking at distribution. We believed in the spirit of the Indian market. We were in 325 cities. We had over a 1,000 stores.”  In pursuing this aggressive expansion, he

says he had the support of global headquarters and

Reebok had innovated with products, price points and distribution all of which resulted in making it the largest

sportswear brand in India with sales of about Rs 700 crore.

When Reebok opened its first store in Delhi in 1996, under the leadership of Mukhtesh Pant, it took a leaf out of a

concept pioneered by Benetton in India: It promised a minimum guarantee to its franchisee. “The whole idea of a minimum guarantee is

that the company is convinced that the retailer will make money, but the retailer is not convinced,”

says Harminder Sahni, managing director, Wazir Advisors. Since then, the concept of a minimum

guarantee has become an industry practice. So the moot question: Why did Prem face so much flak for it from

Adidas’ global HQ in Germany?

It may have had to do with the fact that sports goods companies around the world follow an entirely different

model: They rely on the wholesaler. The company sells its goods on a 44-45 percent margin to a wholesaler, who is then responsible for selling them. He could set up stores

or could sell them to smaller franchisees, but the key point is that the wholesaler is responsible for anything

that doesn’t sell. The rewards are his, but the risk is also his once the goods are off the company balance sheet.

Globally, these wholesalers would decide when to plan stock clearances, how long to have the sale for, how

much to discount goods and so on—all decisions that are typically taken by companies in India.

Now in India, the situation was very different. With an underdeveloped retail market, Reebok realised that there were few wholesalers of repute that they could deal with.

Remember Reebok was the first international sports goods company looking to set shop in India at a time

when few Indians could afford to pay Rs 2,000 for a pair of shoes. Understandably, individual shop owners were also wary of buying expensive merchandise that may or

may not sell. Their risk had to be balanced out.One way of doing this was to compensate them for their

costs. In exchange, the company would balance their upside. So Reebok entered into deals with individual shop owners that took care of their rental and staff expenses. There were also instances when companies were forced to enter into minimum guarantee agreements at prime retail locations where the shop owners had the upper

hand and could demand their pound of flesh. In return, the maximum profit these shops could make was capped at 30 percent. Reebok guided them on how to buy and

sell, trained the staff and also planned the store fit-outs. It also supported them with strong promotional budgets.

Industry watchers say that where Reebok slipped up was in selecting the right partners. Some shop owners had no

interest in selling shoes and treated it purely as a financial investment that fetched a good return. In its

aggression to expand in the marketplace, Reebok ended up opening too many outlets in areas that could only

support one or at most two.

Adidas too, relied partly on the minimum guarantee model to drive its distribution reach. And even after Adidas bought Reebok for $3.8 billion in 2005, both

brands learned to live with this Indian reality. But things start to unravel by 2010.

The Conflict

A forensic audit of Reebok India Co. has found fake transactions with unauthorized customers, allegedly concocted to exaggerate the company’s revenue and

possibly aimed at meeting targets.

It also shed new light on a messy affair that is being investigated by both the Gurgaon Police and the Serious Fraud Investigation Office (SFIO), an arm of the ministry

of corporate affairs.The audit, conducted by the German arm of Ernst and

Young (E&Y), shows transactions between Reebok India and companies owned by Sanjeev Mishra, who ran a

staffing services company that supplied contract employees to the shoemaker, among other circuitous and

complex transactions.Mint has seen a copy of the audit report.

The audit also shows leakages in some transactions that seem to have benefited various individuals or other

entities. However, it is silent on the exact gains derived by the main accused.

E&Y declined to comment on the matter.Adidas AG acquired Reebok International Ltd, the parent of Reebok India, in 2005. In May this year, Adidas claimed

it had uncovered a fraud of the magnitude of Rs.870 crore at the Indian operations of Reebok. Since then, 12

people, either former employees of Reebok India, including its former managing director Shubhinder

Singh Prem and former chief operating officer Vishnu Bhagat (the two are the main accused), or associates

like Mishra, have been arrested.Prem and Bhagat left the company on 26 March.

Praveen Agarwal, the lawyer representing both Prem and Bhagat, said his clients deny “any findings in the E&Y

report” that hold them responsible for any loss to Reebok India.

Mishra’s lawyer Harish Bharadwaj declined comment because “the matter is pending in court”.

A spokesperson for Reebok India said the exact gains of the two main accused are yet to be assessed.

“The falsification of accounts at RIC (Reebok India) will result in a restatement of the prior year financial results of the Adidas Group of €125 million. There has been no

change to these previously reported numbers. Due to the poor state of the customer accounts, reconciliations are

taking much longer than anticipated. As a result, the exact amount of the restatement cannot yet be

determined. The financial gains attributed to the two accused have not yet been fully deciphered,” she said in

a mail.In its original complaint to the Gurgaon Police, Adidas offered a break-up of theRs.870 crore number: Rs.530 crore on account of so-called parallel accounting that

inflated sales, which were not passed on to the company; Rs.147 crore in goods invoiced but not

dispatched; Rs.63 crore in goods returned and pending inspection;Rs.0.9 crore on account of secret warehouse

bills, Rs.14.82 crore in interest lost on a franchisee referral programme; and Rs.98 crore on account of

payments to and from customers (dealers and distributors).

Agarwal said the Rs.530 crore is a difference in “reconciliation” and “as such, a non-monetary loss to the

company”. The audit report backs this.Interestingly, as Mint reported on Monday, the Gurgaon

Police has arrived at a number of Rs.11.3 crore, and not Rs.870 crore, after its investigations.

To be sure, this could be because the police is “essentially looking at the criminal aspect”, according to an official at SFIO, who did not want to be identified. This

person added that his agency is looking at the “accounting aspect” and that the lower estimate by the

police does not necessarily absolve the accused.E&Y was appointed by Adidas to conduct the financial

audit. Mint couldn’t immediately ascertain the total value assigned by it to the irregular transactions it discovered.Agarwal claimed that the audit firm is being paid Rs.130 crore for its services. Mintcouldn’t independently verify

this number.According to the E&Y report, around Rs.147.25 crore of

goods were “billed but not delivered” and stored in secret warehouses owned by Shivam Enterprises and Oriya

Sales, both owned by Mishra.Reebok India hired the warehouses in October 2009, and between then and June 2012, paid a rent of Rs.1.43 crore.On its books, Reebok showed the goods as having been

sold to its dealers and distributors, according to the forensic report—it even had invoices—but it had no intention to deliver them, merely to inflate sales.

The company, the report adds, also inflated sales by storing stock returned by dealers and distributors in other

designated (read: on the book) warehouses, but simply chose not to account for them for a long time. The

forensic audit shows mail trails between employees to the effect.

E&Y’s report also shows that Reebok India showed higher sales revenue by effecting retrospective increases in the price of goods already sold to dealers and distributors.

This increased both the sales revenue and the accounts receivable (or amount due from dealers and distributors). These retrospective price increases netted the company

around Rs.86 crore, according to the report.The firm also seems to have done some circular trading, according to the report, selling goods to be repaired to Mishra’s Shivam Enterprises and Oriya Sales forRs.35.2

crore, when their value was actually lower by around Rs.14.3 crore. Interestingly, it received

only Rs.3.08 crore for these.Some of these goods were further sold to dealers for Rs.3 crore by the two companies, which also sold back the rest

to Reebok India through Om Trading, another Mishra-owned company, for Rs.14.4 crore. And Reebok

paid Rs.4.1 crore of the Rs.14.4 crore.In effect, according to the report, Reebok

received Rs.3.08 crore, while paying Rs.4.1 crore. Mint couldn’t establish how the company

accounted for these transactions or whether its books

recognized the reduction in stock (since Shivam and Oriya sold some goods) in the final leg.

In a similar transaction, Reebok India, the audit shows, also sold defective goods worth Rs.21.5 crore to a

company called KK Enterprises as recently as December 2011, but actually moved them to a secret warehouse from where some part was sold to some unauthorized

buyers.These sales transactions to the unauthorized buyers were off the books. The remaining goods were booked as sales returns in May without accounting for the goods sold to

the unidentified buyers.The Gurgaon Police filed its charge-sheet in the case on 12 November. SFIO will submit its report to the ministry

of corporate affairs by 30 November, said the SFIO official quoted above.

Investor ConcernA quick investigation and trial may help rebuild investor

confidence after India slipped to 46th place, behind Grenada, among the 183 nations ranked for ease of doing

business in the World Bank’s 2012 “Doing Business Report.” It was 44th in 2011.

“Investors will be keeping an eye on the investigation and on what would be the consequences for Reebok and other

brands there going forward,” said Mark Josefson, an analyst at Silvia Quandt Research GmbH in Frankfurt,

Germany. “It’s good that Adidas quantified what the costs

will be. The investigation speeds up the planned reorganization process within India for the Adidas Group

at large.”Adidas estimated last month that irregularities at Reebok

India may cost as much as 125 million euros ($155 million). Reebok India filed the criminal complaint on behalf of Adidas. The parent company operates about

900 Reebok franchise stores and about 700 Adidas licensed retailers in India.

The Economic Times newspaper reported earlier today the Serious Fraud Investigation Office will investigate

Reebok India.The probe is the second conducted by the agency in the

past 16 months involving an overseas company. Citigroup Inc. was investigated in January 2011 after a local

employee illegally siphoned off almost $66 million from investors.

The Serious Fraud Investigation Office was set up under the Ministry of Corporate Affairs to detect and prosecute

fraud. It consists of experts on subjects including accounting, taxation, law and capital markets, according

to its website.Adidas AG’s Reebok business in India will be investigated

by the country’s anti-fraud agency for suspected accounting irregularities, government officials said.

Adidas filed a criminal complaint on May 21 after saying last month it had found flaws at the Indian arm of its

Reebok unit. Police are investigating two former Reebok India executives after the company made allegations of

fraudulent practices worth as much as 8.7 billion rupees ($155 million), one person involved in the inquiry said on

May 23.The Serious Fraud Investigation Office on May 29 was asked to investigate the matter and submit a report within four or five months, two government officials

familiar with the matter said today. They declined to be identified because they aren’t authorized to speak

publicly. Investigators may request more information from Adidas’ headquarters in Herzogenaurach, Germany,

if needed, one of the people said.“We don’t comment on pending investigations,” said Katja Schreiber, a spokeswoman for Adidas. “We shall

continue to cooperate with the authorities in their investigation.”

Adidas shares gained 0.5 percent to 59.96 euros as of 11:41 a.m. in Frankfurt. The stock has risen 19 percent this year, the second-best performance in Germany’s

benchmark DAX Index.

Experiencing Shoe-Bite

For over six years after Adidas acquired Reebok, the two businesses in India operated as separate entities. The

companies had very different operating styles and management reported to the US and Germany

respectively. People who regularly interacted with Reebok say that its American culture was more aggressive, and

bordering on brash.

Adidas, on the other hand, operated in a more disciplined manner. Its employees went about scouting the market more methodically. When Adidas also started using the minimum guarantee approach about five years ago, its

teams were forbidden from deviating from certain minimum parameters while negotiating these deals.

Everything had to be approved by its headquarters in Gurgaon. At Reebok, the teams could make a business

case for a store that would be approved later. This had its downsides because there were allegations that some

employees took advantage of the system to indulge in corrupt practices.

As a result, two things happened. Reebok grew rapidly. After losing money in its initial years in India, Reebok managed to wipe them out and closed its 2011 books

with a profit of Rs 50 crore. It paid out about Rs 120 crore in royalty. Annual sales stood at about Rs 700 crore.

Adidas, he says, has lost Rs 137 crore in the time it has been in India and sells roughly Rs 450 crore worth of

shoes and merchandise every year.In May 2011, Prem was appointed the India managing

director of the Reebok-Adidas combine. That’s when the cookie began to crumble. The business was hit on

multiple fronts. A hike in excise duty on apparel, an increase in value added tax and a rupee that swung

between 49 and 54 to the dollar increased costs by Rs 100 crore. Sales declined and Reebok closed the year

with Rs 650 crore in sales.

The decline in the fortunes of the Indian operations was badly timed. Under Route 2015, Adidas AG began to push for more control over the Indian operations. While Prem was made managing director, they insisted that finance

be headed by someone from within the Adidas fold. Shahin Padath was given the task of integrating the finances of the two businesses in India. It is unclear

whether he approved last year’s financial statements. The company declined to provide a specific answer. Late last year, Adidas AG began to push for the appointment

of Frederic Serrant as sales director. Prem resisted because he felt a local was better suited. But his bosses in Germany decided to send Serrant to India to work on

the Route 2015 project to downsize stores.People familiar with the situation say what eventually did Prem in was the high receivables on the books. They say that Reebok, with its aggressive sales team, stuffed stock on retailers. “Stuffing the retailer channel in this business

is not uncommon,” says Devangshu Dutta, chief executive, of Third Eyesight, a retail consultancy. “The

problem comes when sales slow [down].”Prem agrees that the company’s receivables were high,

but says that all the stock was accounted for. This is probably the reason why Adidas was keen on downsizing

Reebok’s operations more aggressively. When Prem refused he had to move on.

ConclusionOn the evening of March 25, Prem completed his review

and was told he should step aside so that Heckerott could take over. He agreed and boarded a plane to India the next day reaching Delhi on the 27th evening. On the

28th, he emailed his resignation.Prem says the next day he received an email saying

Adidas was surprised he had resigned as he had been terminated for a reason. Thereafter, he sent two emails in

April asking Adidas what the cause for his termination was only to be met with silence.

Meanwhile, Adidas asked KPMG, its auditors in India, to conduct a forensic audit of its books. Their conclusion was

unequivocal. There were commercial irregularities in Reebok’s side of the business that had to be dealt with.

When contacted, KPMG declined to comment.

On the morning of April 30, a few hours before the company announced its annual results, the legal team at Adidas informed Prem that he had been terminated due to commercial irregularities. Adidas clarifies that it is not

accusing him of profiting personally, but declined to make available a copy of the criminal complaint that it has filed with the Economic Offences Wing of the Gurgaon Police. For now, Prem, who has filed two cases against Adidas

AG, says he plans to follow them to their logical conclusion. He refuses to settle with his former

employers. “I have to fight for my honour.”The Gurgaon Police filed its charge-sheet in the case on 12 November. SFIO will submit its report to the ministry

of corporate affairs by 30 November, said the SFIO official quoted above.

Prem and Bhagat and the other executives have been in judicial custody since September. They have been booked for falsification of records, diversion of funds, causing loss

to the company and wrongful gain.

ForesightRemembering last year's Rs 870 crore fraud at its arm

Reebok India as a 'thing in the past', Adidas India MD Eric Haskell has said the company is now focused on building

the brand and driving growth."This (Reebok fraud) is deep in the past for us. We are focused on growing the business. We have been busy with product launches and new marketing activities in

2013," Adidas Group India managing director Eric Haskell told

Adidas, which owns Reebok, had to take euro 211 million hit on account of the fraud at Reebok India that was

allegedly committed by the company's former managing director Shubhinder Singh Prem and former chief

operating officer Vishnu Bhagat. The matter is under investigation.

Haskell said the company has always co-operated in the probe. The fraud was uncovered in May 2012.

In March this year, Adidas group had announced that due to the irregularities at Reebok India it had restated its financial statements which "led to a reduction of net

income attributable to shareholders of euro 58 million for 2011. In addition, shareholders' equity of the opening balance sheet for 2011 is negatively impacted by euro

153 million".The Serious Fraud Investigation Office (SFIO) submitted its final report to the ministry of corporate affairs, which

is expected to take a final decision soon.The report is said to have found violations by the Indian as well as overseas management personnel at Reebok.Meanwhile, Haskell said, fitness brand Reebok India is

targeting 40 per cent of total sales from women customers as it plans to open 100 fit-hub concept stores

by April 2014."There is a big emphasis on focusing on women

consumers. We are seeing big increase in the percentage of women's business... we are targeting 40 per cent

business from women's stores as we open 100 fit hub

stores by April 2014," he said.The Reebok fit-hub stores offer fitness and training

products besides advice, guidance and information on community based fitness events.

Out of the 100 such stores, 50 will be new and the remaining half will be renovated ones, he said.

By 2015, the company plans to convert all of its 400 plus existing stores into fit hub stores.

Acknowledgement: A hearty thank to Kapil Thakur sir for giving us such an interesting topic for research and

assignment.