SEBI Revises Consent Process

While Rajat Gupta, ex-board member of Goldman Sachs is facing the trial by fire on insider trading charges in US, Stock Exchange Board of India (SEBI) has tightened the screws on the consent process for stock market manipulations and offences.

SEBI last week revised the earlier rules passed in March 2007. Some of the critical features of the revised consent process are:

1. Face the Music

Certain defaults including insider trading, front running, failure to make an open offer, redress investor grievances and respond to the summons issued by SEBI are excluded from the consent process. The defaults falling in the category of fraudulent and unfair trade practices, which in the opinion of SEBI are very serious and/or have caused substantial losses to the investors, shall also not be consented.”

The details are below:-

SEBI shall not settle the defaults listed below:
i. Insider trading i.e. violation of Regulation 3 and 4 of the SEBI (Prohibition of Insider Trading)Regulations, 1992;

ii. Serious fraudulent and unfair trade practices which, in the opinion of the Board, cause substantial losses to investors and/or affects their rights, especially retail investors and small shareholders or have or may have market wide impact, except those defaults where the entity makes good the losses due to the investors;

iii. Failure to make the open offer (except where the entity agrees to make the open offer or if in the opinion of the Board, the open offer is not beneficial to the shareholders and / or the case is referred for adjudication);

iv. Front-running; for the purpose of this circular, front running means usage of non public information to directly or indirectly, buy or sell securities or enter into options or futures contracts, in advance of a substantial order, on an impending transaction, in the same or related securities or futures or options
contracts, in anticipation that when the information becomes public; the price of such securities or contracts may change;

v. Defaults relating to manipulation of net asset value or other mutual funds defaults where the actions of the asset management company (AMC)/ mutual fund (MF)/sponsor, result in substantial losses to the unit holders, except cases where the entity has made good the losses of the unit holders to the satisfaction of the Board;

vi. Failure to redress investor grievances(except cases where the issue involved is only of delayed redressal);

vii. Failure to make such disclosures under the ICDR and Debt Securities Regulations, which in the opinion of the Board, materially affect the right of the investors Non-compliance of summons issued by SEBI;

ix. Non compliance of an order passed by the Adjudicating Officer (AO), Designated Member (DM) or Whole Time Member (WTM);

x. Any other default by an applicant who continues to be non-compliant with any order passed by the (AO) or (DM) or (WTM).”

This means that where SEBI considers breach of law or listing guidelines, the companies, investment managers, brokers etc. won’t be able to pay a fine and get away with it. Previously, on such charges, SEBI allowed them to pay the fine while not admitting guilt and sometimes by voluntarily agreeing to debar from the  from stock markets. Now without being allowed to go through the consent process, the organizations and persons alleged to have committed the above-mentioned acts will have to go through a legal process for criminal offences except in some exceptional cases. SEBI has allowed itself some room for maneuverability for some cases. In regular cases, now an organization can go through the consent process only for small technical breaches.

2. One Time Lucky

No consent application shall be considered, if any violation is committed within a period of two years from the date of any consent order. However, if the applicant has already obtained more than two consent orders, no consent application shall be considered for a period of three years from the date of the last order.”

Hence, this clause allows leeway once only in a couple of years. If an organization has already gone through a consent process, it is not going to get away easily without some criminal charges the next time round. The practice of organizations to claim a mistake has been made every year whenever they get caught will have to stop.

Closing Thoughts

The rules are good. SEBI is finally gearing itself to govern and regulate the stock markets properly. This move in the long-run will build investor confidence and dissuade asset managers, brokers and organizations from indulging in malpractices. Reliance Industries has an ongoing case for insider trading, along with a couple of other banks for front running and stock market manipulations. Reliance has appealed to the Bombay Courts to be allowed to go through the consent order process available before as it’s case is  from 2007.

The method SEBI chooses to deal with the older cases, will decide the fate of many organizations. It appears the organizations are worried, and that for regulators is a good strategy. The last high profile case of consent was of Anil Ambani group in which the group paid a Rs 50 crore (USD 8.93 million ) fine. Hence, in all likelihood the organizations with pending cases will either have to pay high fees or face criminal charges.

References:

  1. Streamlining of Consent Process
  2. Modified Consent Process Circular
  3. Reliance Industries moves Bombay High Court on new consent order rules

An Update of Adidas India Euro 125 Million Fraud Story

In the last couple of weeks, some startling information was revealed by the media about the fraud. To recap, Adidas global management disclosed euro 125 million (Rs 870 crore, USD 157.68 million) fraud in India operations in the first quarter end report of 2012. Subsequently, Adidas India management filed a police complaint against the ex-CEO Subhinder Prem Singh and ex-COO Vishnu Bhagat. Now the battle lines are drawn and allegations are flying. Here are some surprising revelations of the case so far.

Adidas management is alleging “commercial irregularities” and mismanagement of Reebok operations for last five years. Reebok and Adidas India operations were merged under Mr. Singh last year. Mr. Singh portrayed it that the allegations are more about a power struggle between the two groups and Adidas India operations has similar number of unreported frauds, as mentioned in the earlier post.

Some financial numbers and other details that were reported by the media are:

1) Profitability of Adidas & Reebok India

An Economic Times article stated that Reebok India March 2010 reported Rs 786.1 crore (USD 142 million) total income with a loss of Rs 40 lakhs (USD 72,000) . On the other hand, Adidas India operations showed a profit of Rs 455.6 crore (USD 82.75 million) for the year ending March 2010, with a profit after tax of Rs 9.01 crore (Rs 1.63 million). Mr. Singh attributed the difference to two aspects. First, Reebok India had a share capital of Rs 23 crore (USD 4.16 million) in comparison to Adidas India’s share capital of Rs 99 crore (USD 17.94 million), hence has to pay interest on borrowed funds. Second, Reebok India paid a royalty of 5% on sales, that amounted to Rs 110 crore ( USD 19.93 million), whereas Adidas India isn’t required to pay royalty. Hence, Mr. Singh’s contention is that Reebok India  performed better than Adidas India.

This practice of charging royalty to one arm of the company and not the other in the same country, is somewhat controversial. It raises questions on the transfer pricing practices followed by the company.  The Income Tax department may view it as an intentional strategy to deflate profits to avoid taxation.

Subsequent to the story breaking, the Income Tax department has commenced an inquiry and issued notices to executives for probing financial wrong-doing in last four years to determine tax evasion.

2) Police Complaint

The FIR, which has been seen by Bloomberg UTV says that: 

– Irregularities include over-invoicing to the tune of Rs 147 crore (USD 26.64 million)
– Running a false franchisee referral programme, receipts from which were about Rs 114 crore (USD 20.66 million)
– Maintaining four secret warehouses where company goods were diverted, all of which have been sealed and goods confiscated
– Raising fake invoices of about Rs 98 crore (USD 17.76 million) to show higher sales and claim promotions, bonus and incentives
– And collusion with some customers to aid the two officers in the scam”

Behind the allegations, the details when pieced together give the following story.

According to the Economic Times story, Mr. Singh started gunning for the top job of the merged entity from 2008, knowing that merger was inevitable. He pursued expansion plans to show numbers and beat internal competition, at the expense of profitability.

The source of the problems appears to be the minimum guarantee strategy adopted for store franchises.  Reebok had 100 stores in 2003, and grew to 800 stores. As per the minimum guarantee program, the franchisee was given a specific sum, irrespective whether the company earned any money from the store. Small time business persons were invited by Reebok to open stores and these stores didn’t make any money. Hence, the costs ran high, with no revenues. Rumors are that some money was earned by Mr. Singh privately for opening these stores.

Another information shared by police is that Adidas management claim that Mr. Singh and Mr. Bhagat diverted stock to four secret warehouses near Delhi doesn’t hold much water as no stocks were found in the warehouses. Adidas India claims to have confiscated goods worth Rs 63 crores (USD 11.41 million) from these warehouses. According to the police, three of the four warehouses were empty, and the fourth the new management has taken the goods.

However, from the information available so far, it appears that sales figures may have been inflated, and closing stock deflated to show higher profitability and meet the growth targets. It is possible, that false sales invoices were created and the goods transferred to the warehouses. There are allegations from store owners also that there are discrepancies between statement of accounts. The debit and credit balances significantly differ. Hence, the sale invoices may have been made in the franchises name without an actual sale. If this is true, most of the internal controls were over ridden by management.

Another aspect reported was that German management at headquarters was aware of the complaints and various issues cropping up, however chose to ignore the same due the great performance being shown. They apparently didn’t take proper action on the auditors report also. Of course, there are likely to be questions raised as to quality of work done external and internal auditors.

With all the information available till date, the fraud figures don’t add up to Rs 870 crore (USD 157.68 million). The police investigators are stating that beside the complaint, no evidence has been provided by Adidas management till date. Reading the corporate boxing match, Registrar of Companies under Ministry of Corporate Affairs has commenced an investigation.

Closing Thoughts

With all the dirty linen being washed in public domain by Adidas group, it has attracted regulators attention. If the plan was to browbeat Mr. Singh, without adequate evidence the prosecution will fail. If in reality all the allegations can be proved, then Mr. Singh along with a number of senior executives are in hot soup. Till date it is the largest fraud case reported by a multinational company in India. Let us wait and watch to get some more juicy information.

References:

  1. How Adidas Slipped in India – Economic Times
  2. Reebok under tax lens, Adidas seizes goods from warehouses
  3. The Reebok Adidas scam – another corporate saga in courts

Indian Social Values – Root of Corruption

Page three newspapers are full of celebrities’ rave parties, fist fights, sex scandals, botox treatments, etceteras. The not so rich idealize these celebrities and mimic all, to be the in-crowd. With these social values, can Indian’s consider it cool to be good?

The west puts India on the pulpit for its values. From Beatles to Julia Roberts, western celebrities talk about Indian culture of prayers, the land of discovering one’s spirit and sense of being. When majority of the middle class Indians themselves are lost, the crown of leader of spiritual world appears  somewhat misplaced. Indians in the present world, from birth, get to understand that all human emotions come at a price. This may sound as a harsh statement, but is reality. Let us walk through the different phases of life of a middle class Indian to discover the spiritual compromises they make.

1. Indian Childhood

India post-independence from a land of leaders propagating good values  has turned into a land people indulging in  unscrupulous behavior in the name of social values. It starts with birth. From the 1960’s the desire to have a son grew among parents. Educated parents get female fetus aborted  since the son has more value in the marriage market. The sex ratio is 109.4 males to 100 females in 2011. According to reports nearly 50,000 female fetus are aborted every month.

The reason for abortions is financial. According to the Indian system, a girl’s father in arranged marriages pays dowry for getting a husband for his daughter. Secondly, in the conservative families daughters aren’t allowed to work. Hence, the cost of raising a daughter, educating her, is lost while a son earns back the money for parents from working and getting a dowry. Therefore, sons get a better treatment from parents from birth. From food, clothes, education and hobbies the girl is forced to sacrifice for the brother. Basically, from the day a child is conceived, Indian parents put a value on the child. There is a profit and loss motive in child upbringing.

With these values apparent in the household from childhood, is it surprising that Indians ethical values are confused? Can a child raised on the basis of returns s/he will bring to the parents on becoming an adult, consider emotions and principles above money? Are parents raising kids or cattle for sale?

2. Indian Youth

Indian parents tom-tom about their love for their children and their dedication to keep the children with them. They look down on their western counterparts, who let the kids leave home between the age of 16-20 years to live on their own. In India, 30 year old unmarried sons and daughters can also be found living with their parents. It arises from an attempt to control who the youngster marries, specially for sons, so that a big fat dowry can be earned.

In respect to daughters, it is a need to keep their image unsullied. A daughter having an affair is a no-no among conservative families. Good girls don’t have relationship with boys. While the boys can have relationships with girls, and any girl who has a sexual relationship with a boy is of loose moral character. It it surprising that with this culture, Indian youth does not have normal relationships with the opposite gender.

India is the 4th most unsafe place in the world. Eve teasing or sexual harassment is rampant and young Indian women endure comments from men even when walking to office at 9 a.m. According to a survey of developing nations, Indian men are the most sexually violent, with 24% having committed a sexual crime. Another survey states 65% men believe sometimes a women deserves to be beaten. With these results and mindset, can one ensure gender equality at work?

An Indian’s professional mentor/buddy in the first job is the person who teaches them to fudge the reimbursement bills of their salary. For instance, employees are entitled to medical reimbursements. The friendly mentor will share information of a medical store from where fraudulent medical bills can be obtained by giving a cut.

After being raised in this culture, can Indian youth have independent thinking, proper adult relationships and professional values? Most lip sync their parents’ desires for them, rather than discovering and understanding their own being. Abnormal behavior – living with one’s parents in adulthood, harassing opposite gender – is socially considered normal. Normal behavior of having adult relationships, independent living and maintaining professional ethics, may make the youth a social outcast. After being raised in this social climate, can Indian youth make India the next superpower?

3. Indian Marriage

The biggest trade in India, is of arranged marriages. Marriages aren’t made in heaven, they are negotiated for the best deal. The sons are put up for sale and the daughters’ fathers attempts to purchase the best available husband for her, according to their financial position.

If one sees it from an economic angle, the husband to provide for the wife lifelong, takes upfront payment from his wife’s father. Looking from another angle, the woman gets a man to have sex with her for life after being paid by her father. Prostitution is illegal in India, and prostitutes are looked down upon. But sale and purchase of husband and wife is a socially accepted norm.

In rural areas, the situation is worse. If a couple belonging to different castes falls in love, the male members of the girl’s family do honor killing, they kill the couple. It is a crime to fall in love, and humiliating for the parents. From all this one can conclude that Indian rational of honor, esteem and self-respect is quite contrary to human race.

Even divorce involves social stigma. In reality, 90% of urban husbands have had extra marital affairs. Most of the urban wives are educated but don’t leave their marriages even after being aware of the affair, as their standard of living will become lower. India has one of the lowest divorce rates with just one in a hundred marriages collapsing. There are just around 10,000 or so divorce cases filed each year. Despite the fact that there were 8391 dowry deaths in 2010 and 90,000 cases of torture and cruelty towards women by their husbands. This is when most women don’t report to police due to sense of social shame. Aren’t the numbers ironical. Abusing women is considered a social privilege of the Indian male. Moreover, educated women prefer to take abuse rather than stand on their own two feet and earn their living.

Closing Thoughts

Can Indian marriages teach valuing human emotions when they are nothing more than a financial transaction? After parent-child relationship, the second most precious relationship is of husband-wife. In India, both have monetary values attached to it. When critical relationships are not based on ethics, what is the probability of the society respecting professional ethics?

Indian ideas of honor, respect, ethics and principles are bunkum. A thief steals a women’s purse, he is a criminal. A  husband steals his wife’s dignity and her father’s retirement saving, he is respectable. It is a case of sacrificing rational thinking to camouflage social ills.

Last week, the government issued a “White paper on black money”. The paper describes ways and methods to curb corruption and reduce black money. However, with this social environment, the best efforts are likely to fail. Can an average Indian be considered as having a fully developed “Conscience”? Anywhere close to spiritual awakening? What do you think?

References:

  1. Disappearing Daughters: Women pregnant with Girls pressured into abortion
  2. Divorce Rate High Among Indian Techies
  3. Dowry murders in India result in few convictions
  4. Indian men most sexually violent, says survey of six developing nations
  5. International Center for Research on Women

Can Compensation Committees in India Decide Executive Pay?

With great power comes great responsibility. However, with the recent protests in US and UK by investors on banks CEO’s pay (RBS, Citi, Barclays), this dictum can be altered to “with great power comes a great salary”. This debate again raised the discussion on role of compensation committees. Are the compensation committees empowered to decide salary of CEOs or is it just a theoretical eye-wash? Let us delve on this topic from an Indian perspective, as till now the investors haven’t raised a hue and cry about it.

1. A Look at the Highest Paid CEOs

Business Today jointly with INSEAD-HBR did a study to identify India’s best CEOs by evaluating their performance from 1995-2011. As per the study Mr. Naveen Jindal, CEO of Jindal Steel & Power ranked first, followed by Mr. A.M.Naik, CEO of Larsen & Turbo and Mr. Y.C. Deveshwar, CEO of ITC. By another study Mr. Jindal is also the highest paid CEO in India with a salary of Rs 69.7 crores. (USD 12.75 million ).

However, the other two CEOs do not come in the top ten list of highest paid CEOs in India, as both are professional CEOs. Mr. Deveshwar’s salary plus perks excluding bonus was Rs 5.52 crores (USD 1.01 million) and he was entitled to a bonus limited to Rs.6.24 crore (USD 1.42 million) for 2011-2012 financial year. Mr. A.M.Naik’s salary including stock options was Rs 14.18 crores (USD 2.59 million) for the same period. Though market capitalization, net profits and growth have been on similar graphs for all the three companies.

Mr. Mukesh Ambai, CEO of Reliance Industries is ranked seventh on the list of best CEOs’. After being on the highest paid CEO list in 2008, he voluntarily decided to restrict his salary to Rs 15 crores ( USD 2.74 million) though he had shareholder approval for Rs 38.82 crores ( USD 7.10 million). However, the amount is peanuts considering his wealth. He is the richest man in India with a net-worth of USD 22.3 billion  and he along with his family are entitled to dividends of Rs 1244.33 crores ( USD 227.73 million) in 2011-12 financial year from Reliance Industries alone.

Most of the highest paid CEOs in India, consist of promoter-owner CEOs, and not professional CEOs. There is a huge disparities in the pay structures.

2. Disparities in Pay Structure of Chairman, Managing Directors and Directors

Looking from the regulatory angle, as per the Companies Bill, a managing director ( CEO in American terms) pay cannot exceed 5% of the net profits of the company. The total remuneration to directors cannot exceed 11% of net profits of the company. However, if approval of higher salary is taken from the shareholders in a general meeting, the limit can be exceeded with the approval of Central Government. Now the question is,  as the CEOs get the highest pay packet and promoter-owner CEOs have controlling stake, can the other directors really have much say, monitor the activities and decide on remuneration?

Coming back to Mr. Jindal’s case, he stated in the Business Today interview, that he spends 20-25% time on business, and most of his time is spent on his constituency as he is a Member of Parliament. Members of Parliament just earn around Rs 50,000/ per month. His mother, Savitri Jindal is the Chairperson of the Jindal group and 56th richest person in the world with the net-worth of USD 13.2 billion in 2011. Therefore, considering all this information, can the success of the company be attributed to him? Moreover, does he deserve this salary? Can the remuneration and compensation committee actually decide his salary independently and objectively?

Now let us look at the compensation of Chairman and Directors. Here are some details from  the India Board Report 2011: 

a) Non-executive director compensation ranged from Rs 1 to 10 lakhs (USD 18,000) in more than half of the companies surveyed. Average compensation rose 20% to Rs 9.9 lakhs in 2009-10 from Rs 8.2 lakhs in 2008-09.

b) The minimum compensation paid to non-executive directors was Rs 15,000 whereas the maximum
was Rs 54 lakhs (USD 100,000) for 2009-10 from among the companies surveyed.

c)  The average compensation paid to non-executive chairmen rose from Rs 15.7 lakhs in 2008-09 to Rs 21.7 lakhs (USD 38,000) in 2009-10, an increase of 38%.

d) Among the companies surveyed, the minimum compensation offered to the non-executive
chairman was Rs 16,000 and the maximum was Rs 13 crores (USD 2.37 million).

Hence, if you see the CEOs pay usually far exceeds Chairperson and Directors pays. There is no parity in their earning capacities and value for time.

3. Questionable Independence of Compensation Committees

In such a scenario, are boards capable of judging remuneration of CEO or other key personnel objectively? Generally, the Nomination and Remuneration Committees are charged with job. As per the Companies Bill in India, the committee should “consist of  three or more non-executive directors out of which not less than one half shall be independent directors.” Hence, the premise is that as there are independent directors, they will be fair. However, the question remains are these directors really independent ? Below are some information nuggets from the India Board Report 2011.

a) On an average in Indian boardrooms, 71% of directors are non-executive and 54% of the directors are independent. Just 16% of the directors are related to promoter or promoter’s spouse.

b) Just 10% of the board members were appointed through search firms. The rest were chosen through personal network of chairperson and managing director.

Therefore, in a way the independent directors appear superficially independent and there are deep relationships existing among them. More so, in family managed business. For instance, ITC has a diverse board room as public sector companies and banks have significant investments in the company. It is a 100 years old company and in last 15 years Mr. Deveshwar was the CEO. Therefore, the compensation committees can be transparent and objective only when they are not under the control of owner-promoter CEOs.

Closing Thoughts

In the western world, CEOs of banks and financial institutions are facing investment ire for unduly rewarding themselves at the expense of the shareholders. In India, the investors generally do not make any noise on pay structure of the owner-promoter CEOs as investors expect them to reward themselves. Although, the owner-promoter pay structures are 3-4 times higher than the professional CEOs. With such a mindset, can we really say corporate governance practices have a chance of succeeding in India? It is a controversial question, nonetheless, let me ask – What should the investors and regulators do to control promoter-owner CEO’s salaries?

References:

  1. Business Today – India’s Best CEOs
  2. India Board Report – Hunt Partners, PWC  and AZB & Partners
  3. Highest paid CEOs in India
  4. Mukesh Ambani’s salary and dividend
  5. Mukesh Ambani’s net-worth as per Forbes
  6. Savitri Jindal’s net-worth
  7. ITC chief Y C Deveshwar Pay Structure
  8. L &T chief A.M.Naik’s Pay Structure

Adidas India Euro 125 Million Fraud Story

The traders of good soles appear to have sold their souls. Adidas has filed a criminal complaint for euro 125 million irregularities reported in Indian operations in the first quarter results of 2012. The complaint mentions “commercial irregularities uncovered at Reebok India”. After Satyam, this is the biggest fraud reported in a private sector organization in India.

Briefly, Adidas acquired Reebok a few years back, however, the Indian operations were merged in 2011. Subhinder Prem Singh, head of Reebok India was appointed as the managing director of the merged entity. In March 2012, both Subhinder Prem Singh and the chief operating officer Vishnu Bhagat left the company. Very few details are available of the case till date, but the twists and turns are interesting. From the looks of it, this is going to be full-blown war and a lot of skeletons are coming out. Below are the events till date.

1. Adidas announcement on 30 April 2012

Following extract is from the Adidas press release. The statement states that commercial irregularities to the tune of euro 125 million ( Rs 870 crore, USD 161 million) have occurred prior to 2012 and prior year financial statements may require re-statement.

“In addition, Management also announces that commercial irregularities discovered at Reebok India Company, in India, will likely affect the consolidated financial statements of the adidas Group. The currently estimated maximum negative impact could be up to a pre-tax amount of € 125 million. Due to the sensitivity of the on-going investigation, specific details will be disclosed as appropriate in due course. As these irregularities have been deemed to have occurred prior to the 2012 financial year, the adidas Group might have to restate prior-year consolidated financial statements in line with the requirements of IAS 8. The financial statements of adidas AG will not be affected by this issue. Management assures its stakeholders that it has, and will continue to, vigorously pursue a course of action to protect the Group’s interests, which has already resulted in the appointment of a new local leadership team in India at the end of March.

Under this new leadership team, Management is further planning an accelerated restructuring of its business activities in India, including significant changes to its commercial business practices. This could lead to additional one-time charges in the remaining quarters of 2012 in an estimated amount of up to € 70 million.

2. Counter attack by Subhinder Prem Singh

After this announcement, Mr. Singh who initially reported that he left the organization on his own, clearly stated that he was terminated. He filed a case for damages of Rs 15 crore (USD 2.83 million, Euro 2.19 million) against Adidas. The Economic Times gave his version of the story. He says:

a) Adidas headquarters were “fully in the loop” on how Indian operations are run and it is not a one-man show. The finance chief of Indian operations was appointed by Adidas group last year.

b) He was called to Arizona, US on March 25, 2012 and after he presented the annual business plan, he was forced to leave and promised a severance package. Adidas did not give him a reason at the time of termination and he received a mail from Adidas subsequently that he was terminated due to “financial irregularities”. He denied any involvement in financial irregularities.

3) Further on he alleges that he exposed three major frauds in Adidas. He has given this statement on record – “The biggest scam was the scavenger deal (dumping rejects) running into Rs 200 crore, where about Rs 20 crore was illegally made by senior officials. However, the scam was brushed under the carpet because it related to Adidas and not Reebok, and the request to notify the fraud to the auditors at the year-end was turned down by the headquarters.” .

3. A few quick ones

a) Previous Frauds – While details are still not known, Mr. Singh’s statement about three previous frauds is definitely jaw dropping. He mentions Rs 200 crore (USD 37.36 million, Euro  28.15 million)) fraud in which senior officials made money. He doesn’t mention whether he terminated the senior officials or took legal action against them. As the managing director of the organization, he was required to investigate the frauds, take action and report the same to headquarters and auditors. He mentions that he sought permission from head office to report fraud to auditors. How can that nullify his responsibility as the head of the entity?

b) Dumping rejects – In Indian organizations sometimes, in rejects sales there is a percentage cut taken by the management. The modus operandi is that some good stuff is passed by the quality inspection team as sub-standard or rejects. These rejects are then sold at nominal values to previously selected vendors. The vendors unofficially give a percentage of the real value of the products to the management. This risk can be easily mitigated by frequently checking the quantum and quality of rejects and getting an independent valuation done of the products. Ideally, Mr Singh should have initiated these risk mitigation steps if he knew the problem. He doesn’t mention this, so can he escape liability?

c) Auditors Role – An Indian firm N. Narasimham & Co. is the auditor of Reebok India.  In this case, KPMG is the group auditor, and till now neither of the auditors have made any statements. However, KPMG has stated that they did not audit Adidas or Reebok India for the past several years. But, as per recent reports in 2010 KPMG was appointed as a forensic investigator for Reebok and gave a clean report. If so many frauds were occurring in the organization, how come they did not detect and report anything previously?

In India, sometimes auditors take kickbacks to hide frauds, or don’t report frauds because they wish to maintain client relationships. Hence, again the question of auditor independence, liability and involvement are likely to arise.  One has to wait and see whether this becomes another incident similar to Satyam PWC case.

d) Risk Management– The 2011 annual report of Adidas states that they upgraded the risk management IT solution in 2011. The Group Risk Management department maintains the risk and opportunity management system. The description of risk management process and techniques used is at par with the best-in-class. The supervisory board is responsible for monitoring the risk management system. According to the annual report, the audit committee in September 2011 checked group wide effectiveness of risk management, internal control system, internal audit and compliance organization. In November 2011, it discussed the internal audit report for the year and then also planned scope for 2012. The question is that if the frauds relate to previous years, then how come with all this narration in the annual report, the frauds remained undetected. Is the description risk management practices for the consumption of the investors, or do these practices actually function?

On May 2, 2012 Transworld Business reported that a former senior marketing manager of Adidas, Britney Obstar, was sentenced for master-minding a fraud scheme of USD 336,000. She got payments made to her husband’s company for services that were never rendered. She continued the fraud for over a year. This definitely shows that there are some loop holes in internal control systems for monitoring senior management activities and transactions.

Closing thoughts

This will be an interesting case to watch. It is apparent that global organizations face challenges in managing local subsidiaries. Without an efficient management and effective internal control and risk management systems, the corporate office will remain blissfully ignorant until it is too late. In India, the corporate governance practices applicable to public listed companies do not apply to private limited subsidiaries of international companies. Hence, the practices that are strictly followed at head offices may not be adhered to at local Indian offices, unless the organization is culturally and technologically integrated. This case will bring out a number of risk management lessons for global organizations. Hence, let us wait for the story to unfold further.

References:

  1. AD-HOC: adidas Group announces preliminary first quarter 2012 results
  2. Criminal complaint filed by Adidas
  3. Ex-MD Subhinder Singh sues Adidas over fraud charge, seeks Rs 15 crore in damages
  4. Former Adidas Marketing Manager Sentenced for Fraud. 

Reflections on New Companies Bill Auditor Rotation Clauses

The New Companies Bill 2011, tabled at the Parliament proposes a few clauses on auditor rotation. According to the new provisions, an auditor will be appointed in the first annual general meeting for a five-year term. Thereafter, the auditor will be changed as per the members’ decisions.

An additional clause for listed companies states that the same individual auditor cannot be appointed for a term exceeding five consecutive years. Secondly, an audit firm cannot be re-appointed for more than two five-year terms. For re-appointment purposes for the individual auditor or audit firm, there has to be a gap of five years. Moreover, for appointment or re-appointment purposes, there should be no common partners between the new firm and old audit firm.

Another interesting clause is that members can resolve to ask the audit firm to rotate the audit partner and team every year.

These clauses will ensure that auditors rotate every five years in the listed companies. As investor confidence is based on independent reporting of the auditors, the thought behind these clauses is that rotation of auditors will ensure independent reporting. The move is good, as economic growth is dependent on investor confidence in financial reporting. These clauses were incorporated in the draft after the Satyam fiasco. However, rotation isn’t a silver bullet that will resolve all auditor independence issues. A few concerns about the clauses are listed below:

1. Appointment of auditors for listed multinational companies.

Similar auditor rotation provision do not exist in other countries. In US, PCAOB recently held discussions on auditor rotation and independence. The general opinion of US auditors was that rotation does not ensure independence and comes with a huge financial cost. Hence, the question comes up whether multinational companies will be open to having different auditors in India, than in their headquarters. For large organizations, consolidation of accounts from different locations is a huge task, and with different auditors the information flow and audit practices may differ. Hence, the head office auditor may find it difficult to rely on the work of a local auditor.

Multinational companies are generally comfortable with big four, hence the audit will continue to rotate between big four. Very few Indian companies have the skill set and bandwidth to audit large multinationals. Therefore, this clause will put some practical challenges for multinational listed companies.

2. Audit firms’ partnerships

Indian audit firms scenario is unique in a way, as Institute of Chartered Accountants of India prohibits foreign audit firms to practice in their own name. Pricewaterhouse is the only one allowed, since it entered the market before these guidelines were passed. Others, for instance, Ernst & Young Indian member firm is S.R.Batliboi and company, and all audits are performed in Indian firm’s name, though partnerships are common. The provision of not having common partners applies in this scenario, as some audit firms are auditing under multiple names. PWC audits under the names of PW and Lovelock & Lewis.

The challenge in this clause is that audit partners move among the group companies. Some firms have organized the partnerships in a way to avoid common partnerships, however work under the same management. It will be a difficult task for companies to identify linkages between various audit firm partnerships. The onus should ideally rest with the audit firm to ensure that there are no common partners.

Another interesting aspect is  audit partners movement among big 4 and other companies. If an audit firm is pursuing an appointment, they now will have to be careful that another firms audit partner is not recruited in their partnership at the same time. This might again result in some fancy footwork to avoid the loss of a client.

3. Independence of the retiring auditor

According to the provisions, audit firm will mandatory be changed after two consecutive five-year terms. In simple words, ten years is maximum period an audit firm can audit a client on a single stretch. Hence, the audit firm knows that it is going to lose the audit client, however, the option to provide non-audit related services opens up. Law prohibits auditors from providing the following services to audit clients:

(a) accounting and book-keeping services;
(b) internal audit;
(c) design and implementation of any financial information system;
(d) actuarial services;
(e) investment advisory services;
(f) investment banking services;
(g) rendering of outsourced financial services;
(h) management services; and
(i) any other kind of services as may be prescribed

These services generally are more lucrative than the audit fees earned. Hence, a retiring auditor may wish to keep good client relationships to obtain future assignments. In such a scenario, one has to view rotation benefit skeptically, as the audit firm may not maintain independent reporting  as desired. Rotation of auditors in such a case may just result in adherence to legal requirement instead of contributing to auditor independence. As such, old Indian business houses have 2-3 audit firms that they use interchangeably in various subsidiaries for audit and other services. The work would just get shared among them.

4. Selection of new audit firm

As mentioned earlier, selecting a new audit firm will be difficult for large organizations. Reason being, besides big four there are just a handful of Indian audit firms who have the capability of conducting audits of multinational organizations. A few of these would already be providing some consulting services to the audit client, hence would not be eligible for appointment as auditors. If the potential of earning from consulting services is more, they might not drop those assignments in favor of audit.

Next aspect is that the provisions have additional clauses for barring a person from becoming an auditor. These relate to the usual clauses of individual, partner or his relative not having in holding or subsidiary companies – securities, directorships, loans, business relationships, managerial positions, or any other conflict of interest.

These clauses result in audit firms and client doing a lot of leg work to ensure that all legal requirements are met. All these aspects limit the choice of selection of new auditor to 3-4 audit firms. Since the audit business is going to circulate among the same set of audit firms, it is doubtful that mere auditor rotation would result in better financial reporting.

Closing thoughts

Auditor independence is a complex subject as it forms the bedrock of investor confidence in financial reporting.  Auditor rotation is a good step to ensure that auditors do not lose their professional skepticism and independence by doing the same audit for decades. However, additional quality monitoring procedures of audit firms and review procedures of financial reports need to be built in the regulatory system in India. India lacks a few aspects of US and other developed countries in this matter, however, that is a discussion for another post. On a positive note, the rotation clauses give an opportunity for medium-sized Indian audit firms to build skill sets to pitch in for business of large organizations.

Diversity Management Risks in Global Organizations

Barack Obama in his autobiography “Dreams of My Father” reflects  “where do I belong?”. Being a child of parents of different races and religions, he spent a childhood searching his identity. Bill Clinton in his autobiography “My Life” discusses a white child’s perspective on segregation of schools in America in 1950s. Both men grew up without their real fathers presence; Obama’s lived in Kenya and Clinton’s lost his real father before birth in a car accident. Their step-fathers didn’t play an important role in building their characters, both attribute their mothers for raising and guiding them.  The personalities reflected in the books are different. Obama comes across as an intellectual and philosophical man, Clinton appears to be a people person and detail oriented. However, Americans and worldwide public had remarkably different viewpoints just because of the color of the skin.

Moreover, their religious faith did swing some votes in their favor. Barack Obama’s credibility is still questioned by opponents by stating that his grandfather was a Muslim, hence Obama cannot be following Christianity. Even in the world super power politics, race and religion play an important role. The more recent case is of Nicky Haley stating she has converted from Sikhism to Christianity. She is an Indian born in US, with the name Nimrata Rhandawa married to Michael Haley. That she felt the need to convert, and was questioned by a Time magazine reporter as to whether she will give a bigger tip to Sikh cab drivers, depicts the hypocrisy of choosing candidates based on performance, ideologies and meritocracy.

Closer home in India, religion still plays a major role in politics. Dynastic politics prevails and even the first family of Indian politics projects belief in Hinduism. It is ironical that the family is secular in religious belief, however, has to present themselves as Hindus for public consumption. As per historical records Indira Gandhi a Kashmiri Brahmin (Hindu) married Feroze Ghandi, a Zoroastrian. To prevail politically, the surname spelling was changed to Gandhi, making it sound similar to Mahatma Gandhi, though there was no family connection. Rumors prevail that Feroze Ghandi by birth was a Muslim. Their first son Rajiv Gandhi, married Antonia Edvige Albina Maino (Sonia Gandhi), an Italian Christian and the second son Sanjay Gandhi married Maneka Anand,a Sikh.  However, the next generation of Gandhi’s – Rahul, Priyanka and Varun – publicly follow Hinduism.

Can’t blame them, because in India religion and region bias are huge. South Indians will view North Indians suspiciously and vis-a-versa. Among South Indians, the Telugu and Tamils will fight, whereas in North India the Punjabis and Jats will battle for superiority. Worse, grouping also  occurs on bases of caste and sub-castes. In such a scenario, with globalization, can organizations really ensure unbiased behavior and decisions on race and religion? Is it possible to wade out prejudices, suspicions and intolerance for a few hours at work, and come home to indulge in the same?

The challenges for organizations are mind-boggling due to technological advancement. As in this wordpress blog where readers from 50 countries visit daily to read posts, in global organizations faith, philosophies, ideologies, race and religion of employees are quite different. Homogeneous behavior cannot be brought about by a code of conduct or compliance team. Meritocracy can win only when it is built into the culture of the organization, else the spirit of the organization will be in tatters due to the dichotomies in employees faiths and beliefs. Hence, let us take a look at diversity management risks in multinational organizations.

1. Regulations of various countries.

Labor laws relating to age, race, religion and gender differ among countries depending on the legal, political and cultural environments. Additionally, in large countries, for instance US or India, they differ state wise and some vary according to industry. Therefore, multinational organizations have to devise policies and procedures on diversity management according to the laws of the country in which head quarters is located, and international operations.  Compliance to various laws and regulations can be a challenging task and head office may not have the full picture.

2. Variance in local cultures

Local cultures impact diversity management initiatives of multinationals. For instance, in Saudi Arabia, women sit separately in a room and do not mix with the men in office. In India, the number of local languages tend to group people of a state together. Hence, the status of embedding diversity management initiatives in head office and regional offices may differ significantly. Cultural integration may become difficult due to behavioral attitudes. For instance, Americans are more outspoken and aggressive in nature, whereas Indians are diffident and respectful. Due to these aspects, global communication and integration plans have to be adopted to local environment.

3. Anti-discrimination protection

The effectiveness of anti-discrimination protection is dependent on enforcing laws and the judicial environment in the country. For example, in US a number of discrimination cases are filed by employees and huge penalties are levied on the organizations. However, in India, though similar laws exist, there is hardly an instance where a case is filed by an employee on the basis of discrimination, as there is minimal possibility of employee winning the case against a large organization. To ensure same level of adherence is maintained at head office and regional offices, diversity management officers need to play a critical role.

 4. Increase in workplace violence

Globally and in India, workplace violence is increasing. Employees report increasing number of cases of bullying, harassment, sexual harassment and physical threats in various surveys. Here again, a group or individual  belonging to a specific race or religion may get mobbed by the majority, depending on the political climate in the country. Hence, the challenge for multinationals again is that similar laws may not exist in other countries. For example, India still doesn’t have an act passed on sexual harassment in workplace, though the bill has been pending in the parliament for sometime. Therefore, awareness levels of these issues differs in various countries. Multinationals, to bring uniformity need to have extensive training in regional offices and subsidiaries.

5. Mergers and Acquisitions

With the ongoing trend of multinationals acquiring companies in different countries, addressing diversity issues becomes critical. Mergers fail, due to failure in culture alignment and not because of failure in merging financial numbers. Post merger, for cultural integration one of the first things to do is devise a strategy for diversity management and implement the same.

Closing Thoughts

An extremely complex subject that impacts organizations especially those with international operations, at three levels – customers, productivity and staffing. However, it is often ignored by the management and definitely by risk managers and auditors. Very few risk managers do a human resource risk assessment, hence these problems continue to brew within the organization, till the culture becomes toxic or legal cases are filed. Hence, it is a good move to develop global and local diversity management strategies and implement the same. Indian organizations can take a leaf out of US organizations, and start appointing diversity management officers.

References:

Workforce diversity initiatives by US Multinationals in Europe – Mary Lou Egan.. Marc Bendick, Jr.